February 17, 2009
The Gibson, Dunn & Crutcher Financial Markets Crisis Group is closely tracking government responses to the turmoil that has catalyzed a dramatic and rapid reshaping of our capital and credit markets.
We are providing updates on key regulatory and legislative issues, as well as information on legal issues that we believe could prove useful as firms and other entities navigate these challenging times.
This update focuses on two issues: changes to executive compensation rules made by the just-signed American Recovery and Reinvestment Act (Stimulus Act) and the recently-announced expansion of the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF).
Enhanced Executive Compensation Standards
The Stimulus Act contains an enhanced set of executive compensation and corporate governance standards applicable to all recipients of government funds under the Troubled Asset Relief Program (TARP). These standards generally codify the Treasury Department’s guidelines on executive compensation announced on February 4, 2009 with a few important differences. First, unlike the Treasury Department’s guidelines and the Senate’s original version of the new stimulus bill, there is no mandatory cap on total compensation. Second, unlike the prior iterations of the TARP programs and the Treasury Department’s guidelines, the standards apply equally to all TARP recipients (other than with respect to the scope of employees covered by the limitation on bonus, retention award and incentive compensation as outlined in further detail below). Third, the standards apply to all TARP recipients the most restrictive limitation on severance benefits – an absolute prohibition on any payment (other than accrued salaries and benefits) following departure of the "senior executive officers" (SEOs) and next five most highly compensated employees; the Treasury Department’s guidelines only applied such a limitation to institutions requiring "exceptional assistance." Additionally, the Stimulus Act directs the Treasury Department to adopt implementing rules for these standards and also grants the Treasury Department the authority to establish additional standards. Thus, it is not clear whether, and how, the Treasury Department intends to harmonize the guidelines it proposed on February 4th with the standards set forth in the Stimulus Act.
It is also not clear whether these standards are effective immediately or are only effective once the Treasury Department has issued its regulations. The Stimulus Act did not establish a time period for the issuance of those regulations. Until those regulations are issued, the following standards leave many open questions and unresolved issues.
Description of standards to be adopted by the Treasury Department
All firms currently or in the future receiving financial assistance under TARP, for as long as obligations (other than warrants) to Treasury remain outstanding.
Deductibility limit of $500,000 in annual compensation, including performance-based compensation, for Senior Executive Officers (SEOs) (defined as the 5 most highly paid executive officers of the institution under the SEC’s proxy disclosure rules). This provision was implemented in October 2008.
Limits/prohibition on compensation that include incentives for SEOs to take unnecessary and excessive risks.
Recovery of any bonus, retention award or incentive compensation to SEOs and 20 next most highly compensated employees if payment was based on statements of earnings, revenues, gains or other criteria that are later found to be materially inaccurate.
Prohibition on any payments (other than accrued wages/benefits) to SEOs and 5 next most highly-compensated employees for departure from the institution for any reason.
– Prohibition on paying or accruing any bonus, retention award or incentive compensation to the certain employees, other than long-term restricted stock that
– Limits do not apply to bonuses required to be paid pursuant to a written employment contract executed on or before February 11, 2009 (the validity of which is subject to Treasury’s determination).
– Employees covered by this prohibition depend upon the level of TARP funds received:
Prohibition on compensation plans that encourage earnings manipulation to enhance compensation of any employee.
CEO/CFO are required to certify compliance with the executive compensation and corporate governance standards.
Board Compensation Committee – comprised solely of independent directors – is required to meet at least semiannually to discuss and evaluate employee compensation plans and conduct risk assessment.
Required adoption (by the Board) of a company-wide policy on "excessive or luxury expenditures" covering (at least) the following:
Entertainment or events; office and facility renovations; aviation and other transportation and other activities or events that are "reasonable" or "ordinary course."
Say on Pay
Non-binding "Say on Pay" shareholder vote to approve compensation of executives, as disclosed pursuant to SEC compensation disclosure rules (i.e., named executive officers) – includes CD&A, tables and related material. The SEC must adopt final implementing rules within one year of the date of the Stimulus Act.
Prior Bonus Review
Review of prior payments of bonus, retention awards and other compensation to SEOs and 20 next most highly-compensated employees to determine whether inconsistent with TARP or otherwise contrary to public interest and negotiate reimbursement.
Withdrawal from TARP
Repayment permitted from any funds with approval of banking regulators; Treasury will liquidate warrants at market price.
As noted above, there is a large amount of uncertainty regarding the application of these standards that will not be resolved until the Treasury Department has issued its implementing regulations (and/or imposed any additional standards). Until such time, following are some of the more significant open issues:
The Federal Reserve has recently announced an expansion of its TALF program. The program, which has not yet begun operations, was established to "increase credit availability and support economic activity by facilitating renewed issuance of consumer and small business ABS at more normal interest rate spreads." The TALF program will offer non-recourse loans to eligible borrowers covering up to 95 percent of the face value of eligible asset-backed securities (ABS). The program is generating considerable interest within the financial community and is expected to be launched soon. Indeed, the Federal Reserve is currently circulating key subscription documents among primary dealers for comment and is still targeting initiation this month.
On February 10, 2009, the Federal Reserve announced that it intends to expand the size and scope of the TALF program significantly, providing as much as $1 trillion in financing for the purchase of ABS, with a parallel five-fold increase (to $100 million) in Treasury Department support under TARP. As originally announced, the program was to provide financing solely for borrowers purchasing securities collateralized by AAA-rated student and auto loans, credit card debt, and loans guaranteed by the Small Business Association. However, the Federal Reserve is expanding the program to include other types of securities, including those backed by commercial mortgages, subject to the same AAA-ratings criteria. The Fed has signaled further that it may expand the program to include assets collateralized by corporate debt and non-Agency residential mortgage-backed securities.
Sponsors of Asset-Backed Securities
Sponsors of ABS that desire to participate in the TALF must meet a number of requirements. Under the TALF, a "sponsor" is one who "who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity." A sponsor may apply to make its ABS eligible for the program and, in doing so, must certify that the obligations underlying its ABS meet the program’s requirements, that it has not made any untrue statements to the credit ratings agencies in connection with obtaining a credit rating for the ABS, and that a nationally recognized independent accounting firm has certified that the ABS are eligible to participate in the program.
Once admitted to the program, sponsors will be subject to the executive compensation restrictions passed as section 111 of the Emergency Economic Stabilization Act (EESA) and applicable to recipients of TARP assistance. In addition, Federal Reserve guidance indicates that forthcoming TALF documentation could specify an "applicable entity" different than the sponsor that could be subject to executive compensation restrictions.
As noted above, the Stimulus Act makes several changes to section 111 of the EESA and instructs the Treasury Secretary to "require each TARP recipient to meet appropriate standards for executive compensation and corporate governance." The Stimulus Act includes a non-exclusive list of such "appropriate standards." As a result, it is not entirely clear which executive compensation standards will be imposed on TALF recipients.
Under TALF rules, for the duration of the sponsor’s participation in the program, if the sponsor fails to provide annual certification, its securities will not be accepted as eligible collateral on subsequent TALF subscription dates.
Purchasers of Asset-Backed Securities/Borrowers of Federal Reserve Funds
Borrowers are not subject to executive compensation restrictions as a result of their participation in the TALF. Any U.S. company that owns eligible collateral may participate in the TALF program by borrowing against eligible collateral from the TALF, provided that the company maintains an account relationship with a primary dealer. A U.S. company is defined as (i) any entity or institution that is organized under the laws of the United States or a political subdivision or territory thereof and (ii) conducts significant operations or activities in the United States. Additionally, a U.S. subsidiary of a foreign company may participate in the program if it conducts significant operations or activities in the United States and is not directly or indirectly controlled by a foreign government.
The Federal Reserve is also allowing investment funds that are organized in the U.S. and managed by an investment manager whose principal place of business is in the U.S. to participate in the program. This means that hedge funds, private equity funds, mutual funds, or other pooled investment vehicles which invest primarily in eligible collateral are eligible to participate in the program. Investment funds which are controlled by a foreign government, or managed by an investment manager which is controlled by a foreign government, are not eligible to participate in the program. For the purpose of the program, an entity is controlled by a foreign government if the foreign government owns, controls or holds the power to vote 25 percent or more of a class of the companies’ voting securities.
An eligible borrower must enter into a customer agreement with a primary dealer that authorizes the primary dealer to execute a master loan and security agreement with the Fed. The primary dealer will be required to use its due diligence procedures to certify that each borrower is eligible to participate in the program. The dealer will then act as the borrower’s agent and carry out all of the program’s operational requirements on its behalf.
Under the program, the New York Fed will loan an amount equal to the value of the pledged ABS minus a haircut, which represents the risk capital investors are required to commit. The Fed has created a preliminary table of haircut amounts based upon sector, prime and sub-prime classifications and the average life of the underlying loans. Currently, the proposed haircuts range from five to 16 percent and will be the same for all borrowers.
Eligible borrowers must indicate the value of the loan (which must be at least $10 million), the ABS collateral being pledged to secure the loan, and the type of interest rate, whether fixed or floating. A prospective borrower does not need to own the ABS that it plans to pledge on the subscription date. Instead, primary dealers will collect the information regarding each borrower’s requested loan amount and interest rate structure, along with the CUSIPs and offering documents of the ABS the borrower wants to pledge. An administrative fee will be assessed based on each borrower’s request.
On each monthly subscription date, borrowers may request one fixed-rate and one floating-rate loan. The interest rate on floating-rate loans will be 100 basis points over 1-month LIBOR and the interest rate on fixed-rate loans will be 100 basis points over the 3-year LIBOR swap rate. Borrowers may pledge a combination of ABS as collateral for a single loan, however, the securities’ interest rate format must mirror the interest rate format of the TALF loan.
On the subscription date, the primary dealer will submit an aggregate loan request of all the borrowers it represents along with information regarding the individual borrower requests to the New York Fed. Within two business days, the New York Fed will confirm approved loans. In circumstances where the borrower has not yet purchased the ABS, the borrower must deliver payment on the loan settlement date against the portion of the collateral not covered by the loan. Should any portion of expected ABS collateral not be received on the settlement date, that portion of the loan will be cancelled and the administrative fee will not be refunded. TALF loans will have a three-year term and be non-recourse to the borrower, except upon the breach of certain representations or warranties. Additionally, the loans are not subject to mark-to-market or re-margining requirements and are pre-payable, without penalty, at the buyer’s option. Any principal payments on eligible collateral must be used immediately to reduce the principal amount of the TALF loan in proportion to the original loan-to-value ratio (e.g., if the LTV ratio is 90%, then 90% of the of principal payment must be allocated toward repayment of the loan). Until December 31, 2009, borrowers may assign their TALF obligations to other eligible borrowers, but at no time may a borrower substitute the collateral that was originally used to secure the loan.
The Fed has issued a number of regulations regarding the type of collateral that may be used to secure a TALF loan. Eligible collateral includes non-synthetic, U.S. dollar-denominated, asset-backed securities issued on or after January 1, 2009. While there is not a minimum maturity limit for ABS that can collateralize TALF loans, the expected term of a credit card or auto loan ABS cannot exceed five years. The collateral may not be backed by loans that were originated or securitized by the borrower or its affiliates. Eligible collateral must have received the highest credit rating from two or more rating agencies and not have received a lower rating, or been placed on review or watch for downgrade by any other nationally recognized rating agency. Any credit rating cannot depend upon a third-party’s guarantee of the ABS. Once the ABS has been pledged, a subsequent ratings downgrade will not affect an existing loan’s status. However, a downgraded ABS may not be used as collateral for new TALF loans.
Except for SBA Pool Certificates or Development Company Participation Certificates, only ABS that were issued on or after January 1, 2009 are eligible for the TALF program. Eligible ABS may be secured by obligations that were originated before January 1, but at least 85% of the underlying obligations must not have been originated earlier than on dates ranging from May 1, 2007 to January 1, 2008, as specified by the Fed based on the type of loan. Currently the underlying obligations must be auto loans, commercial mortgages, credit card loans, student loans or small business loans guaranteed by the Small Business Administration. As previously mentioned, the Fed has announced that the program will be expanded to include commercial mortgages, and is considering whether to expand TALF to include other assets classes, such as non-Agency residential mortgage-backed securities and assets collateralized by corporate debt.
All of the ABS that the New York Fed receives in connection with the TALF program will be sold, pursuant to a forward purchase agreement, to a special purpose vehicle (SPV). The SPV will purchase the assets at a price equal to the amount of the TALF loan plus any accrued, but unpaid, interest. The U.S. Treasury has decided to participate in the TALF program by committing to purchase the first $20 billion of the SPV’s assets with TARP funds. If the SPV purchases more than $20 billion in assets, then the New York Fed will loan the SPV money to fund the rest of the asset purchases. The Fed’s loan will rank senior to the TARP loan and will be secured by all of the assets in the SPV.
The New York Fed plans to announce the initial TALF subscription date this month as originally planned. The Fed has indicated that that the newly announced portions of TALF – the inclusion of commercial mortgage-backed securities and the expansion of the program to $1 trillion – would not delay initial implementation of the program. Unless extended by the Board of Governors, the Fed will originate loans under the program until December 31, 2009.
As noted, the Fed is currently circulating the master loan service agreement to primary dealers. Parties wishing to participate in the program should begin taking the necessary steps to ensure that they will be prepared to meet the program’s requirements when it comes on line in the near future.
* * * * *
The Gibson, Dunn & Crutcher Financial Crisis Markets Group will continue to monitor these issues and will provide further updates on the enhanced executive compensation standards applicable to TARP recipients and the TALF program as information is developed.
 For more details on TALF’s mechanics, see
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:
Public Policy Expertise
Mel Levine – Century City (310-557-8098, email@example.com)
John F. Olson – Washington, D.C. (202-955-8522, firstname.lastname@example.org)
Amy L. Goodman – Washington, D.C. (202-955-8653, email@example.com)
Alan Platt – Washington, D.C. (202- 887-3660, firstname.lastname@example.org)
Michael Bopp – Washington, D.C. (202-955-8256, email@example.com)
Securities Law and Corporate Governance Expertise
Ronald O. Mueller – Washington, D.C. (202-955-8671, firstname.lastname@example.org)
K. Susan Grafton – Washington, D.C. (202- 887-3554, email@example.com)
Brian Lane – Washington, D.C. (202-887-3646, firstname.lastname@example.org)
Lewis Ferguson – Washington, D.C. (202- 955-8249, email@example.com)
Barry Goldsmith – Washington, D.C. (202- 955-8580, firstname.lastname@example.org)
John H. Sturc – Washington, D.C. (202-955-8243, email@example.com)
Dorothee Fischer-Appelt – London (+44 20 7071 4224, firstname.lastname@example.org)
Alan Bannister – New York (212-351-2310, email@example.com)
Adam H. Offenhartz – New York (212-351-3808, firstname.lastname@example.org)
Mark K. Schonfeld – New York (212-351-2433, email@example.com)
Financial Institutions Law Expertise
Chuck Muckenfuss – Washington, D.C. (202- 955-8514, firstname.lastname@example.org)
Christopher Bellini – Washington, D.C. (202- 887-3693, email@example.com)
Amy Rudnick – Washington, D.C. (202-955-8210, firstname.lastname@example.org)
Rachel Couter – London (+44 20 7071 4217, email@example.com)
Howard Adler – Washington, D.C. (202- 955-8589, firstname.lastname@example.org)
Richard Russo – Denver (303- 298-5715, email@example.com)
Dennis Friedman – New York (212- 351-3900, firstname.lastname@example.org)
Stephanie Tsacoumis – Washington, D.C. (202-955-8277, email@example.com)
Robert Cunningham – New York (212-351-2308, firstname.lastname@example.org)
Joerg Esdorn – New York (212-351-3851, email@example.com)
Wayne P.J. McArdle – London (+44 20 7071 4237, firstname.lastname@example.org)
Stewart McDowell – San Francisco (415-393-8322, email@example.com)
C. William Thomas, Jr. – Washington, D.C. (202-887-3735, firstname.lastname@example.org)
Real Estate Expertise
Jesse Sharf – Century City (310-552-8512, email@example.com)
Alan Samson – London (+44 20 7071 4222, firstname.lastname@example.org)
Andrew Levy – New York (212-351-4037, email@example.com)
Fred Pillon – San Francisco (415-393-8241, firstname.lastname@example.org)
Dennis Arnold – Los Angeles (213-229-7864, email@example.com)
Michael F. Sfregola – Los Angeles (213-229-7558, firstname.lastname@example.org)
Andrew Lance – New York (212-351-3871, email@example.com)
Eric M. Feuerstein – New York (212-351-2323, firstname.lastname@example.org)
David J. Furman – New York (212-351-3992, email@example.com)
Bankruptcy Law Expertise
Michael Rosenthal – New York (212-351-3969, firstname.lastname@example.org)
David M. Feldman – New York (212-351-2366, email@example.com)
Oscar Garza – Orange County (949-451-3849, firstname.lastname@example.org)
Craig H. Millet – Orange County (949-451-3986, email@example.com)
Thomas M. Budd – London (+44 20 7071 4234, firstname.lastname@example.org)
Gregory A. Campbell – London (+44 20 7071 4236, email@example.com)
Janet M. Weiss – New York (212-351-3988, firstname.lastname@example.org)
Matthew J. Williams – New York (212-351-2322, email@example.com)
J. Eric Wise – New York (212-351-2620, firstname.lastname@example.org)
Executive and Incentive Compensation Expertise
Stephen W. Fackler – Palo Alto (650-849-5385, email@example.com)
Charles F. Feldman – New York (212-351-3908, firstname.lastname@example.org)
Michael J. Collins – Washington, D.C. (202-887-3551, email@example.com)
Sean C. Feller – Los Angeles (213-229-7579, firstname.lastname@example.org)
Amber Busuttil Mullen – Los Angeles (213-229-7023, email@example.com)
© 2009 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.