Emergency Economic Stabilization Act Implications For Banks

The Emergency Economic Stabilization Act of 2008 (EESA), signed by the President on October 3, 2008, authorized the Secretary of the U.S. Department of the Treasury (Treasury) to establish the Troubled Assets Relief Program (TARP) to purchase "troubled assets." Troubled assets are broadly defined in two 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. In this category, Treasury is working on the details of a program to purchase troubled mortgage-related assets through an auction format and plans to issue guidance soon. The second category includes other financial instruments if, after consultation with the Chairman of the Federal Reserve, the Treasury makes a determination that the purchase is necessary to promote financial market stability. Under this second category, the Treasury announced on October 14, 2008 the Capital Purchase Program (CPP). Through the CPP, Treasury will make capital investments in banking institutions in order to strengthen and stabilize U.S. financial institutions. Also on October 14th, the FDIC announced the Temporary Liquidity Guaranty Program (TLGP), a new guarantee program for certain banking institution liabilities. We are providing a brief summary of the major features of these programs.

Troubled Asset Auction Program

Under this program, Treasury may purchase troubled mortgage-related assets from financial institutions through an auction process. To qualify, an asset must have originated or have been issued on or before March 14, 2008. Additionally, Treasury must make a determination under the program that the acquisition of the asset promotes stability in the financial markets.

Where the purchases of troubled assets from a financial institution, aggregated with any other assets acquired by Treasury under TARP, exceed $300,000,000, the institution is prohibited from entering into any new employment contracts with its senior executive officers that provide for golden parachute payments in the event of an involuntary termination, bankruptcy filing, insolvency, or receivership. This prohibition applies from the date of the first purchase under the TARP through December 31, 2009, (the end of the authority period for the EESA) or, if the EESA is extended, the prohibition extends to October 3, 2010. Additionally, the prohibition applies without regard to whether the federal government ceases to hold an equity or debt position in the financial institution. In other respects, the restrictions on executive compensation appear to be similar to those described below under the Capital Purchase Program. The details of the auction program are still being developed.

Capital Purchase Program

Under the CPP, the Treasury will purchase up to $250 billion of senior preferred shares from qualifying U.S. banking organizations on standardized terms. The forms of the required documents have not yet been provided by the Treasury, but they are expected to reflect the term sheet made publicly available on the Treasury's website. The Treasury has indicated that participants in the CPP will not be able to negotiate any significant substantive changes to the standard documents. A Qualified Financial Institution (QFI) may elect to participate in the CPP by filing an application with its federal banking agency no later than 5:00 p.m. on November 14, 2008.

Eligibility

As a general matter, any bank, savings association, bank holding company and savings and loan holding company organized under the laws of the United States qualifies for participation in the CPP. Working in consultation with the federal banking regulators, Treasury will determine if the application will be accepted and the amount of preferred shares that will be purchased from the QFI. If Treasury preliminarily approves the application, the QFI will have 30 days from the date of notification of preliminary approval to submit the investment agreements and related documentation for the purchase of preferred shares. In order to participate in the CPP, the QFI must also comply with certain executive compensation standards described below under the heading "Executive Compensation Standards."

Securities to be Issued to the Treasury

The minimum amount of Treasury's investment in the senior preferred stock of any institution is 1% of the institution's risk-weighted assets; the maximum investment is 3% of the institution's risk-weighted assets. The securities that will be issued to the Treasury will be (i) non-voting (subject to certain exceptions) senior preferred stock of the QFI, with a liquidation preference of $1,000 per share (Preferred Stock) and (ii) warrants, immediately exercisable in whole or in part during a ten year term, to purchase shares of common stock of the QFI having an aggregate market price equal to 15% of the value of the Preferred Stock on the date of the investment. The Preferred Stock will rank senior to common stock and equal to any existing preferred stock (unless the existing preferred stock is by its terms junior to any existing preferred stock). Although generally non-voting, the Preferred Stock will have voting rights with respect to certain matters directly impacting the Preferred Stock (e.g. any amendments affecting the terms or rights of the Preferred Stock).

Executive Compensation Standards

Companies participating in the CPP must adopt the Treasury standards for executive compensation and corporate governance for the period during which the Treasury holds equity securities under the CPP. These standards apply to the senior executive officers (SEOs) of the financial institutions. The SEOs are the QFI's top five most highly paid executive officers. SEO status is determined during the current year. This will mean that the SEOs could change during the course of the year. While none of the executive compensation standards set forth below are required at the time of application for the CPP, they are conditions precedent to receiving the Treasury's investment under the CPP.

The executive compensation standards the QFI must meet during the period that Treasury holds equity issued under the CPP include: (1) ensuring that incentive compensation for SEOs does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) requiring "clawback" of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate; (3) prohibition on the QFI from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and (4) an agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. The Treasury's capital investments will be conditioned on (i) the QFI and its SEOs agreeing to modify any existing arrangements to conform to the requirements of the executive compensation rules, and (ii) an agreement by the SEOs to waive any claims they might have as a result of the modification requirements. The specific criteria are briefly described below.

Unnecessary and Excessive Risk. As long as the Treasury holds an equity or debt position, the QFI will be prohibited from entering into incentive compensation arrangements that encourage SEOs to take unnecessary and excessive risks that threaten the value of the financial institution. Treasury defers the decision of unnecessary and excessive risk to the compensation committee and provides that the committee could consider long-term and short-term risks. Within 90 days of the first purchase under the CPP, the compensation committee must meet with the senior risk officer of the QFI to discuss and identify any features in the institution's incentive compensation arrangements that could lead the executives to take unnecessary and excessive risks that could threaten the institution's value.

Clawbacks. SEO bonus and incentive compensation paid by the QFI while the Treasury holds an equity or debt position must be subject to recovery or "clawback," by the QFI if the payments were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria.
Golden Parachute Payment Prohibition. The QFI would also be prohibited from making any golden parachute payments to SEOs while the Treasury holds an equity or debt position in the company. For purposes of the CPP, the prohibition on parachute payments applies not only in instances of change of control as is the case for all other parachute payments under Section 280G, but also in instances of involuntary termination or bankruptcy or receivership of the institution. Since these limits only apply to payments to the SEO during the period the Treasury holds an equity or debt position, if the SEO is terminated during this period, it may be possible to retain severance provisions but withhold payment of the severance until after the Treasury no longer holds an interest. Any deferrals would need to be drafted carefully in light of the deferred compensation rules under Section 409A of the Internal Revenue Code.
Deduction Limitations. Section 302 of the EESA modifies Section 162(m) of the Internal Revenue Code and reduces the annual limit on the deductibility of compensation paid to "covered executives" from $1 million to $500,000. As a condition of participation in the CPP, Treasury requires that institutions agree to be subject to Section 302's limitation on tax deductions for covered executive remuneration in excess of $500,000, including its provision that commissions and performance-based compensation cannot be excluded from the calculation of the $500,000 limit.

Temporary Liquidity Guaranty Program

Through the TLGP, the FDIC will provide insurance to previously uninsured amounts in non-interest bearing deposit accounts and certain newly issued senior unsecured debt.

Eligibility

The institutions eligible to participate in the TLGP are essentially the same as the QFI under the CPP. All eligible institutions are automatically covered by the TLGP until November 13, 2008, (the first 30 calendar days following announcement of the program on October 14, 2008). Any newly issued senior unsecured debt of an eligible institution, for an amount that is under the issuance cap, is guaranteed automatically and without further action by the institution. This includes all inter-bank debt.

If an institution is not interested in participating after November 13, 2008, it must affirmatively opt-out of the program. Failure to opt-out of the program will automatically enroll the eligible participant and fees will be assessed by the FDIC. The opt-out is a one-time event and is a permanent decision for the duration of the program; an institution's status after November 13, 2008, will be its status throughout this program.

Senior Debt Covered

Under the TLGP, newly issued senior unsecured debt issued on or before June 30, 2009, will be fully insured in the event the issuing institution subsequently fails, or its holding company files for bankruptcy. The debt included in the program includes all newly issued unsecured senior debt, including: promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt. The aggregate coverage for an institution may not exceed 125% of the debt outstanding on September 30, 2008, that was scheduled to mature before June 30, 2009. The guarantee of any newly issued debt will extend to June 30, 2012; however the maturity of the debt may be after that date.

While this program has been named a "guaranty program" it operates under the same terms as FDIC insurance. The FDIC is not providing a payment guarantee in the event the issuer of senior unsecured debt fails to make payments of interest or principal. The FDIC will pay the guaranteed debt only in the event of an institution's failure, receivership or bankruptcy. The FDIC has not determined whether participants will be able to elect which of their new senior debt instruments they would like to have guaranteed. Recent statements from the FDIC indicate that new guaranteed debt cannot be used to redeem or replace outstanding debt prior to the maturity of the outstanding debt according to its current terms. There are many questions that are unanswered and subject to further discussion and determination.

Important Differences Between TLGP and CPP

The CPP and the TLGP are separately administered and impose different requirements on their participants. The executive compensation requirements imposed through participation in the CPP are not applicable to participants in the FDIC's guarantee program. Similarly, there is no requirement of a capital investment by a federal regulator in the financial institutions that volunteer for the guaranty program. An institution can participate in either, both or neither program, depending on eligibility.

Fannie and Freddie Losses

Good news for qualifying financial institutions holding preferred stock in Fannie Mae and Freddie Mac. Community banks and qualifying financial institutions may treat their Fannie Mae and Freddie Mac loss as ordinary losses. This rule applies to preferred stock that was held on September 6, 2008 or sold or exchanged on or after January 1, 2008 and before September 7, 2008.

Notice 2008.91

Although not part of EESA, the Treasury Department released Notice 2008-91 on October 3, 2008 easing a rule to help U.S. based multinational corporations borrow cash from their offshore subsidiaries without subjecting them to the 35% tax penalty under Section 956 of the Internal Revenue Code. Notice 2008-91 extends from 30 to 60 days the time foreign subsidiaries may lend money to their U.S. parent to assist them in issuing commercial paper while avoiding the 35% tax penalty by accessing their offshore cash. Typically, domestic corporations hold cash abroad to defer paying U.S. taxes. The relief provided in Notice 2008-92 is intended to thaw frozen credit markets.

This is just a brief summary of the implications of EESA for banking institutions. If you would like more details, please contact James A. Ulsh or Mary Alice Busby in our Business Organization and Banking Practice Area.