On July 8, 2009, after several months of little public comment, the Treasury, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation issued a joint statement (the "Joint Statement") concerning the Legacy Securities Public-Private Investment Program (the "Legacy Securities Program").1 The Treasury also released an updated version of the Legacy Securities Program Frequently Asked Questions (the "FAQs").2 This client alert briefly summarizes and analyzes the material provisions of the Joint Statement and the FAQs, which together provide significant new information concerning the Legacy Securities Program.
The Legacy Securities Program is a plan that joins the forces of public and private investment to facilitate the creation of a market for the sale of certain illiquid securities by eligible financial institutions. The program provides for the establishment of public-private investment funds ("PPIFs"), each of which is to be managed by a qualified fund manager selected by the Treasury. The Treasury will match equity capital raised by the PPIFs from private investors and will also provide debt financing for the PPIFs. The PPIFs will initially be permitted to invest only in commercial mortgage-backed securities and non-agency residential mortgage-backed securities that were issued prior to 2009 that were originally rated "AAA" or an equivalent rating by two or more rating agencies and that are secured directly by the actual loans, leases, or other assets and not other securities ("Eligible Assets").3
I. The Selection of PPIF Fund Managers
The Joint Statement announces the nine firms, out of a pool of over 100 applicants, that have been pre-qualified by the Treasury to serve as PPIF fund managers for the initial round of the Legacy Securities Program. Those nine firms are as follows:
- AllianceBernstein, LP and its sub-advisors Greenfield Partners, LLC and Rialto Capital Management, LLC;
- Angelo, Gordon & Co., L.P. and GE Capital Real Estate;
- BlackRock, Inc.;
- Invesco Ltd.;
- Marathon Asset Management, L.P.;
- Oaktree Capital Management, L.P.;
- RLJ Western Asset Management, LP.;
- The TCW Group, Inc.; and
- Wellington Management Company, LLP.
The firms were chosen on the basis of criteria previously established by the Treasury, including: (i) demonstrated capacity to raise at least $500 million of private capital; (ii) demonstrated experience investing in Eligible Assets, including through performance track records; (iii) a minimum of $10 billion (market value) of Eligible Assets under management; (iv) demonstrated operational capacity to manage the PPIF in a manner consistent with Treasury's stated investment objective while also protecting taxpayers; and (v) being headquartered in the United States. The Treasury conducted extensive legal, compliance and business due diligence prior to pre-qualifying the selected fund managers. The due diligence process included presentations by firm management and limited partner reference calls, as well as an extensive analysis of actual and potential conflicts of interest (as further described in Section III, below).
The Joint Statement emphasizes the importance to the Treasury of providing a role for small-, veteran-, minority- and women-owned businesses in the Legacy Securities Program and states that the selected managers have established "meaningful partnership roles"4 with ten such businesses, including in the areas of asset management, capital raising, broker-dealer services, investment sourcing, research services, advisory services, cash management and fund administration. Those ten businesses are as follows:
- Advent Capital Management, LLC;
- Altura Capital Group LLC;
- Arctic Slope Regional Corporation;
- Atlanta Life Financial Group, through its subsidiary Jackson Securities LLC;
- Blaylock Robert Van, L.L.C.;
- CastleOak Securities, LP;
- Muriel Siebert & Co., Inc.;
- Park Madison Partners LLC;
- The Williams Capital Group, L.P.; and
- Utendahl Capital Management.
In addition, the Joint Statement stresses that there will be further opportunities for the pre-qualified fund managers to partner with small-, veteran-, minority- and women-owned businesses in the future.
The Treasury has negotiated term sheets with each PPIF fund manager setting forth the terms of the Treasury's equity investment in the PPIFs as well as the terms of the debt financing to be provided by the Treasury.5 The Treasury is continuing to negotiate final documentation with each fund manager and expects to announce the formation of the first PPIF in early August 2009.
II. The Economic Terms of the Public-Private Investment Funds
Each PPIF fund manager will have twelve weeks to raise at least $500 million from private investors for investment in the PPIF. Each fund manager will also be required to invest, directly or through its affiliates, a minimum of $20 million of its own funds in the PPIF (which amount may be included for purposes of reaching the $500 million minimum referred to in the previous sentence). The Treasury will make an equity investment in the PPIF equal to the aggregate of the amounts contributed by private investors and the amount contributed by the fund manager or its affiliates (up to certain limits). In addition, the Treasury intends to provide limited recourse debt financing for each PPIF in an amount up to 100% of the total equity contributed to the PPIF. However, the Joint Statement indicates that the total amount of equity contributed and debt financing provided by the Treasury to all PPIFs in the aggregate will not exceed $30 billion.
In addition to the debt financing provided by the Treasury, PPIFs will be permitted to seek additional loans for the purchase of assets from private sources as well as through the Federal Reserve Board's Term Asset-Backed Loan Facility ("TALF"), which has recently been expanded to provide financing for the purchase of certain high quality commercial mortgage-backed securities issued prior to 2009.6 At this time, however, residential mortgage-backed securities are not eligible to be financed under TALF, and therefore loans for the purchase of that class of Eligible Assets will be limited to the Treasury debt financing described in the preceding paragraph and financing that can be acquired from private sources. The Joint Statement, indicates, however, that the Federal Reserve Board and the Treasury are continuing to assess the possibility of expanding TALF to include as eligible collateral residential mortgage-backed securities issued prior to 2009.
The PPIFs will be structured such that their size can be quickly expanded if such expansion is warranted by deteriorating market conditions. The Joint Statement makes clear that the Treasury is willing to increase the amount of government resources committed to the Legacy Securities Program if market conditions warrant such an increase.
As currently structured, resecuritizations of Eligible Assets are not eligible for purchase by PPIFs under the Legacy Securities Program. The Treasury should consider expanding the definition of Eligible Assets to permit the purchase of the senior classes of such resecuritizations by PPIFs (including resecuritization transactions closed in 2009, provided that the underlying assets were issued prior to 2009 and otherwise qualify as Eligible Assets). Typically, these resecuritizations are straightforward transactions pursuant to which a single class of senior certificates and a single class of subordinate certificates are issued, which are backed by mortgage-backed securities that were initially rated "AAA". These structures have become very popular in recent months, as they enable the owners of mortgage-backed securities to effectively reestablish the initial "AAA" rating with respect to a portion of such mortgage-backed securities.They should not be confused with more complicated collateralized debt obligation transactions, which typically involved the repackaging of pools of mortgage-backed securities that were initially rated below investment grade. Permitting the purchase of the senior classes of such resecuritizations would significantly expand the ability of PPIFs to obtain beneficial ownership Eligible Assets, albeit in an indirect manner.
III. The Legacy Securities Program Conflicts of Interest Rules and Ethical Guidelines
Both the Joint Statement and the accompanying FAQs stress the importance to the Treasury in pre-qualifying PPIF fund managers of ensuring compliance with the Legacy Securities Program Conflicts of Interest Rules and Ethical Guidelines (the "Guidelines").7 The Guidelines were developed by the Treasury in consultation with the Special Inspector General for the Troubled Asset Relief Program, the compliance staff of the Federal Reserve Bank and the prospective fund managers. Their primary purpose is to protect taxpayer funds that will be invested in the PPIFs.
The Guidelines require all PPIF fund managers to abide by specific conflicts of interest rules and ethical guidelines, which include the following:
- Each PPIF is prohibited from buying Eligible Assets from or selling Eligible Assets to (i) any affiliate of the fund manager (including other affiliated investment funds), (ii) any other PPIF managed by a different fund manager or (iii) any investor that has invested 10% or more of the aggregate private capital raised by the PPIF.
- In order to align the interests of the fund manager and the investors in the PPIF, each fund manager must (i) invest a minimum of $20 million of firm capital in the PPIF it manages,8 (ii) permit co-investment in the PPIF by fund manager staff and (iii) demonstrate that its compensation system aligns the economic interests of the individuals that manage the PPIF with the economic interests of the investors in the PPIF.
- Each fund manager is required to be a registered investment advisor that has adopted policies and procedures to comply with the Investment Advisers Act of 1940, to maintain strict internal policies regarding ethics and compliance and to maintain independent auditors and corporate governance processes.
- In order to ensure that no fund manager is purposefully disadvantaging the PPIF relative to other investment funds, each fund manager will be required to maintain an independent compliance department that reports on all trading of Eligible Assets among the fund manager's "family of funds".9
- All PPIFs must maintain stringent policies relating to personal conflicts of interest and all key employees of the fund manager must abide by an approved code of ethics and personal trading policy. Fund managers may not have "pay-to-play" arrangements with any placement agent, underwriter or other service provider and the PPIFs may not trade through any broker-dealer that is affiliated with the fund manager.
As part of the process of pre-qualifying the selected fund managers, the Treasury took steps to investigate and mitigate any actual or potential conflicts of interest that could affect a PPIF. This process required the prospective fund managers to identify conflicts of interest and to describe how each intended to avoid or mitigate such conflicts. In addition, all prospective fund managers selected as finalists were required to complete detailed diligence questionnaires addressing conflicts of interest and corporate governance issues and to discuss their responses in depth with the staff of the Treasury, the Federal Reserve Bank of New York and the Special Inspector General for the Troubled Asset Relief Program.
IV. Additional Updates to the Terms of the Legacy Securities Program
The Joint Statement and the accompanying FAQs expand upon several other aspects of the Legacy Securities Program that may be of interest to potential participants in the program.
Subject to the fund manager's fiduciary duties to the PPIF, the general partner's independent analysis of its duties to the partnership and the overall objective of maximizing the value of the PPIF's investments, the fund manager and the general partner will be required to take certain steps to promote participation by mortgage loan servicers and trustees in the Treasury's Making Home Affordable Program (the "Home Affordable Program"). Generally, the PPIFs, as owners of Eligible Assets, will be expected to consent to reasonable requests by servicers or trustees to include the loans underlying such Eligible Assets in the Home Affordable Program and to approve the implementation of other reasonable loss mitigation measures. If a PPIF owns 100% of the residential mortgage-backed securities that are backed by a particular pool of mortgage loans, and the related servicer or trustee participates in the Home Affordable Program, the PPIF will be expected to instruct such servicer or trustee to include such pool in the Home Affordable Program. The ability to implement this feature may be limited by the requirement to invest only in securities that were initially rated "AAA". Presumably, the subordinate securities issued which were not rated "AAA" would have to have had their balances reduced to zero through losses. Non-economic REMIC residuals may also need to be acquired for their consent as well.
Foreign entities will be welcome to invest in the PPIFs, which is in keeping with the goal of the Legacy Securities Program to attract the maximum amount of private investment in order to maximize the program's impact on the distressed asset market. However, no private investor (whether domestic or foreign) may contribute more than 9.9% of the total equity of the PPIF. Sellers of Eligible Assets to PPIFs must generally be financial institutions that are established and regulated10 in the United States and that have significant operations in the United States. However, the FAQs provide that foreign governments11 may sell to PPIFs if their ownership of the Eligible Assets results from the failure of eligible financial institutions or the default by such financial institutions on financings provided by such foreign governments.
The FAQs address the inclusion of retail investors in the Legacy Securities Program. The Treasury continues to express a desire for direct retail investment in the PPIFs in order to increase capital availability. The Treasury, acknowledges, however that such retail participation will require compliance with applicable securities laws and approval by the Securities and Exchange Commission.12 However, we note that in connection with the Legacy Securities Program, many of the fund managers who were pre-qualified have recently filed registration statements for the creation of public mortgage real estate investment trusts, the prospectuses of which state an intention to invest in the PPIF. These registration statements, if approved, may permit indirect public investment in the PPIFs.
V. Update on the Legacy Loans Public-Private Investment Program
The Joint Statement and the accompanying FAQs also discuss the status of the Legacy Loans Public-Private Investment Program (the "Legacy Loans Program"). Although recently published information has cast some doubt on the future of the Legacy Loans Program, the Joint Statement emphasizes that the Federal Deposit Insurance Corporation (the "FDIC") remains committed to developing the program for open banks. The design of the Legacy Loans Program has been modified to incorporate comments received during the public comment period earlier this year. The FDIC intends to test the Legacy Loans Program through a sale of receivership assets sometime this summer, bids for which will be solicited in July.
The selection of pre-qualified PPIF fund managers and the establishment of certain specific terms for the PPIFs is a significant step towards the implementation of the Legacy Securities Program. While certain aspects of the Legacy Securities Program require further elaboration, we are optimistic that the program will soon become a valuable tool for increasing liquidity in the market for distressed mortgage-backed securities.