October 2, 2008
We are pleased to provide our clients and friends with a section-by-section analysis of the Emergency Economic Stabilization Act of 2008 (hereinafter, the "Act") as passed by the Senate, by a vote of 74-25, on October 2, 2008. The section-by-section analysis includes commentary from experts on Gibson, Dunn & Crutcher LLP’s Financial Markets Crisis Group. We hope you find it useful as you work through the challenges and opportunities posed by the market crisis and the government’s response.
On a procedural note, the Senate used H.R. 1424, which was a resolution to amend the Employment Retirement Security Act to include mental health parity provisions, as a vehicle to pass the Emergency Economic Stabilization Act. As passed by the Senate, the bill also included energy and tax extender provisions. We have not included those provisions in this analysis.
Division A – Emergency Economic Stabilization
Sec. 1: Short Title and Table of Contents
Sec. 2: Purposes
Sec. 3: Definitions
The most relevant definitions of which our clients should be aware include:
The definitions of "financial institution" and "troubled assets" are critical in terms of who and what can participate in the asset purchase program created by the bill. Both definitions have evolved since earlier drafts and, yet, each raises a number of questions.
The definition of "financial institution," for example, employs undefined terms in phrases like "significant operations in the United States" and "owned by a foreign government." It is not clear what "significant operations" means; nor is it clear what constitutes foreign ownership. Also, the Treasury Secretary is not granted authority to expand the scope of eligible "financial institutions" as was the case in earlier drafts. Finally, as worded, there are technically no limits on what constitutes a "financial institution" other than that it has to be an "institution" and cannot be a central bank or an institution owned by a foreign government. The list of institutions is just illustrative.
The definition of "troubled assets" was broadened from earlier versions to include "commercial mortgages." The language gives the Secretary the authority to expand the definition to include assets that if their purchase is necessary to promote "financial market stability." How the Secretary will exercise this authority – and what additional assets or instruments he might include in the definition of "troubled assets," is an important question for financial institutions who would like to participate in the program.
Title I: Troubled Assets Relief Program
Sec. 101: Purchases of Troubled Assets
The Treasury Department has proposed the hiring of experienced private asset managers to aid the government in valuing securities – as the Fed did when it hired BlackRock to manage Bear Stearns’ asset portfolio earlier this year. The rescue bill requires the Secretary to establish procedures for choosing asset managers. The bill grants the Secretary broad authority to solicit proposals, manage potential conflicts of interest, and restrict information sharing by managers contracted to aid the government’s asset valuation. Section 107 of the bill further allows the Treasury Department to hire the Federal Deposit Insurance Corporation as an asset management entity, similar to the agency’s role in the Savings & Loan bailout. However, Secretary Paulson has publicly supported the retention of private portfolio managers.
Sec. 102: Insurance of Troubled Assets
Sec. 103: Considerations
Sec. 104: Financial Stability Oversight Board
This is one of four oversight entities created or tapped into by the bill. In addition to the Board, the bill creates a Special Inspector General for the Troubled Asset Relief Program (SIGTARP) (section 121) and a congressional oversight panel (section 125). It also gives the Comptroller General substantial oversight and audit responsibilities and requires it to undertake a study and report on margin authority (sections 116 and 117). This is all on top of congressional oversight and investigatory committees as well as executive branch oversight bodies.
The responsibilities of these oversight entities overlap considerably. That is not surprising given the concerns that have been expressed repeatedly by Members of Congress over the potential cost of this legislation. Presumably, Congress wants to hear from multiple perspectives how the asset purchase program is performing and whether it is meeting its goals. However, the potential for these oversight entities to trip over each other in the course of their work is great.
Sec. 105: Reports
Sec. 106: Rights; Management; Sale of Troubled Assets; Revenues and Sale Proceeds
House Democrats had proposed committing a portion of profits to fund affordable housing assistance through the Housing Trust Fund and the Capital Magnet Fund. This provision was strongly opposed by Republicans and was dropped during negotiations on the final package.
Sec. 107: Contracting Procedures
Sec: 108: Conflicts of Interest
This provision is focused on possible conflicts with respect to (1) hiring contractors, including asset managers, (2) purchasing assets, (3) managing assets, and (4) post-employment restrictions. The provision does not prescribe the form or content of the regulations but rather reflects significant congressional concern with conflicts that could arise during the program’s implementation.
Sec. 109: Foreclosure Mitigation Efforts
Sec. 110: Assistance to Homeowners
Sec. 111: Executive Compensation and Corporate Governance
The legislation does not provide a definition of the terms "employment contract" or "golden parachute;" likely, we will have to wait for Treasury to issue guidance on those terms once legislation is passed. The provision will not apply, however, to existing golden parachute agreements.
Sec. 112: Coordination With Foreign Authorities and Central Banks
Sec. 113: Minimization of Long-Term Costs and Maximization of Benefits for Taxpayers
Secretary Paulson testified before the House Committee on Financial Services that the Treasury Department would employ market mechanisms to value mortgage securities. Paulson identified key goals of the auctions as "price discovery" and "transparency."
The Secretary mentioned instituting reverse auctions as a means of pinpointing market prices and allowing smaller financial institutions to enter the process. In a reverse auction, the government would accept bids from multiple sellers to offload debt, and the sellers would compete by successively lowering their bids until only one participant remained. The government has past experience in operating reverse auctions for mineral rights, Treasury securities and wireless spectra.
The Treasury Department also may utilize the descending auction model. In a descending auction, the government would start the auction for a particular quantity of security at a relatively high price. The price would then be lowered gradually until supply equals demand – at the price where the aggregate of security holders wish to sell the stated auction quantity. The descending auction would help accomplish Paulson’s "price discovery" goal, hopefully leading the secondary market to use newly acquired pricing information and re-liquidate the assets among private investors.
Federal Reserve Chairman Bernanke opined in questioning before the Senate Banking Committee that opening up the auctions to a greater number of institutions would increase competition and allow for market forces to determine prices with greater accuracy. Ideally, these market forces would eventually settle prices well above the "fire-sale" point, but slightly below "hold-to-maturity" book prices.
In order to structure an efficient buyout, the government could set up separate auctions for an announced quantity of different classes of securities. The Treasury may decide to auction the most widely held mortgage-backed securities first in order to create an overall pricing scheme for later, more specialized sales of collateralized-debt obligations. Declining to give details, Secretary Paulson has merely stated that the initial auctions would probably be for "smaller" amounts.
Sec. 114: Market Transparency
The provision duplicates SEC authority by providing that the Secretary shall determine whether the public disclosure by firms that sell assets to the Secretary is adequate with respect to items such as off-balance sheet disclosures.
Sec. 115: Graduated Authorization to Purchase
The joint resolution of disapproval must be passed by both chambers within 15 calendar days of the President submitting a report to Congress. That is not a lot of time and, hence, it stands to reason that there would have to be a significant groundswell of opposition to the program for the President’s plan to be rejected.
Sec. 116: Oversight and Audits
Sec. 117: Study and Report on Margin Authority
Sec. 118: Funding
Sec. 119: Judicial Review and Related Matters
Sec. 120: Termination of Authority
Sec. 121: Special Inspector General for the Troubled Asset Relief Program
This language is based on the organic statute creating the Special Inspector General for Iraq Reconstruction. With broad authority and a $50 million budget, the SIGTARP could be a robust overseer.
Sec. 122: Increase in Statutory Limit on the Public Debt
Sec. 123: Credit Reform
This means that the bill will be scored on a subsidy, as opposed to an outlay basis. In other words, funds will not be scored as they are spent. Rather, the Office of Management and Budget and the Congressional Budget Office will project how much the government will lose, or gain, over time, in buying and selling assets under the bill’s authority.
Sec. 124: Hope for Homeowners Amendments
Sec. 125: Congressional Oversight Panel
Sec. 126: FDIC Authority
Sections 126(a) and (b) of the Act provide the FDIC with broad express authority to stop and penalize any person or entity that misrepresents or implies falsely that any "deposit liability, obligation, certificate, or share" is covered by FDIC insurance. The FDIC currently does not have express statutory authority to address false representations concerning whether such an obligation, investment or instrument issued by an entity other than an insured bank is protected by FDIC insurance.
Section 126(c) of the Act broadly protects acquirers of FDIC-insured banks, or their assets, in a FDIC supervisory transaction from being subject to litigation or damages based on existing standstill, confidentiality, or other agreements that would restrict or prohibit the acquisition of such bank. This provision would thus relieve a company from the potentially adverse effects of agreements that the target banks had entered into prior to the acquisition. This protection extends both to the acquisitions commenced before enactment of the Act as well as to future acquisitions.
It is our understanding that the FDIC requested that this authority be added to the bill in order to allow for a full range of possible buyers in the case of a bank failure, including banks that may have been involved in merger discussions with another bank before that bank failed.
Sec. 127: Cooperation with the FBI
Sec. 128: Acceleration of Effective Date
Sec. 129: Disclosures on Exercise of Loan Authority
Sec. 130: Technical Corrections
Sec. 131: Exchange Stabilization Fund Reimbursement
Sec. 132: Authority to Suspend Mark-to-Market Accounting
A number of House members recently signed on to a letter to the SEC asking Chairman Christopher Cox to suspend the mark-to-market accounting rules, which have been a major source of concern throughout the debate on the rescue bill. The new legislation, if passed, would affirm that the SEC does have the authority to suspend those rules. In the meantime, the SEC and the Financial Accounting Standards Board have provided guidance about how mark-to-market accounting should be applied, and now will allow companies to use their own assumptions about the value of illiquid assets in their public accounting in cases where market values do not reflect the actual value of the assets because markets have ceased to function normally. The SEC has, however, thus far elected not to suspend the rules altogether.
Sec. 133: Study on Mark-to-Market Accounting
Sec. 134: Recoupment
Sec. 135: Preservation of Authority
Sec. 136: Temporary Increase in Deposit and Share Insurance Coverage
Title II: Budget-Related Provisions
Sec. 201: Information for Congressional Support Agencies
Sec. 202: Reports by the Office of Management and Budget and the Congressional Budget Office
Sec. 203: Analysis in President’s Budget
Sec. 204: Emergency Treatment
Title III: Tax Provisions
Sec. 301: Gain or Loss from Sale or Exchange of Certain Preferred Stock
Many applicable financial institutions acquired preferred stock of Fannie Mae and Freddie Mac in order to satisfy their regulatory capital requirements. The preferred stock qualified as "Tier 1 capital" for these purposes. Since the stock paid a hefty dividend rate that, unlike interest on debt instruments, allowed its owners to exclude 70 percent of the return from taxable income, it was an attractive investment for financial institutions and their holding companies. When the government placed Freddie Mac and Fannie Mae into receivership in early September 2008, the preferred stock became worthless and resulted in a loss for federal income tax purposes. Since the preferred stock was a "capital asset" for tax purposes, however, its worthlessness in most cases resulted (prior to the Act) in a capital loss.
Under the tax rules, capital losses may be used to offset capital gains (including capital gains realized in prior years), but not ordinary income (such as income from most banking operations). Since applicable financial institutions, especially large banks and savings and loans, generally earn relatively meager capital gains relative to their ordinary income, they would receive little if any tax benefit from the worthlessness of the preferred stock without this change in law. Banks and their lobbying groups, including the American Bankers Association and the Independent Community Bankers of America, cried foul and sought this change of law in order to lessen the impact of the Fannie Mae and Freddie Mac receiverships. In certain cases, the refund generated by tax losses resulting from current economic events may be among the largest assets of applicable financial institutions, because they could reach as much as 35 percent of the income upon which tax was paid during the current year and preceding two years (plus any state benefits). We expect to see significant litigation concerning the rights to these refunds.
As a result of the Act, a loss recognized by an applicable financial institution on the preferred stock will be treated as an ordinary loss. This means that the applicable financial institution can use the loss against its ordinary income for the current tax year, and if the institution has a net operating loss for the current year, the loss could be carried back to the two preceding tax years in order to obtain a refund of taxes paid in those years (subject to certain limitations).
Interestingly, the benefit extends not only to the banks and savings and loans, but to their holding companies as well. Individuals and other entities will not be entitled to this special treatment, and thus their losses on Fannie Mae and Freddie Mac preferred stock generally will be treated as capital losses. Whether individual states will adopt conforming changes to their tax laws in order to permit the same treatment for state income tax purposes remains to be seen, but it is worth noting that certain states do not permit the carryback of net operating losses. We have not seen estimates of the tax cost of this change, but press reports thus far seem to ignore the revised treatment of these losses when referring to the cost of the Act.
Sec. 302: Special Rules For Tax Treatment of Executive Compensation of Employers Participating in the Troubled Assets Relief Program
Section 302 addresses certain tax consequences of compensation paid to senior executives at firms that transact business with the government pursuant to the Act. The provision contains two sets of rules: one designed to limit the deductibility of compensation deemed excessive and the other making the "golden parachute" rules applicable to certain severance benefits of top executives at participating firms.
Deductibility rule, Section 302(a)–as mentioned above in this summary, Section 111 of the Act provides disparate treatment for executive compensation paid by firms selling securities to the government. The same holds true for the tax treatment of executive compensation paid by those firms. For instance, if a firm engages only in direct purchase transactions with the government, the firm is not treated as an "applicable employer" and the new deduction limits will not apply to that firm. The theory here is that firms engaging in direct purchase transactions under Section 111(b) of the Act will be subject to stringent requirements imposed by Treasury relating to limits on compensation, recovery of certain bonuses, and limits on golden parachutes.
Firms that sell assets in the auction process and sell more than $300 million of securities to the government overall (including in direct purchase transactions) are the firms targeted by the deductibility limits. While these firms are prohibited by the Act from entering into new employment contracts providing for golden parachutes, they are not prohibited from fulfilling the terms of existing agreements and are not prohibited from entering into new employment agreements providing for compensation in excess of $500,000 per year.
One must parse through several defined terms in order to fully understand the deduction limits. Below is a list of relevant terms with a summary of the definition of each:
The deduction rules as set forth in the Act are as follows:
The deduction rules also coordinate with the golden parachute provisions and the rules for stock compensation of employees of expatriated corporations. These rules apply to all tax years ending on or after the date of enactment of the Act.
Golden parachute excise tax rules, Section 302(b)–the second set of compensation-related tax rules apply the existing golden parachute provisions to payments made to executives of participating firms whose employment is terminated.
By way of background, the golden parachute tax rules deny deductions to corporations for certain payments and other benefits, and impose a 20 percent nondeductible excise tax on the recipient of those payments or other benefits, if (a) the recipient is a "disqualified individual," (b) the payments and other benefits are deemed contingent on a change of control of the corporation, and (c) the payments and other benefits exceed three times the individual’s average compensation for the five-year period preceding the change of control. Once the payments and other benefits exceed this three-times threshold, all payments in excess of the five-year average are subject to the deduction disallowance and the excise tax.
Under the Act, a "covered executive" (described above) is automatically treated as a disqualified individual. In addition, the rules now treat the "applicable severance from employment" of a covered executive as a change of control for purposes of applying the golden parachute rules, and treat payments that are "on account of" the "applicable severance" as payments contingent on a change of control.
"Applicable severance from employment" means any severance from employment resulting from involuntary termination or in connection with the bankruptcy, liquidation, or receivership of the employer. The rules also substitute the term "applicable employer" for "corporation" as that term is used in Section 280G, meaning that they apply to all payments by entities subject to the deduction disallowance rules described above, and to "covered executives" with respect to such applicable employers.
Exceptions under the golden parachute rules for payments that are deemed "reasonable compensation" and for payments by private (i.e., non-publicly traded) companies or corporations that could qualify as S corporations do not apply. Thus, private corporations and corporations that could qualify as S corporations also are subject to the golden parachute rules in the Act.
The actual language implementing this particular provision is not clear. The main area of uncertainty stems from language stating that "this section" (meaning Section 280G of the Internal Revenue Code) applies to severance payments to a covered executive. Section 280G, however, applies only to "excess parachute payments," and we would have expected the language to say something to the effect that the applicable severance payments are to be treated as "parachute payments" under these rules instead of providing that the entire section applies to the severance payments. Nevertheless, our sense is the rules are intended to treat payments to a covered executive on account of applicable severance from employment as parachute payments for purposes of the golden parachute rules. If this is the case and if those severance payments exceed three times the executive’s five-year average compensation, the employer is denied a deduction and the employee incurs a nondeductible 20 percent excise tax to the extent of severance payments in excess of that five-year average.
The Act also contains a few coordinating provisions, including a rule making the excise tax provision inapplicable to any payment that would be treated as a parachute payment without regard to the new rules, and a grant of regulatory authority to Treasury in order to (a) carry out the purposes of the provision and the Act in the case of any acquisition, merger or reorganization of an applicable employer, (b) apply the deduction disallowance and the excise tax rules where payments are treated as parachute payments under the new rules and other payments are treated as parachute payments under the old rules, and (c) prevent avoidance of the rules by mischaracterizing a severance from employment as something other than "applicable severance."
These rules apply to all payments with respect to severances occurring while Treasury’s authorities under Section 101(a) of the Act are in effect.
Much like the existing rules imposing limits on the deduction of compensation in excess of $1 million and limiting the deduction and imposing an excise tax on golden parachute payments, in many cases these rules will require significant clarification before they can be implemented with any degree of certainty. While the intent to limit what is perceived as excessive compensation to senior executives of institutions that participate in asset sales under the Act is clear, the implementing rules are far from clear. Terms like "involuntary termination," "in connection with a bankruptcy, liquidation, or receivership," and "on account of such applicable severance" will require more elaboration.
Moreover, it is questionable whether it makes much sense from a policy standpoint to place these limits on the compensation of persons who fall within the definition of "covered executive" while placing no such limits on employees who fall outside that fairly narrow definition.
Historically, in our experience, many employers have considered the limits on deductibility in setting their compensation structures, but ultimately decide what they will pay their executives based on factors independent of tax deductions. One would think this will be even more likely for firms selling assets under the Act, as presumably these firms are not overly concerned with income taxes given the magnitude of their tax losses resulting from the recent economic downturn.
In addition, many executive employment agreements require the employer to pay the 20 percent nondeductible excise tax incurred by the executive as a result of the receipt of golden parachute payments, as well as the additional income and excise taxes incurred by the executive resulting from those payments (since those payments by the employer are treated as additional compensation), ultimately costing the employers significantly more than they would have spent without these rules. While Treasury has authority under the Act to limit payments to executives where it engages in direct purchase transactions, it has no such authority where it is participating in auctions (other than the limited right to prohibit golden parachutes in new employment agreements). Therefore, the excise tax rules could result in substantially higher costs to the entities, and ultimately the shareholders or other stakeholders of those entities, that suffered huge losses leading up to the Act.
Sec. 303: Extension of Exclusion of Income From Discharge of Qualified Principal Residence Indebtedness.
Section 303 of the Act simply extends the expiration date of the current provision addressing income from the cancellation of "qualified principal residence indebtedness." Under this rule, borrowers who negotiate a reduction in indebtedness incurred to acquire their principal residence will not be required to pay tax on the reduction, provided certain conditions are met. Without this special rule, assuming the borrower was not in bankruptcy or insolvent, the borrower would be deemed to have ordinary income equal to the amount of the reduction in his or her indebtedness. The Act extends this rule to reductions in debt that occur prior to January 1, 2013. Prior to the Act, this rule would apply only to cancellations that occur prior to January 1, 2010.
Interestingly, this provision does not shelter gain on sale, including gain on sale that would result from a foreclosure on a home that secures nonrecourse debt in excess of the homeowner’s tax basis in the home (e.g., where the homeowner refinanced and borrowed more than the original cost of the home plus capitalized improvements and the debt is nonrecourse). Other Internal Revenue Code provisions may apply to shelter that gain, however.
The Financial Markets Crisis Group will continue to keep our clients updated on the latest events in Washington. Additional updates relating to the financial markets crisis are available on Gibson Dunn’s website.
Gibson Dunn has assembled a team of experts who are prepared to meet client needs as they arise in conjunction with the issues discussed above. Please contact Michael Bopp (202-955-8256, firstname.lastname@example.org) in the firm’s Washington, D.C. office or any of the following members of the Financial Markets Crisis Group:
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