President Bush recently signed the Emergency Economic Stabilization Act of 2008. Although both the implications and effects of the current financial crisis and this Act are far reaching, Congress intentionally limited the lifespan of the Act. It will expire Dec. 31, 2009, absent an extension. The Treasury Department will have an unprecedented challenge in terms of unraveling the damage done to America’s financial markets and institutions over the last decade.
The Act’s purpose is (1) to provide the Secretary of the Treasury the means to restore liquidity and stability to the United States’ financial system; (2) protect home values, college funds, retirement accounts and life savings; (3) preserve homeownership; (4) promote jobs; (5) promote economic growth; (6) maximize returns to U.S. taxpayers; and (7) provide public accountability. To accomplish these objectives, Congress has created the “Troubled Asset Relief Program” (“TARP”), which will be run by the United States Department of Treasury. The Secretary of the Treasury’s authority will be very expansive. For example, although Congress has told the Secretary what he is to accomplish and generally how to do it, the details were left to the Secretary. Still, the Act addresses a number of issues important to asset buyers, sellers and servicers. Some key aspects of the Act are discussed below.
The Secretary’s Powers in Carrying out the Purpose of the Act
To expedite the implementation of the TARP, the Act gives the Secretary some discretion to begin buying troubled assets and carrying out the purposes of the Act even before all necessary regulations are promulgated and guidance documents are issued. Thus, at least initially, the TARP program is likely to be run on more of an ad hoc basis than a bureaucratic one. The Act also allows the Secretary to exercise the equitable and debt rights it receives when it purchases troubled assets. This potentially allows the Secretary to pursue legal remedies against parties that originated, packaged and sold securities, if in his discretion, the Secretary deems this action necessary to minimize the bailout’s impact on taxpayers.
Impacted Financial Institutions and Troubled Assets
The best known and noteworthy aspect of the Act is the $700 billion Congress has made available to the Secretary to purchase and insure “troubled assets” from “financial institutions.” Congress estimated that it would take this much money to stabilize America’s financial institutions and prevent the continued disruption of America’s economy.
Congress has defined the “financial institutions” covered under the TARP to include: banks, savings associations, credit unions, security brokers or dealers, and insurance companies. Moreover, Congress gave the Secretary the flexibility to expand this definition to include securitization vehicles. Covered financial institutions must be regulated under federal or state law (or the laws of U.S. territories) and have significant operations in the U.S.. The Act specifically excludes foreign central banks and financial institutions owned by foreign governments from taking advantage of the TARP. However, the Secretary may have discretion to purchase troubled assets held by foreign institutions, but only if he believes it necessary to accomplish the Act’s goals.
Congress defined “troubled assets” as (1) pre- March 14, 2008, residential or commercial mortgages and securities (or other obligations) whose purchase will promote financial market stability; and (2) any other financial instrument that both the Secretary and the Federal Reserve Chairman agree (with written notice to appropriate Congressional oversight committees) whose purchase will promote financial market stability. Without doubt, Congress has given the Secretary extremely broad authority to decide what “troubled assets” should be purchased to stabilize the nation’s economy.
Buying and Selling Troubled Assets
While Congress has allotted $700 billion to bail out the financial markets, it is making this money available in stages. The Secretary has immediate access to $250 billion. The next $100 billion will be made available after the President notifies Congress of the need for additional money. The Secretary will receive access to the remaining $350 billion only after both Presidential notification to Congress of the need and a report to Congress of how he will use those funds. Congress, however, gave itself the ability to deny access to these funds if it passes a joint resolution of disapproval within 15 days of receipt of the Secretary’s report. In 2013, the government will prepare a report about the money that has flowed through the TARP and to explore potential ways to recover any program shortfall from the financial industry so as to not add to the national debt.
Once the Secretary has access to these funds, he is to create the means through which the TARP will purchase “troubled assets” and issue obligations. For example, the Secretary may use auctions or reverse auctions. Such auctions, however, have been controversial because of the difficulty associated with pricing illiquid assets. The Secretary is required to make available in electronic form the description, amount and pricing of assets acquired under the TARP, within 48 hours of any purchase, trade or disposition of troubled assets, to ensure program transparency.
When creating various means to purchase troubled assets, the Secretary is required to make the best use of the funds available to ensure the long-term viability of the nation’s financial institutions. Thus, some ongoing financial businesses may be allowed to fail. The Secretary is additionally charged with preventing institutions from unjustly profiting from the sale of troubled assets to the TARP. Finally, the Act allows the Secretary to sell, enter into securities loans, and enter into repurchase transactions and other types of financial transactions with respect to the troubled assets. However, when the Secretary sells these troubled assets, he is not limited to any specific market pricing mechanisms.
Restrictions and Requirements Placed on Financial Institutions Participating in the TARP
The Act places two significant requirements on sales of troubled assets by financial institutions to the TARP. First, the Secretary may not purchase or commit to the purchase of troubled assets from any financial institution unless the government also receives an equity stake in the institution (i.e., non-voting common stock, or preferred stock or voting stock in which the Secretary agrees not to vote) or a senior debt instrument (or stock) if the financial institution is not publically traded. The government can, at its discretion, sell or otherwise dispose of these instruments.
An institution’s decision regarding whether to participate in the TARP and to what extent, will likely be contingent on the amount of equity or the size of the debt instrument the Secretary will require. The Act requires the Secretary to obtain enough equity or debt to cover the government’s potential losses when it ultimately sells the troubled assets. Likewise, the Act requires that any warrant received include anti-dilution provisions and an exercise price set by the Secretary. If the cumulative amount of troubled assets purchased from any one institution is less than $100 million, the Act requires the Secretary to establish de minimus exceptions to these requirements. In situations where a financial institution is prohibited from creating debt or equity instruments, the Secretary must create alternative requirements allowing TARP participation.
In addition to the equity or debt requirement, if there is no bidding process or market price available to appropriately price the troubled asset, the Secretary must require that the “financial institution meet appropriate standards for executive compensation and corporate governance.” This means that the financial institution must: (1) limit executive compensation to exclude incentives to take unnecessary and excessive risks; (2) require the financial institution to attempt to recover any past bonus or compensation paid to a senior executive officer based on financial statements that later prove to be materially inaccurate; and (3) prohibit golden parachute payments. Different rules apply to financial institutions that sell more than $300 million in troubled assets, including a prohibition from entering into new employment contracts with golden parachute provisions. Additionally, the Act amends the Internal Revenue Code to lower the limit these financial institutions can deduct for compensation paid to their five most highly compensated executive officers from $1 million to $500,000 (including deferred compensation). It also amended the Code to apply an excise tax on all severance payments made to a financial institution’s CEO, CFO and the other three most highly paid executive officers upon involuntary termination, bankruptcy, insolvency or receivership of the institution. Given these requisites on a financial institution’s executive officers’ personal finances, it remains to be seen how they will impact decisions to participate in the TARP and at what level.
The Private Sector’s Role
The Secretary is directed to encourage the private sector to participate in the purchase of troubled assets and to invest in financial institutions. The Act gives him flexibility to take advantage of private sector equity. Thus, given the size and scope of the TARP, opportunities will abound for many private funds.
For example, the Act allows the Secretary to enter into private sector service agreements and to designate financial institutions as agents for the federal government. This includes creating a streamlined process for the awarding of contracts for asset managers, servicers, property managers and other providers. This streamlined process is accomplished by a Federal Acquisition Regulation waiver, but the Secretary must ensure that minorities and women are a part of this process.
Abrogation of Standstill and Confidentiality Agreements
The Act voids contractual provisions that limit the ability of a party that performs due diligence on an institution to later bid on that institution’s receivership.
Guarantee of Troubled Assets
In addition to buying troubled assets, the Act requires the Secretary to create a program that will guarantee these assets. This allows the Secretary, at the request of a financial institution, to guarantee the timely payment of up to 100 percent of a troubled asset’s principal and interest. Of course, the terms and conditions of the guarantee are to be set by the Secretary.
This aspect of the TARP program is to be funded by premiums paid by participating financial institutions. The premiums are to be set to create sufficient reserves to cover the anticipated claims on these guarantees. However, there is some doubt as to whether this program will be used, given these funding requirements.
Public Disclosure of Information
If the Secretary determines the current public financial disclosures do not accurately describe a TARP-participating institution’s true financial position, the Act gives him the discretion to recommend to the appropriate regulatory authority that that financial institution be required to provide additional disclosures about such items as off-balance sheet transactions or contingent liabilities.
One of the goals of the Act is to minimize future foreclosures. It, therefore, requires the Secretary to create and implement a plan to maximize the assistance to homeowners and encourage servicers of underlying mortgages to take advantage of programs that will minimize foreclosures. It also requires the Secretary to consent to reasonable mortgage modifications (i.e., adjusting the rate, principal and/or term of the mortgage). He is also authorized to use loan guarantees and credit enhancements to prevent foreclosures.
Temporary Increase of the Cap on Deposit Insurance
The Act provides that the cap on the deposit insurance for depository institutions and credit unions is increased from $100,000 to $250,000 until Dec. 31, 2009.
The Act made two other important changes to the Internal Revenue Code. First, the Act provides that gains or losses by certain financial institutions from the sale or exchange of Fannie Mae or Freddie Mac preferred stock held on Sept. 6, 2008 or sold between Jan. 1, 2008 and Sept. 7, 2008 will be taxed as ordinary income or loss. Second, it extended the rule that gross income does not include income from the discharge of “qualified principal residence indebtedness” through Dec. 31, 2012.
Legal Review and Oversight
The Secretary’s actions are subject to review under the Administrative Procedures Act. However, the Act limits the type of actions and injunctive relief available to financial institutions that sell troubled assets under the TARP. To oversee the TARP, the Act created a Financial Stability Oversight Board and an independent Special Inspector General.