Troubled Asset Relief Act of 2008

As of the issuance of this update on September 24, 2008, three legislative propos- als are now being considered by Congress to restore liquidity and stability to the financial system. Any of these proposals, if enacted, would result in the most significant economic intervention by the federal government since the Great Depression. The first of these proposals was announced on September 20, 2008, by Secretary of the Treasury Henry Paulson. This proposed Troubled Asset Relief Act of 2008 (“TARA”) is a comprehensive plan authorizing the Treasury to remove distressed assets from the financial system primarily through the purchase of mortgages and mortgage-related assets from qualified financial institutions. Earlier this week, Senate Banking Committee Chairman Christopher Dodd and House Financial Services Committee Chairman Barney Frank each also released proposed alternatives to TARA.

While these proposals are similar in many ways, each proposal emphasizes a different goal. The Treasury proposal focuses almost exclusively on the removal of troubled assets from the financial system using a not yet fully defined auction or reverse auction pricing mechanism which is intended to both protect taxpayers and provide a market price to all market partici- pants to unfreeze the capital markets so that the flow of capital to consumers and companies can resume. Its narrow focus is designed to ensure maximum participation by financial institutions and provide the Secretary of the Treasury with the discretion to more easily adapt the program to changing market condi- tions as necessary. Although there are some material differences between the Senate and House proposals, both Senator Dodd and Representative Frank are seeking to provide Congressional and GAO oversight of this program to assure that taxpayers are ade- quately protected and to protect homeowners by permitting loan modifications to prevent foreclosures and bankruptcy judges to modify loans. Both are concerned that executive compensation be limited for senior executives in financial institutions selling assets to the government under this program. In addition, both would limit Treasury’s guarantee or insurance of money market mutual fund shareholders to the limit of FDIC insurance available to bank depositors and would require the Secretary to charge such money market funds a premium for such insurance equal to the premium charged by the FDIC. Unlike the Treasury and House proposals, Senator Dodd’s proposal expressly prevents the Treasury from purchasing troubled assets unless Treasury receives contingent securities from the selling institution. While providing for somewhat less oversight than Senator Dodd’s proposal, Congressman Frank’s proposal imposes limitations on executive compensation at financial institutions selling troubled assets to the Treasury similar to those proposed by Senator Dodd and increases shareholders’ rights in this regard as well.

The Treasury Proposal

The Treasury proposal would give the Secretary of the Treasury broad discretion to purchase “troubled assets” over the two years following passage of the Act; such two year limitation would not apply to the Secretary’s management or disposition of the assets purchased. The amount of troubled assets purchased by the Treasury would be limited to $700 billion outstanding at any one time. Treasury’s actions would be subject to only minimal oversight from any agency, court, or institution. Troubled assets would include residential and commer- cial mortgages and mortgage-backed securities, obligations, and other instruments originated or issued before September 17, 2008, as well as “any other financial instrument, the purchase of which the Secre- tary determines necessary to promote financial market stability.” The assets could be purchased from any qualified “financial institution”—i.e., an institution organized and regulated under U.S. federal or state law and having significant operations in the U.S. whether domestic or foreign owned, other than any foreign central bank of or institution owned by a foreign government, and any institution that is providing financing secured by troubled assets of a qualified financial institution. The program would be funded through the auction of U.S. public debt, without the need for any appropriations by Congress.

The Secretary of the Treasury would have the authority to take such actions as the Secretary deems necessary to carry out the authorities of the act, including desig- nating financial institutions as financial agents of the government and establishing vehicles that are author- ized to purchase troubled assets and issue obligations. The Secretary would have discretion to exercise any rights received in connection with the purchased troubled assets and could sell or enter into securities loans, repurchase transactions, or other financial transactions with respect to the assets purchased. The goal is for the Secretary to purchase the troubled assets at a price determined by market mechanisms, manage the assets (including providing loan modifications as appropriate to homeowners to avoid preventable foreclosures), and then either hold the assets or sell them when market conditions improve. The revenues and proceeds from the assets would be deposited into the general fund of the United States Treasury. When possible, the Secretary would use market mechanisms, such as auctions or reverse auctions, to determine the purchase price of assets. The Secretary would also have discretion to make direct purchases where no bidding process or market prices are available, in which case the Secretary must pursue additional measures to ensure that purchase prices are reasonable and to share the risk of loss with the seller including, among other things, by obtaining warrants or sharing losses. All actions by the Secretary would be non-reviewable and no court of law or administrative agency could issue an injunction or any other form of equitable relief.

The Dodd Proposal

Senate Banking Committee Chairman Christopher Dodd’s proposed alternative would give the Secretary discretion to purchase, manage, and sell mortgage- related assets, but would provide for greater restrictions on and oversight of the program. Like the Treasury proposal, the Dodd proposal authorizes the Secretary to purchase and hold up to $700 billion in troubled assets outstanding at any one time, but “troubled assets” would be restricted to those assets originated or issued on or before March 14, 2008. Furthermore, the Dodd proposal would restrict the Secretary from purchasing any assets without receiving “contingent shares” from the selling institution of equal value to the purchase price of the assets purchased. If the Secretary disposes of troubled assets for less than their purchase price, such shares would automatically vest in the Treasury in an amount equal to 125% of the amount of the loss divided by the average share price of the related financial institution during the fourteen business days prior to the purchase of the troubled assets. If the equity of the financial institution is not publicly traded on a national securities exchange, the Secretary would acquire a senior contingent debt instrument that would automatically vest on a loss on sale in an amount equal to 125% of the amount of the loss and which would be payable on demand by the Treasury. In addition, the Dodd proposal would require financial institutions seeking to sell assets to the Treasury to meet “appro- priate standards” for executive compensation, including a “claw-back” provision for incentive compensation paid to a senior executive based on earnings, gains, or other criteria that are later proven to be inaccurate. The Dodd proposal would amend the federal bankruptcy code to permit bankruptcy judges to modify loan terms on residential mortgages on primary residences and would divert 20% of any profits on the sale of assets by the government to certain housing initiatives. The Dodd proposal would also modify the recent Treasury guaran- tee of money market mutual funds to be in parity with FDIC insurance on bank deposits by providing that Treasury guarantee or insurance of money market mutual funds shareholders could not exceed the insurance provided depositors by the FDIC and would require the Secretary to charge such funds premiums for such insurance equal to those charged by the FDIC. Senator Dodd’s proposal provides for oversight through an Office of Financial Stability established with the Treasury, an Emergency Oversight Board consisting of the Chairman of the Board of the Federal Reserve, the chair of the Board of Directors of the FDIC, the chair of the SEC and two non-governmental employees with financial expertise, auditing by the Comptroller General, appointment of a special inspector general and signifi- cant reporting requirements with respect to the pro- gram. Determinations by the Secretary under the program although final could be set aside if they are found to be arbitrary, capricious, an abuse, or discretion or not in accordance with law.

The Frank Proposal

House Financial Services Committee Chairman Barney Frank’s proposal for the purchase of troubled assets is similar to the Treasury’s proposal in the authorized dollar amount and duration of the program. It also does not require the Treasury to acquire contingent shares in the seller of the troubled assets, but leaves this issue to the discretion of the Treasury. In lieu of a formal Emergency Oversight Board, the Frank proposal calls for the Secretary of the Treasury to consult with the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the FDIC, and the Secretary of Housing and Urban Development when exercising its authority under the act. For financial institutions whose assets the Secretary acquires by direct purchase, the Frank proposal provides shareholders of such financial institutions additional rights including giving any shareholder(s) holding three percent of more of the equity of such institution access to the proxy solicita- tions and shareholder vote of any election of the board of directors “for the purpose of nominating and electing a designated individual to the board of directors of the institution” and allowing all shareholders “the opportu- nity to cast a non-binding vote, in any annual proxy solicitation and shareholder vote, on the executive compensation to be provide[d] to the executive officers of the financial institution,” and further restricts executive compensation by prohibiting all severance compensation to senior executives for so long as the government holds an equity position in such financial institution. In addition, to facilitate market transpar- ency, Treasury would be required to make public disclosures of the description, amount and price of all assets acquired within 48 hours of purchase.

Legislative Hearings

At the September 23, 2008, Senate Banking Committee Hearing, the salient points in testimony by Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, SEC Chairman Christopher Cox, and Federal Housing Finance Agency Director James d Lockhart included the pricing of assets to be acquired, whether the federal government should get equity interests in the financial institutions it helps and whether a bill should put limits on the compensation of executives at those institutions. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson suggested that a reverse auction could set a value close to what the assets are really worth. Given uncertainties in the housing and financial markets, institutions are being forced to mark assets at fire-sale prices, Chairman Bernanke said, which are generally much lower than a hold-to-maturity price, feeding a “vicious circle” of asset sales and further write-downs. “If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits,” Chairman Bernanke said. “First, banks will have a basis for valuing those assets and will not have to use fire-sale prices. Their capital will not be unreasonably marked down.” Secretary Paulson testified that the pricing mechanics would create a “price discovery mechanism” freeing private capital from the current freeze in the capital markets. Both Chairman Bernanke and Secretary Paulson argued that equity interest provisions and limits on executive compensation would limit the participation by institu- tions. Chairman Bernanke stated, “If we keep the range of participants too narrow, then we won’t have a robust, competitive auction.” Secretary Paulson remarked, “If you impose these kinds of punitive measures, it won’t work and we’ll all lose.”

Following Tuesday’s Senate Banking Committee hearing and today’s House Financial Services Committee hearing, Congress is expected to debate and vote on the proposed legislation prior to the end of this week; however, as a result of the significant differences among the proposals and contrasting views of the Bush Administration and members of the Democratic and Republican Congressional leadership and the recent addition of this proposed legislation as an issue in the Presidential campaign, it is unlikely that such an aggressive timetable will be followed. Dechert attorneys will continue to closely monitor the progress of the legislation and analyze the expected impact on our clients and the financial markets generally. In light of the fast pace at which the proposals discussed in this update are being modified and supplemented, we encourage you to consult with a Dechert attorney for the current status of this legislative effort and to check Dechert’s website where we may post further updates on this topic.

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