After weeks of tumult in the financial markets and tense negotiations on Capitol Hill, the U.S. Senate has passed legislation aimed at restoring the flow of credit and stabilizing the nation's financial markets. The Emergency Economic Stabilization Act of 2008 represents a significant new role for the federal government in financial markets. The House of Representatives is scheduled to vote on the legislation on Friday, October 3, 2008. If passed into law, the Act's consequences will likely be felt not only by financial institutions, but also by participants in all aspects of the nation's economy.

A Faegre & Benson task force has been monitoring industry events and studying legislative developments. This article summarizes the Act's key provisions and considers how the Act will affect the market and legal environment.

What Does the Legislation Do?

Purchase of Troubled Assets. The Act is designed to "restore liquidity and stability to the financial system of the United States." The principal vehicle for accomplishing this goal is the Troubled Asset Relief Program (TARP). Under TARP, the Treasury Department has the authority to purchase "troubled assets" from financial institutions, which are defined in the Act as any entity holding qualifying assets, so long as the institution has a sufficient connection to the United States. The Act defines troubled assets very broadly to include residential or commercial mortgages, or any instruments that relate to those mortgages, that were originated or issued before March 14, 2008. This is the date that JPMorgan Chase agreed to acquire Bear Stearns, and is presumably the date Congress believes was the beginning of the most acute phase of this crisis. The Secretary of the Treasury can also purchase financial instruments that are not related to mortgages if the Secretary decides doing so would promote financial market stability and notifies Congress of the expansion.

Congress has given very little detail on how the Treasury Department should decide what assets to purchase, what price to pay or what to do with the assets after purchase. For example, the Act directs the Treasury Secretary to consider all methods to arrive at market-based pricing, including auctions, reverse auctions or direct purchases from institutions, but does not provide guidance as to how to select the method. The Act also gives the Secretary of the Treasury broad discretion to dispose of purchased assets or hold them to maturity. The Treasury Department, as authorized by the Act, likely will hire and deputize private asset managers to implement TARP and make crucial decisions concerning its implementation. Some of these details will be fleshed out in the coming weeks through policies and procedures which the Treasury Department will issue, but the Department is still expected to retain significant discretion.

Troubled Assets Under the Act. The "troubled assets" eligible for purchase under TARP are expected to be mainly mortgages and securities related to mortgages. However, because the Act gives the Treasury Department broad authority to purchase any other financial instrument, TARP could potentially include a vast array of instruments, such as instruments related to student loans, auto loans or auction-rate securities.

The principal type of troubled asset the government is expected to purchase under TARP will be mortgage-backed securities. These securities were created by pooling a large number of mortgages, then issuing securities representing various layers of claims to cash generated by the mortgage pools. The securities represent different categories of risk and return related to the performance of the mortgage pool. The securities that have the most senior rights to receive cash generated by the pool of mortgage loans have the lowest rate of return (the risk being relatively low) and the securities that have the most junior rights to receive cash generated by the pool of mortgage loans have the highest rate of return (the risk being relatively higher). As delinquency and foreclosure rates rise and the value of real estate declines, those securities that represent the more junior claims to cash from the pooled mortgage loans experience ever greater losses. If the pooled mortgage loans were subprime loans, the losses can reach even the more senior securities that were considered very safe at the time they were issued.

Many securities that TARP will purchase are even more complicated and further-removed from the mortgages themselves than the mortgage-backed securities. One example is collateralized debt obligations (CDOs), which are often securitizations of pooled mortgage-backed securities. In other words, CDOs bundle mortgage-backed securities into pools and then issue new securities that are based on the performance of the pool of mortgage-backed securities.

It is expected that the first purchases under TARP will be of the more simple mortgage-backed securities. But given the breadth of discretion granted to the Secretary under the Act, we will have to wait until the Department begins exercising its authority before we can accurately say what troubled assets will comprise the bulk of the acquisitions.

Insurance Program. The Act also requires the Treasury Department to establish an insurance program that will guarantee the performance of "troubled assets" that were issued before March 14, 2008. This program will be funded through premiums charged to participating institutions. The Treasury Department is authorized to guarantee up to 100 percent of the payments on troubled assets, including principal and interest.

Purchase Limits. The Act creates a cap on the total value of assets the Treasury Department may hold at any one time. The initial cap is $250 billion, which can be increased by $100 billion if the President certifies that it is necessary. The cap can be increased by an additional $350 billion if the President produces a detailed plan to spend those funds. Even if the President issues such a report, Congress will be able to reject the use of the final $350 billion.

New Regulation of Financial Institutions. The Act contains several provisions governing the conduct of institutions that sell troubled assets to the government under TARP.

Financial Interest to the Government. Institutions selling troubled assets to the government will be required to grant the government some financial stake. This provision is intended to give the government some additional financial gain if the institutions benefit from their participation in TARP. Publicly-traded firms will have to issue warrants for non-voting shares, and private firms will have to issue senior debt to the government.

Limits on Executive Compensation. The Act provides certain restrictions on pay to the senior executives of institutions participating in TARP to protect against risky or fraudulent conduct and to avoid rewarding senior executives, generally the five highest paid executives, upon termination. An institution that sells troubled assets directly to the government, which is expected for firms most threatened with imminent failure, will not be permitted to offer senior executives incentives for taking unnecessary risks, and will be prohibited from paying departing senior executives severance payments—sometimes called "golden parachutes"—when the government has an equity or debt interest in the institution. Also, the institution will be required to "claw back" compensation paid to a senior executive if it is later proven that the compensation paid was based on inaccurate statements. Institutions that sell more than $300 million in assets through auctions will be prohibited from offering golden parachute payments in new agreements. If the institution makes a golden parachute payment, it will not be tax-deductible for the institution, and the senior executive will be subject to a tax penalty on the payment. These institutions also will not be allowed to take a tax deduction for any amount over $500,000 paid to a senior executive.

Oversight and Homeowner Assistance. The Act includes numerous oversight provisions, including public disclosure of details of the purchases, regular reports by the Treasury Department to Congress, and the creation of two different oversight boards and a special inspector general for TARP. The Act includes several provisions related to individual homeowners, including requiring the Treasury Department to use its best efforts to avoid foreclosure of mortgages underlying the assets it has purchased.

Possible Reform of Mark-to-Market Rules. Many observers of the current crisis have suggested that mark-to-market or "fair value" accounting has been a significant contributing cause. The Act authorizes the SEC to suspend the application of the mark-to-market accounting standards in Financial Accounting Standards Board (FASB) Statement No. 157, Fair Value Measurements ("Statement 157"), for any issuer or type of transaction if the SEC determines that such suspension is in the public interest and is consistent with the protection of investors. In addition, within 90 days of the Act's passage, the SEC must complete a study of the application of mark-to-market accounting standards to financial institutions and provide Congress a report that includes administrative and legislative recommendations.

On September 30, 2008, the SEC and FASB issued joint guidance regarding Statement 157. The guidance does not suspend Statement 157, but it does seek to provide companies and their accountants with added flexibility in making fair value determinations under Statement 157 in the current market environment. Among other things, it clarifies that (1) management may consider internal assumptions (e.g., expected cash flows) in making fair value determinations when relevant market evidence is not present, (2) broker quotes are not necessarily determinative of fair value when an active market does not exist, (3) the results of disorderly transactions are not determinative of fair value, and (4) while transactions in inactive markets may be input when measuring fair value, they are likely not determinative. The FASB is also considering the issuance of a new staff position to illustrate key principles for determining fair value in a market that is not active.

Increase in Deposit Insurance. The Act temporarily increases the amount of insurance from $100,000 to $250,000 on deposits at institutions insured under the Federal Deposit Insurance Act or the Federal Credit Union Act. This increase sunsets on December 31, 2009.

Other Provisions in the Legislation. After the House failed to pass a version of the bill on September 29, 2008, procedural rules required the Senate to vote on a new version. The Act passed by the Senate on October 1, 2008, includes additional items that were also pending before the Senate. The Act will extend and expand renewable energy and alternative energy tax credits and benefits, including tax credits related to wind energy, biodiesel, and carbon mitigation. The Act will also extend and alter other tax code provisions, including extension of Alternative Minimum Tax credits, addressing employee benefit plan coverage and benefits for mental health and addiction issues, and tax relief to disaster areas.

What Happens Next?

While the Act establishes broad guidelines for TARP, it leaves some of the most significant questions about the program unanswered. Specifically, the Act gives the Treasury Department time before it must publish "guidelines" addressing:

• What mechanisms will the government use to buy troubled assets?
• How will the government set prices and values for the troubled assets?
• What criteria will the government use to identify which troubled assets to purchase?
• How will the government select the asset managers, and who will make many crucial decisions in administering TARP?

The Act provides that establishing procedures for TARP should "not delay commencement" of the program. Accordingly, the Act allows the Treasury Department to begin purchasing assets before answering any of these important questions. If this happens, however, the Department must issue its program guidelines no later than two days after the first TARP purchase. If the Department chooses to issue guidelines before making asset purchases, it must publish the guidelines no later than 45 days after the Act's enactment.

How Will TARP Affect Financial Markets?

For financial and credit markets, even more important than the type of assets purchased is the price that the government will pay for them. As noted above, the Act does not explain how the prices will be established. It is only clear that the government will have complete discretion to set the offering price, and very broad discretion about the institutions from whom it will buy the assets.

Using low "fire sale" prices, while perhaps seeming attractive at first blush, may do more harm than good, since an artificially low price will not accurately reflect the value of the securities and will fail to revive the market for such securities. Many experts agree that reviving the market is crucial, as there are likely far more troubled assets than the Treasury Department can purchase within its $700 billion limit.

If TARP succeeds in reviving the credit markets, then the economy would improve, and mortgage and other credit defaults could be minimized. If the plan works well and the government could sell the formerly troubled assets, the government would be repaid, at least in part. It is even possible that the government could recognize a substantial return on some of the assets that it purchases under TARP.

How Will TARP Change the Legal Landscape?

With the details of TARP so vague and the discretion vested in the Treasury Department so great, the program could spawn a wide variety of litigation.

The government, as purchaser of troubled assets under TARP, may choose to exercise legal claims and rights that go along with those assets. If it does, then another field of litigation could be opened in which, as in the S&L bailout of the 1980s and 1990s, the government pursues legal claims that formerly belonged to the old asset holders.

Another possible area of litigation relates to the review of TARP's activities. Until "program guidelines" are issued—no later than 45 days after the Act is enacted—we will not have a sense of when and to what degree the government's actions can be successfully challenged by those who feel that the Treasury Department—or the asset managers that it deputizes to run TARP—have exceeded or abused their authority. The Act does provide for judicial review and reversal of Treasury Department decisions that are "arbitrary, capricious, an abuse of discretion, or not in accordance with law." But the Act also sets strict limits on the type of relief available, prohibiting injunctive relief for anything other than constitutional violations.

Yet another source of civil litigation may be related to the rights of firms that "service" mortgages that have been pooled and securitized. In mortgage-related securities, the mortgage rights themselves are generally left in the hands of a "servicer" that administers the loans. This permits one entity to service individual loans and distribute funds to trustees to pay the various investors. Servicers and trustees have contractual obligations related to the mortgages that have been pooled and securitized, but may be under government pressure to change mortgage terms and avoid foreclosure of certain mortgages. Despite language in the Act attempting to preserve a servicer's right and duties, it is possible that litigation may arise over how TARP's purchases will affect the contractual duties of these participants in securitizations.

Besides civil litigation, we expect that the government will pursue criminal charges against people whose allegedly illegal conduct contributed to the crisis. The FBI has already announced that a task force has opened 26 investigations into whether fraud contributed to the failures of Lehman Brothers and the bailouts of AIG, Fannie Mae and Freddie Mac. The FBI's investigation extends to 1,400 individuals, in addition to the corporations themselves. While no indictments have yet been issued, it is likely that an investigation of this size and scope will result in a number of criminal prosecutions.

Conclusion

News and details about the Act continue to emerge. The Faegre & Benson TARP task force will continue to analyze developments so that our clients will have the latest and best information about how this crisis and its potential solutions will affect their business and the economy.

If you have any questions or would like more information, please contact one of the following Faegre & Benson ERS Task Force lawyers: