On Friday, the House of Representatives approved, and the President signed, the Emergency Economic Stabilization Act of 2008 (the “EESA”), which grants the U.S. Treasury Secretary (the “Secretary”) the authority to establish a program – to be known as the Troubled Asset Relief Program (or “TARP”) – to buy mortgage-related and other troubled assets in order to restore the capital base of financial institutions holding the troubled assets.
The version of the EESA passed by the House was the same as the version passed by the Senate earlier in the week. By Friday, 33 Democrats and 24 Republicans in the House who voted “no” on Monday decided to support the legislation. The shift in sentiment in all likelihood was prompted by a combination of fears of economic meltdown, calls from constituents reacting to equity market plunges following Monday’s “no” vote and to concerns over obtaining credit, and political cover provided by the Senate in the form of extensions of tax relief and an increase in the level of FDIC deposit insurance. Again underscoring the seriousness of the crisis and the importance attached to the rescue effort, the President signed the legislation within two hours of the House action.
We set out below the principal features of TARP. Note that a number of the details of how TARP will work are to be set out separately in program guidelines (due within 45 days of enactment).
- Up to $700 billion may be used to buy troubled assets from financial institutions. The money would be disbursed in tranches – $250 billion is to be available immediately, the next $100 billion is to be available upon certification by the President that it is needed, and the remaining $350 billion will become available (if needed) unless, within 15 days of the request, Congress objects through a joint resolution.
- Sellers of troubled assets (“participating institutions”) will be required, subject to a de minimis exception, to issue warrants to Treasury exercisable for nonvoting common or preferred shares, or voting shares as to which the Secretary will waive voting rights (or, in the case of participating institutions that are not listed in the United States, warrants for common or preferred shares or senior debt instruments).
- Participating institutions selling more than $300 million of troubled assets in an auction would be subject to limitations on the ability to provide new “golden parachute” arrangements to certain senior executive officers. Those institutions selling troubled assets directly, where Treasury has a meaningful equity participation, would be subject to limitations on golden parachutes. They would also be subject to limitations on compensation that increases risk-taking and provisions for bonus recapture where earnings or other statements later prove to be materially inaccurate. Separately, participating institutions with sales of more than $300 million (excluding sales made directly, if any such institution only sells directly) would not be entitled to tax deductions for annual compensation payable to their CEO, CFO and their three other most highly compensated officers in excess of $500,000 per covered employee.
- Treasury is to create a federal insurance program, the premiums for which are to be paid by participating institutions.
- Oversight is to be provided by a newly established Financial Stability Oversight Board, consisting of the Chairman of the Fed, the Secretary, the Chairman of the SEC, the Director of the Federal Housing Finance Agency and the Secretary of Housing and Urban Development, as well as by an Office of the Special Inspector General for TARP and a Congressional Oversight Panel.
- Judicial review of Treasury decisions will be available.
- The SEC will have authority to suspend the application of the mark-tomarket accounting standards in Statement of Financial Accounting Standards No. 157 (fair value measurements). The SEC is also directed to study the mark-to-market accounting standards and to report its findings to Congress within 90 days.
- In five years, if TARP has generated a shortfall, the President is to submit proposed legislation to recoup amounts from the financial industry to avoid adding to the deficit or national debt.
Key Elements of the EESA
The EESA has the following key elements:
Authority. The Secretary is authorized to purchase “troubled assets” from “financial institutions.”
Term. Authority in respect of TARP terminates on December 31, 2009, subject to extension until the second anniversary of enactment of the EESA. The authority to hold troubled assets is not subject to these termination dates.
“Troubled Assets.” Troubled assets are defined as residential and commercial mortgages and other securities, obligations and instruments based on or related to such mortgages, in any case originated or issued before March 14, 2008. The Secretary may treat other financial instruments as “troubled assets” if the purchase of the assets would promote financial market stability. In making such a determination, the Secretary would be required to consult with the Chairman of the Fed and provide notification to Congress.
“Financial Institution.” The term “financial institution” may also be interpreted broadly. The term includes any institution, including, but not limited to, any bank, saving association, credit union, securities broker or dealer, or insurance company “established” and regulated under the laws of the United States and that has significant operations in the United States. It excludes non-U.S. central banks. The use of the phrase “but not limited to” appears to permit the Secretary to include other types of institutions not specifically listed. In light of some of the other requirements of the EESA, such as the limitations on compensation and the obligation to provide equity participations, non-U.S. institutions will have additional issues to consider as they weigh the consequences of participation. The replacement of “organized” with “established” (from prior drafts) reflects input from the perspective of non-U.S. institutions, though the use of the term “licensed” may have been clearer.
Mechanisms. The EESA does not mandate how TARP will operate. Instead, the Secretary is to issue program guidelines no later than 45 days after enactment of the EESA or, if earlier, the end of the second business day after the first purchase under TARP. The guidelines are to address the mechanisms for asset purchases, the methods for pricing and valuing assets, procedures for the selection of asset managers and the criteria for identifying troubled assets for purchase. TARP is to ensure that assets are not purchased at a price higher than that initially paid for them by the selling institution.
The Secretary may hold assets to maturity or for resale, and may sell assets at prices to maximize the government’s return. The Secretary may also enter into securities loans, repurchase transactions or other transactions in respect of purchased troubled assets. Revenues and proceeds of sale, as well as from sale, exercise or surrender of warrants or senior debt received under TARP (see below), are to be applied to reduce the public debt.
The Secretary is to “encourage” private sector participation in purchases of troubled assets and in investment in financial institutions.
In making purchases, the Secretary is to purchase assets at the “lowest” price consistent with the purposes of the EESA. The Secretary may use auctions or reverse auctions and, where such mechanisms are deemed not feasible or not appropriate, may purchase troubled assets directly (using appropriate pricing measures). In determining whether to engage in direct purchases, the Secretary is to consider the long-term viability of the institutions in question.
Oversight. Oversight is to be provided by the newly established Financial Stability Oversight Board. The EESA also establishes an Office of the Special Inspector General for the Troubled Assets Relief Program and a Congressional Oversight Panel.
Insurance Program. If the Secretary uses the TARP authority to purchase troubled assets, the Secretary is required to establish a program to guarantee troubled assets issued or originated prior to March 14, 2008. Upon the request of a financial institution, the Secretary would guarantee principal and interest on troubled assets. Financial institutions that participate in the insurance program would pay premiums into a newly established Troubled Assets Insurance Financing Fund. Premiums could be based on credit risk of the assets being guaranteed. The Secretary is to publish the methodology for setting premiums by asset class.
Limits on Executive Compensation. The EESA imposes limits on executive compensation for financial institutions that participate in TARP. Institutions that sell assets directly rather than through an auction process would be subject to the following limitations:
- no compensation incentives for senior executive officers to pursue business strategies that pose excessive risk to the institution;
- a right on the part of the institution to recover bonuses and other incentives paid to senior executive officers based on reported results that subsequently prove to be materially inaccurate; and
- no golden parachute payments (undefined, but presumably include those described below) for senior executive officers while the Secretary holds an equity or debt position in the institution.
For purposes of these rules, covered officers are the CEO, CFO and three other highest paid executive officers, as presented in an SEC proxy statement (or its counterpart in the case of a private company).
Institutions that participate in auctions of troubled assets resulting in purchases (directly or through auctions) of more than $300 million would be barred from entering into new golden parachute arrangements for senior executive officers that would pay out on involuntary termination or insolvency events.
The EESA also provides for amendments to Section 162(m) of the Internal Revenue Code that, in effect, will limit participating institutions that sell assets in aggregate exceeding $300 million from deducting as an expense any compensation above $500,000 for each of the CEO, CFO and any of the three other highest paid officers in the institution. (Those that sell directly only would not count their sales towards the $300 million threshold.) Unlike the current Section 162(m) rules, the $500,000 deduction limit has no performance compensation exception.
Receipt of Equity/Debt Interests. The Secretary is directed, as a condition to buying troubled assets, to receive from participating institutions that are publicly traded in the United States, warrants for nonvoting common or preferred shares in the institution (or voting shares, as to which the Secretary would waive voting rights). With respect to participating institutions that are not publicly traded in the United States, the Secretary is to receive warrants for common or preferred shares or senior debt. The participation is to provide gains on sale and interest income for the benefit of taxpayers, as well as downside protection for asset sales. The Secretary can apply a de minimis exception (not to exceed $100 million) and such other exceptions/alternate arrangements where an institution cannot, as a legal matter, issue the securities in question.
Recoupment of Shortfall. Five years after the date of enactment of the EESA, the President must submit to Congress a proposal for recouping any losses incurred under TARP from the “financial industry” (prior drafts called for the burden to fall on participating institutions).
Many of the details of TARP will need to be worked out. And, as with any legislation that is rushed through against the backdrop of significant political pressure to “do something” and hardened positions, it remains to be seen whether in the short term confidence returns to the capital markets and whether the grip on market liquidity begins to loosen. (Keep an eye on the money market funds and the commercial paper market. Investors seeking safety in the ongoing crisis continue to pour money into Treasury bills, further driving down yields to close to zero.)
Over the medium term, understanding and clarifying the details of implementation will be paramount. How troubled assets are priced, particularly in a housing market where prices remain in free-fall, can have a substantial impact on the market as well as on balance sheets. Over the longer term, questions of cost and ultimate success will keep economists, analysts and regulators busy for years.
In the meantime, there is plenty to do to get TARP up and running. The EESA gives the Secretary unprecedented power not seen outside wartime emergency programs to administer TARP – involving decisions ranging from who will manage the assets Treasury purchases to how much Treasury will pay for those assets. What is clear is that Treasury will need to outsource most of the effort and, not surprisingly, attention has focused immediately on the administrative details:
- which senior Treasury official will supervise TARP;
- which asset mangers will run the auctions (reports cite five to ten as the targeted number of managers);
- how will asset managers manage conflicts of interests; and
- how will asset managers be compensated.
Expect decisions on the administrative details quickly. Treasury hopes to be in a position to begin purchases within six weeks. Attention will quickly shift to the program guidelines and, in particular, to the details of the auction mechanisms and the insurance program (including the actuarial models for assessing the premiums to be payable under TARP). Many of the challenges will come down to one imperative: how to place a value on distressed assets, the difficulty of which over the past 12 months has been at the heart of the crisis.
The tension will be between acting quickly and getting it right. All of this is happening in the context of deeply skeptical markets – the Dow fell 1.5% Friday and short-term credit markets remained largely frozen, placing an increasing burden on the ability to fund day-to-day operations. Meanwhile, the impact of the credit crisis on global economies is becoming increasingly evident in the announcements and developments being reported around the world on a daily basis – from unemployment figures to the weekend meeting of European leaders to consider a more coordinated response to the crisis in the EU following government rescues of four lenders this past week and a private effort in German that is reported to be jeopardy.
So, the devil will be in the details. Watch
- how the valuation/pricing mechanisms are addressed in the program guidelines;
- what data will be relied upon in executing the auctions and how will that data be made available to Treasury;
- whether Treasury will also purchase Tier I preferred or similar instruments, as was done this week to rescue Fortis as well as historically in Japan and Sweden in response to their respective banking crises; and
- the implications of the equity participation requirement, and how the combination of the troubled assets and equity participations will be priced relative to the cash provided by Treasury: Will both be sold for fair value, or would Treasury have been better off getting a more readily saleable senior debt instrument? Will Treasury be able to overpay for assets and get the warrants as well? Or are the warrants the equivalent of a penalty, with the assets and warrants expected to exceed the amount of the purchase price?
The markets will also be watching how all of this will be paid for, particularly in the context of the existing budget deficit.
Certain Other Developments
FDIC deposit insurance. As part of the package of additional items added to the EESA in anticipation of the Senate vote, the level of FDIC deposit insurance was raised from $100,000 to $250,000.
Short sales. The SEC issued guidance on its emergency short sales prohibitions and issued additional guidance regarding the sale of loaned but recalled stock. It also extended its September 17 and 18 emergency relief as follows:
- • the short sale prohibitions in respect of the specified institutions (on the list initially of 799 financial institutions, but since enlarged) are extended to 11:59 p.m. ET on October 8 (clarified in a release issued late Friday);
- the Form SH reporting requirements are extended to 11:59 p.m. ET on October 17, but the SEC has indicated that these requirements will continue after that date in the form of an interim final rule, pending a comment period and final rulemaking;
- the relief for issuer repurchases (under Rule 10b-18) is extended to 11:59 p.m. ET on October 17; and
- the hard T+3 close-out requirements for naked short selling are extended to 11:59 p.m. ET on October 17, but the SEC has indicated that these requirements will continue after that date in the form of an interim final rule, pending a comment period and final rulemaking.
In the extension order for Form SH reporting, the SEC indicated that Form SH filings would remain nonpublic indefinitely (and not just for two weeks), without requiring the submission of a confidential treatment request.
Money market funds. On September 29, Treasury opened its Temporary Guarantee Program for Money Market Funds. Under the program, Treasury will guarantee the $1 share price of eligible money market funds (including both taxable and tax-exempt funds) that apply and pay a fee to participate in the program. The program provides coverage to shareholders for amounts held in participating money market funds as of the close of business on September 19, 2008, and the guarantee will be triggered if a participating fund’s net asset value falls below $0.995 per share, which is referred to as “breaking the buck.” Funds that broke the buck before September 19, 2008 are not eligible for the program. Following an initial three month term, the Secretary will have the option to renew the program through September 18, 2009. The program is being funded through Treasury’s Exchange Stabilization Fund, which currently has approximately $50 billion in assets. .
Credit default swaps. Last week, the SEC Chairman, following the lead of New York State, turned his attention to credit default swaps (“CDS”) and other credit derivatives and urged Congress to provide the SEC with the authority to regulate these instruments. The Governor of New York announced that New York State would regulate CDS, at least to the extent that the buyer of the CDS protection owns the underlying reference security. In these cases, the seller of the protection would be deemed to be selling insurance and required to be licensed in the State of New York under the New York State Insurance Law. These requirements would not apply where the buyer, at the time the swap is entered into, does not hold, or reasonably expect to hold, a “material interest” in the reference obligation (as contemplated by guidelines issued by the New York State Department of Insurance in Circular No. 19 (“Best practices for financial guaranty insurers”)).
Industry participants are in discussions with the NYS Insurance Department regarding a range of issues relating to implementation of the proposed regulation of covered CDS, including whether it will be prospective only and what other instruments might be brought within the scope of the initiative. How individual State initiatives will mesh with possible Federal action, as well as voluntary industry action, remains an open question.
Minority investments in banks. In another sign of the times, the Federal Reserve issued a policy statement on equity investments in banks and bank holding companies, which sets forth its views on the general question of when a minority investor (holding 10.0% - 24.9% of voting stock) in a bank or bank holding company would become subject, by reason of the investment, to supervision, regulation and other requirements applicable to bank holding companies under the Bank Holding Company Act and related regulations. However, the Fed left for another day application of its views on control to a group of multiple investors making a contemporaneous investment in a bank or bank holding company. The principal concern of minority investors has not been triggering the bright line tests (control over, or the power to vote, 25% of voting securities or controlling the election of a majority of the board), but rather on the limits of the third prong: a determination that an investor exercises a “controlling influence” over management or policies. The policy statement addresses board representation, total equity ownership, consultation with management, business relationships and covenant protection.
Elimination of the CSE program. On Friday, the SEC announced the elimination of the Consolidated Supervised Entities (“CSE”) program, which was established in 2004 as a way for global investment banks to avoid regulation abroad by voluntarily submitting to SEC oversight. Under the program, the SEC had responsibility for the oversight of capital, leverage and liquidity levels at investment bank holding companies like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns – authority that went far beyond the agency’s traditional regulation of broker-dealers. The decision to eliminate the CSE program was a tacit concession that the SEC does not have the expertise or the resources to regulate these financial institutions on an entity-wide level. Going forward, in the newly reconstituted landscape of U.S. financial institutions, all of the surviving investment banks that were part of the CSE program will be subject to statutory supervision by the Federal Reserve under the Bank Holding Company Act.
Mark-to-market accounting. In the face of significant criticism of the mark-tomarket accounting rules (SFAS 157 – fair value adjustment) and calls from some quarters to suspend them, the SEC and the FASB issued a clarification on mark-to-market accounting, ahead of release by the FASB of further guidance.