The Act permits Treasury to establish programs to buy and to insure financial institutions' troubled assets. The outstanding program obligations will be $700 billion, subject to the requirements and limitations set forth in the Act. The purchase program will be conducted using either auctions or direct purchases of troubled assets. Participating financial institutions will be required to issue securities to Treasury in connection with anything other than de minimis sales of troubled assets. In addition, Treasury will impose limitations on executive compensation for participating financial institutions.
It is worth noting the speed with which the Act was passed and its unique transition from a three-page outline initially provided by Treasury to the over 150-page series of acts that ultimately were approved on October 3rd. Not surprisingly, there are some drafting inconsistencies. While the purchase program is defined as the TARP, that same term is used in various places to refer to both the purchase program and the insurance program. For example, the Special Inspector for the TARP is responsible for both the purchase program and the insurance program. We expect that the guidelines, procedures and reports released from Treasury will clarify how the programs will work.
Who Can Participate And What Assets Are Covered?
Treasury will be able to purchase or insure troubled assets of financial institutions.
A Financial Institution is any institution established and regulated under U.S. laws and having significant operations in the U.S.
The definition includes a non-exclusive list of institutions, including: any bank, savings association, credit union, security broker or dealer or insurance company.
It is expected that U.S. branches of foreign financial institutions, if their U.S. operations are significant, would qualify. Institutions owned by a foreign government and foreign central banks are expressly excluded. However, to the extent that a foreign financial authority acquired troubled assets as a result of extending financing to a financial institution that has failed or defaulted on the financing, those assets are eligible for purchase. For example, if a foreign financial institution with a significant U.S. presence, such as a branch, became significantly undercapitalized or failed, its home jurisdiction banking authority would take action. If, as a result of a bailout or other emergency measures, the home country banking authority acquires troubled assets, those troubled assets could be eligible for purchase under the program.
The Act also requires that Treasury take into consideration protection of retirement security of Americans. See "Treasury Secretary to Consider Protecting Some, but Not All Employee Benefits" below.
Treasury must also consider the impact of the current environment on public instrumentalities, including the increased costs and losses faced by counties and cities. It is currently unclear how the TARP will remediate the impact to public instrumentalities, as a municipality would not appear to be a "financial institution." The most straightforward approach may be to conduct auctions to purchase, and rebuild price stability in, securities issued by counties and cities. That in turn raises questions regarding the allocation of funds of the TARP and its goals of reestablishing the broader markets, protecting taxpayer resources and preserving homeownership. We expect that this, as with many other areas, will be addressed in guidance and reports to be released by Treasury in the coming days and weeks.
Troubled Assets Are Broadly Defined In Two Broad Categories.
The first category includes residential or commercial mortgages and any securities, obligations or other instruments that are based on, or related to, such mortgages. To qualify, an asset must have been originated or issued on or before March 14, 2008. Additionally, Treasury must make a determination under the program that the acquisition of the asset promotes financial market stability.
Second, Treasury can include other financial instruments if, after consultation with the Chairman of the Federal Reserve, it makes a written determination that the purchase is necessary to promote financial market stability, and that determination is provided to the appropriate committees of Congress. We would note that there is no approval process, only a requirement that notice be provided to Congress.
Under this second category, Treasury announced the development of the TARP Capital Purchase Program on October 14th. See below for a detailed description of the program. See also a summary of the related executive compensation and governance requirements as a result of participation under "Bailout Related Tax Changes and Impacts."
How Will The Programs Work?
Purchase Programs
Program guidelines for the purchase program will be established within two business days of the first purchase, or at the end of the 45 days after passage of the Act. Based on the announcement with respect to the purchase of equity of banking institutions, program guidelines are required this week. Given the speed with which the bank equity purchase program was established, we would expect additional detail on other troubled assets to come in amendments to any program guidelines issued this week, and, in any event, no later than the expiration of the 45-day period.
The Act provides some guidance on the key components of the TARP. Treasury is directed to use market mechanisms, such as auctions and reverse auctions, wherever possible to achieve the purposes of the Act. Where an auction would not be feasible or appropriate, Treasury may engage in direct purchases. For example, distressed financial institutions are expected to need structured and negotiated direct sales.
The Act directs Treasury to prevent unjust enrichment of the participating financial institutions, including by preventing the sale of a troubled asset to Treasury at a higher price than what the seller paid to purchase the asset. However, methods to price and value the troubled assets are yet to be established. There are extensive and detailed reporting obligations, as described more fully under "Reporting and Information" below. Additional information will become available through the initial sales disclosures, release of the program guidelines and through periodic reports required under the Act. As described under "TARP Advisors" below, Treasury has already made significant progress in recruiting the external contractors that will conduct auctions, manage and hold assets and perform other key functions.
On October 13, Treasury officials described the creation of policy teams, including three related to specific purchase programs:
- Mortgage-backed securities program: This team is working to identify which troubled assets should be purchased, from which financial institutions, and what purchase mechanism will best meet Treasury's policy objectives. The team is designing detailed auction protocols and will work with the vendors selected to run the program.
- Whole loan purchase program: This team is working with bank regulators to identify which types of mortgage loans should be purchased first to alleviate the strain on regional banks, how to value the mortgage loans and which purchase mechanism will best meet Treasury's policy objectives.
- Equity purchase program: This team is designing a standardized program to purchase equity in a broad array of financial institutions. Treasury announced that the program would be voluntary and designed with attractive terms to encourage participation from healthy institutions, while encouraging firms to raise new private capital to complement the public capital.
On October 14, 2008, Treasury announced that work was ongoing to develop a program to potentially provide assistance to failing institutions. The Program for Systemically Significant Failing Institutions will have terms negotiated on a case-by-case basis. As described in more detail in our discussion of executive compensation, one key element of this program will be the prohibition of golden parachute payments.
On October 14, 2008, Treasury announced that it had developed the TARP Capital Purchase Program and nine financial institutions had agreed to participate in the program.
TARP Capital Purchase Program
On October 14, 2008, in a joint statement with the FDIC and the Federal Reserve, Treasury announced the development of the TARP Capital Purchase Program. Treasury has earmarked the first $250 billion from the Act for the program, and has allocated the first $125 billion to nine major financial institutions, reported to include: Bank of America, The Bank of New York Mellon, Citigroup, Goldman Sachs, J.P. Morgan Chase, Merrill Lynch, Morgan Stanley, State Street Corp., and Wells Fargo. The terms of the program are standardized and any financial institution may elect to participate by notifying their federal banking agency by November 14, 2008, 5:00 p.m. After notification of elections to participate, Treasury will consult with the appropriate regulator and determine eligibility and allocations.
The principal terms are as follows:
- Subscription amounts: minimum available is one percent of risk-weighted assets and the maximum amount is the lesser of $25 billion or three percent of risk-weighted assets
- Each participating financial institution will issue securities
to Treasury, including senior preferred shares, which will:
- qualify as Tier 1 capital
- be senior to common stock
- be pari passu with existing preferred shares (other than junior preferred shares)
- pay a dividend of 5% per year for the first five years, and 9% per year thereafter; the dividend will be cumulative unless the financial institution is a bank that is not a subsidiary of a holding company
- pay dividends quarterly beginning February 15
- permit Treasury to elect two directors if dividends are not paid for six consecutive quarters
- be non-voting (other than class voting rights on matters that could adversely affect the shares or similar market provisions)
- be callable at par after three years (and otherwise redeemable with the proceeds of an offering of replacement equity securities that provide Tier 1 capital)
- restrict the ability of a financial institution to increase common dividends until the third anniversary of the investment (unless Treasury has transferred the investment)
- require Treasury's consent before any share repurchases other than in connection with a benefit plan or in the ordinary course of business consistent with past practice until the third anniversary of the program
- be transferable by Treasury
- be covered by a shelf registration statement filed by the financial institution as soon as practicable and be subject to piggyback registration rights
- be funded by Treasury by December 31, 2008
- In connection with each investment, Treasury will also receive warrants to purchase common stock with an aggregate market price equal to 15 percent of the senior preferred instrument. The exercise price on the warrants will be the financial institution's 20-day average market price prior to issuance. The term will be 10 years, and the warrants will be immediately exercisable. The financial institution will be required to file a registration statement as soon as practicable after the investment, grant piggyback registration rights to Treasury, and apply to list the underlying common stock on the relevant exchange. There are limitations on Treasury's ability to transfer warrants and the exercise price for the warrants is subject to reduction upon successful completion by the financial institution of an offer of equity securities generating Tier 1 capital. If the financial institution does not have a sufficient number of authorized shares of common stock, it is required to take all actions necessary to increase the number of authorized shares. If unsuccessful, the exercise price of the warrants will be reduced every six months until the number of authorized shares is sufficient, or the reduction reaches 45%. In the event the financial institution is unable to obtain approval to increase the number of authorized shares, or its common stock is no longer listed, the warrant will be exercisable for senior term debt or another instrument.
- Financial institutions will be subject to the executive compensation requirements described below for participants in the TARP.
- Eligibility requirements for financial institutions are set forth in the program Term Sheet published by Treasury and Treasury will determine eligibility of interested participants. The definition of a qualified financial institution under the program (QFI) is narrower than the definition of a financial institution under the Act. QFIs include banks, savings associations, bank holding companies and savings and loan holding companies, in each case that are U.S. entities not controlled by a foreign bank. U.S. entities are those organized under the laws of the United States, any state, the District of Columbia or any territory or possession of the U.S. There are also requirements that bank holding companies or savings and loan holding companies only be engaging in permitted activities under Section 4(k) of the Bank Holding Company Act (BHC) or whose depository institution subsidiaries are the subject of an application under Section 4(c)(8) of the BHC.
Treasury has also released information regarding the executive compensation and governance requirements for participation in the program, as described below.
Insurance Program
Less is known about the insurance program, due in large part to its legislative history. Not part of the original plan submitted by Treasury, the insurance provision is believed by the members of Congress that argued for its inclusion to be a less costly alternative. The program is referenced inconsistently throughout the Act, and we expect that this is also due to the last minute nature of the addition. Treasury has announced the creation of an insurance program policy team. And on October 10, 2008, Treasury submitted a public Request for Comment to solicit the best ideas for structuring the insurance program. Responses are due by October 28, 2008 and design of the program will commence immediately thereafter.
Guidelines for an insurance program are not required on a specific time frame, unlike the purchase program. The Act does set forth a limited number of requirements and principles around which those guidelines will be based, focusing on the establishment and treatment of premiums. Premiums will be established and collected by Treasury in exchange for guaranteeing no more than 100% of the interest on, and principal of, troubled assets. These premiums will be deposited in the new Troubled Assets Insurance Financing Fund (Fund), which will in turn invest those proceeds in Treasury securities, cash or deposits.
The Act requires that premiums be established at a level to create reserves sufficient to meet anticipated claims against the troubled assets. Treasury has the authority to charge risk-based premiums based on the credit risk of particular assets, but Treasury must publish the methodology for setting those premiums. Moreover, Treasury must set the premiums at rates "necessary to create reserves sufficient to meet anticipated claims, based on actuarial analysis, and to ensure that taxpayers are fully protected."
Authority
As noted, Treasury will be buying, selling, managing and insuring assets. The authority granted to Treasury to undertake these actions is flexible and broad. With respect to management, Treasury has the ability to exercise all security-holder rights that accompany any acquired assets. This will include, among others, voting rights, contract rights and the exercise of rights against collateral. Treasury also has broad authority with respect to monetization and disposition of assets. It may sell assets or enter into securities loan agreements, repurchase transactions or "other financial transactions in regard to" any asset held under the program. See also the discussion below regarding foreclosure mitigation efforts.
We expect Treasury will follow the Act's mandate to encourage private investment in troubled assets, including through the use of loans. As several market participants have noted, some elements of the Resolution Trust Corporation model may be used for the private/public partnership elements of the Act.
Price Transparency
The Act provides for significant pricing transparency. Within two business days of any purchase, trade or other disposition of a troubled asset, Treasury is required to publicly disclose pricing information. The disclosure, which must be made electronically, will include a description of the troubled assets and the quantity involved in the transaction as well as the price. Treasury has yet to announce the form or location of these publications, and we expect there may be some adjustments through the first auctions. Additionally, numerous reports that include information regarding sellers, troubled assets, prices and the determination of pricing information are required. Market participants have raised concerns as to whether the pricing information from the TARP will constitute market pricing under FAS 157. We expect interpretations to follow the initial reports of purchases and sales. See the Reporting Appendix for more information about the reports that are required under the Act.
Duration Of Programs
The troubled asset purchase and insurance programs will terminate on December 31, 2009. Upon written certification to Congress identifying the expected cost, Treasury may extend the programs until October 3, 2010, provided the extension is necessary to achieve the goals of the Act.
Executive Compensation
As noted, financial institutions selling troubled assets to the Treasury will be subject to executive compensation requirements. See "Bailout Related Tax Changes and Impacts" below for a description of the Act's requirements.
Footnote
* See Morrison & Foerster LLP's News Bulletin "Economic Stabilization Act: Overview of Transactions involving Troubled Assets" at http://www.mofo.com/news/updates/files/14548.html
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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