30 October 2008

The Troubled Asset Relief Program (TARP)


David Guin
Partner | US

The Emergency Economic Stabilization Act of 2008 (“the Act”) aims to alleviate the capital market crisis in the United States by providing a broad grant of authority to the Treasury Department to implement a variety of economic stabilization measures. 

First, the Act establishes the Troubled Asset Relief Program (“TARP”) through which a newly created office within the Treasury, the Office of Financial Stability, will buy, sell, and manage a wide range of eligible “troubled assets” from qualifying financial institutions.  Eligible “troubled assets” are broadly defined to mean residential and commercial mortgages, or any securities, obligations or other instruments based on or related to such mortgages, originated or issued prior to March 15, 2008.      

Although the TARP may ultimately access $700 billion to purchase troubled assets, it will only receive these funds in installments – the first installment being $250 billion (with $100 billion and $350 billion following thereafter generally with Presidential and Congressional review). 

Second, the Treasury has the authority to apply TARP funds to invest directly in debt and equity instruments of financial institutions.  This authority is derived from the definition of “troubled assets,” which, in addition to the above, includes any other financial instrument necessary to promote financial market security.  This second component of economic relief is apparently the one that Treasury used to deploy an estimated $125 billion to strengthen the balance sheets of nine top tier financial institutions to help avert a total credit market freeze and will use to invest $125 billion in other financial institutions. 

Third, the Treasury is also authorized to establish a program to guarantee troubled assets that would be funded by premiums collected from certain participating financial institutions. 

Only financial institutions with significant operations in the United States may participate in the TARP.  Financial institution is broadly defined to include most, if not all, regulated U.S. banking entities and foreign banks with significant U.S. activity (such as through branches).  It also includes U.S. mutual funds (technically referred to as “Regulated Investment Companies” or “RICs”), money market funds, and qualified employee retirement plans.  Hedge funds, private equity funds, and other pooled investment vehicles are not currently covered. 

Fourth, the Act provides for a temporary increase in the amount of the FDIC’s deposit insurance limit from $100,000 to $250,000 per account through December 31, 2009, after which it will revert back to $100,000. 

Lastly, the Act authorizes the Securities and Exchange Commission to suspend the application of FAS 157 – the accounting rule requiring mark-to-market accounting for financial instruments — if it determines that it would be in the public interest and would protect investors.  FAS 157, which became effective after November 15, 2007, has forced deep financial statement write downs of mortgage-backed securities and other related derivatives.  Moreover, the Act requires the SEC, in consultation with the Federal Reserve Board and Treasury, to study the mark-to-market account standards of FAS 157 and consider its effect on financial institution balance sheets, the 2008 failures, and the quality of financial information available to investors, as well as consider alternatives.  

TARP Tax and Compensation Provisions

1.  Ordinary Losses on Preferred Stock in Fannie Mae and Freddie Mac

The Act provides ordinary loss treatment to qualifying financial institutions (generally community banks) on the sale or exchange of preferred stock in the Federal National Mortgage Corporation (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”).  Such banks were major holders of Fannie Mae and Freddie Mac preferred stock, but typically do not realize substantial enough capital gains to utilize the capital losses sustained on Fannie Mae or Freddie Mac holdings.  Accordingly, this provision alleviates the impact of the capital loss limitation on these financial institutions by treating the preferred stock loss as ordinary so it may be used to offset operating income.  This provision applies to preferred stock that was owned on September 6, 2008, or sold between January 1 and September 6, 2008.  The Treasury Department has authority to write regulations that would extend this treatment to losses incurred by financial institutions that hold certificates in “pass-through trusts” substantially all of the assets of which are Fannie Mae or Freddie Mac preferred stock.

2. Executive Compensation Regulatory and Tax Provisions

The Act imposes two overall sets of regulatory and tax limitations on executive compensation paid by financial institutions participating in the TARP.  The determination of which set of limitations applies is governed by the type and amount of troubled assets purchased. 

A.  Purchases of Troubled Assets In Excess of $300M

The first set of regulatory and tax limitations applies to financial institutions from which the Treasury Department purchases troubled assets in excess of $300 million. 

A financial institution in this category is prohibited from entering into any new employment contract with a senior executive providing a golden parachute upon an involuntary termination of employment or upon the bankruptcy, insolvency or receivership of the financial institution.  A golden parachute is a contingent payment based on a change in ownership of either stock or a substantial part of the entity’s assets.  For this provision, a senior executive includes the five most highly compensated executive officers. 

A financial institution that sells more than $300 million of troubled assets to the Treasury through an auction process or directly (except if all such troubled assets are sold directly) will be subject to golden parachute tax rules that makes severance payments non-deductible and imposes a 20% excise tax on the executive.  This provision applies whether or not a change of control occurred and covers any severance triggered by an involuntary termination of employment or bankruptcy, liquidation, or receivership of the financial institution.   A second applicable tax limitation is that deductible executive wages are capped at $500,000, with no exceptions for Board-approved performance-based pay.  The unused portion of the $500,000 limit may be carried forward until the year in which the compensation is otherwise deductible. Executives covered under these latter two tax provisions include the CEO, CFO, and the three most highly compensated executive officers. 

B.  Treasury Purchase of Debt or Equity Interest

Under a TARP non-tax provision, regulating executive compensation and corporate governance, if the Treasury Department acquires a meaningful equity or debt position through a direct purchase where no bidding process or market prices are available, the issuing financial institution would be required to (i) eliminate incentives for senior executives that encourage unnecessary and excessive risks; (ii) provide for the clawback of bonus or incentive compensation paid to senior executives based on criteria later proven to be materially inaccurate; and (iii) prohibit payment of golden parachutes to such senior executives.  These standards would be required to be met during the period that Treasury holds the debt or equity position.  This provision will be subject to further clarification by the Treasury Department.  The requirements apply to a financial institution’s five most highly compensated executive officers. 

3. * *Homeowner Protection Against Mortgage Cancellation Of Indebtedness Income

The Act extends to December 31, 2012 the temporary exclusion from gross income for income created by the cancellation of mortgage indebtedness.  Under this temporary exclusion, borrowers who negotiate a reduction in indebtedness incurred to acquire their principal residence will not be required to pay tax in the reduction, provided certain conditions are met.   

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