The federal government is acting with unprecedented speed to use the powers granted to it in, and perform its obligations under, the Economic Emergency Stabilization Act passed into law earlier this month. The scope of EESA and the actions taken by the Treasury Department, the federal banking agencies, the SEC, the IRS and others since the beginning of October is too wide-ranging for a complete summary. The following is a brief synopsis of some of these developments.
Rolling Out the TARP
The most visible aspect of EESA—the grant of authority to the Treasury Department to spend billions of dollars in buying or insuring troubled securities assets and mortgages—is the Troubled Assets Relief Program. The initial size of the TARP is $250 billion. The TARP could involve a wide range of financial companies, including banks, securities firms and insurance companies, even foreign entities with significant U.S. operations. Troubled assets include mortgages and mortgage-related securities that were originated before March 14, 2008. EESA also permits the Treasury Department to acquire other “financial instruments” upon notice to Congress. This is the aspect of EESA that authorizes the direct capital investments that the Treasury Department is making in U.S. banks.
Although the Treasury Department has approved outside contractors, including auction experts, investment advisors and custodians for the TARP, and created various policy teams to identify troubled assets and create TARP program rules, those actions are ongoing. Most importantly, the Treasury Department needs to develop a method to value troubled assets that will not “unjustly enrich” the participants. TARP rules are to be finalized by mid-November at the latest.
On October 14, 2008, the Treasury Department announced the TARP Capital Purchase Plan by which it would make direct investments of up to $250 billion in U.S. financial institutions. A total of nine major financial institutions have agreed to the terms of proposed investments in an aggregate amount of $125 billion. The other $125 billion remaining in the initial TARP allocation is expected to be invested in small and medium sized banks who apply to participate in the CCP before November 14, 2008. Unlike the TARP itself, the CCP is limited to U.S. banks, thrifts, bank holding companies and some thrift holding companies. Most notably, and despite the loans the Treasury Department recently made to AIG (and a related controlling equity position), insurance companies are not eligible to participate in the CCP.
The Treasury Department has published a standardized term sheet for the preferred stock and warrants it would receive under the CCP (available on the Treasury Department’s website). Principal terms of the preferred stock include:
- the amount invested cannot be less than 1% of the participant’s risk-weighted assets or more than 3% of risk weighted assets.
- the preferred stock will carry quarterly dividends of 5% per year which increases to 9% after five years.
- the preferred stock is non-voting, but includes rights to elect two directors if dividends are not paid for six consecutive quarters.
- the preferred stock is callable at par after three years or earlier with the proceeds of a replacement equity issue.
- participants cannot increase dividends on common stock or repurchase common stock for three years.
- the preferred stock (and warrants) must be covered by a resale shelf registration statement as soon as practicable and will also carry piggyback registration rights.
The warrants will permit the Treasury Department to buy the participant’s common stock at current market values for up to ten years. The number of shares of common stock that can be purchased by exercising the warrants will have an aggregate current market value equal to 15% of the amount of the preferred stock investment. The number of warrants would be reduced by 50% if the participant successfully raises equity capital equal to the CCP investment by the end of 2009.
Cost of Participation
Judged by the financial terms alone, participation in the CCP is likely to appeal to many financial institutions. However, the conditions attached to participating include limits on the participant’s executive compensation arrangements during the time that the CCP investment is on the books. In an extremely truncated form, these include:
- participants will have to modify any existing executive compensation arrangements that need to be changed to conform to the CCP’s requirements;
- the executives who are “named executive officers” for proxy statement purposes will be subject to a “clawback” similar to Section 304 of Sarbanes-Oxley (which only applies to the CEO and CFO);
- no “golden parachute” severance payments can be made to a named executive officer for “involuntary terminations,” even if the executive’s agreement would have entitled him or her to terminate employment for “good reason” and receive severance;
- the participant must agree to limit its compensation deduction for any named executive officer in a single year to $500,000, with no exception for deferred compensation or performance-based compensation; and
- additional responsibilities will be placed on compensation committees to ensure that incentive compensation arrangements with the named executive officers do not encourage them to take unnecessary or excessive risks.
FDIC Guarantee Programs
In an effort to break the logjam in the interbank credit market, the FDIC announced on October 14, 2008 that it will guarantee (1) any newly-issued senior unsecured debt issued by an eligible institution on or before June 30, 2009 and (2) funds in non-interest bearing transaction accounts held by FDIC-insured banks through December 31, 2009. Participation in the senior debt guarantee program is limited to FDIC-insured financial institutions, bank holding companies and some thrift holding companies. The amount of senior debt that can be guaranteed is limited to 125% of the participant’s debt that was (1) outstanding on September 30, 2008 and (2) scheduled to mature on or before June 30, 2009.
The guarantees would last up to three years and the issuer will have to pay the FDIC an annualized 75 basis points for the senior debt guarantees and 10 basis points for the guarantee of non-interest bearing transaction deposit accounts.
IRS Eases Ownership Change Rules in Bank Acquisitions
On September 30, 2008, the IRS issued guidance that significantly changes tax rules that have limited the ability of an acquiring bank to use a target bank’s unrealized losses to reduce post-acquisition taxable income. Until further action by the IRS, any deduction properly allowed to a bank that is acquired in a stock purchase or tax-free transaction will no longer be subject to the ownership change limitations under Section 382(h) of the Internal Revenue Code.
This allows a target bank’s losses on loans or bad debts (including reasonable additions to a reserve for loan losses) to be used to reduce the acquiring bank’s post-acquisition taxable income. The unrealized losses that can be taken over would not include losses on real estate, derivatives and, possibly, mortgage-backed securities.
It is not clear if the guidance is intended to have retroactive effect. It would not apply to acquisitions that are a taxable asset acquisition.
Challenges to “Mark-to-Market” Accounting
“Fair value” accounting has been tagged as one of the contributing factors to the financial crisis. As prices of certain investments, most notably mortgage-backed securities and auction rate securities, have fallen and markets stopped functioning, many companies have reported write-downs in asset values in accordance with Statement of Financial Accounting Standards No. 157, “Fair Value Measurements.” “Fair value” accounting under FAS 157 is intended to report the market value of assets and liabilities as opposed to historic or future values. FAS 157 establishes a framework for determining fair value and mandates expanded disclosures. It relies on concepts such as “orderly transactions” and a “principal market,” terms that have had less meaning for valuing distressed sales in inactive markets.
In recent months, many financial institutions and others found themselves with a need to improve liquidity by selling troubled assets at increasingly reduced prices. These in turn have established increasingly lower market floors for determining market value of comparable securities—creating a downward spiral. These problems were evident when the markets for auction rate securities—viewed by many as almost as liquid as cash—began failing earlier this year.
In late September, the SEC and the Financial Accounting Standards Board (FASB) issued a joint statement providing guidance on determining fair value in today’s markets. The guidance indicates that sales made in disorderly markets are not determinative of the fair value of similar securities. The guidelines also addressed the factors that should be taken into account in deciding whether an asset is “other than temporarily” impaired. These include the amount of the decline in the asset’s value, how long it would take for the asset to recover from the decline, the probability of recovery, how long the decline has existed and whether the company holding the asset has the ability to retain it until the anticipated recovery occurs.
International accounting authorities recently provided similar guidance with respect to international accounting standards.
In EESA, the Congress expressly confirmed the SEC’s authority to suspend FAS 157 if the SEC found it to be appropriate and in the public’s interest. The SEC has not exercised this authority. EESA also directs the SEC to study fair value accounting and provide a report by January 2009. The SEC will be holding public roundtables on the issue in the near future.
Finally, on October 10, 2008, the FASB provided additional guidance directed to banks with respect to valuing assets in a distressed market. This latest guidance is generally consistent with the earlier joint statement from the SEC and FASB. The new guidance repeats the concept that distressed sales or forced liquidations are not orderly transactions and therefore are not an accurate measure of fair value; yet, at the same time the FASB is clear that, even in times of market dislocation, not all sales represent distressed sales or forced liquidations. Reporting companies are left with the need to consider all of the facts and circumstances surrounding a particular investment and use significant judgment when determining if a sale is an orderly transaction or not. Not much more is expected on this subject until the SEC releases its mandated report.
Despite the multitude of actions taken in the past few weeks, there is much that remains to be resolved by the next Congress and administration. The challenges that will face them include the wholesale restructuring of how we regulate financial companies and the markets they operate in. Current risk management systems will need to be changed to reflect the realities of the international economy.