U.S. Law Briefing. Government Response to Global Credit Crisis: Mortgage Bailout Legislation

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1 U.S. Law Briefing Government Response to Global Credit Crisis: Mortgage Bailout Legislation The global financial markets have undergone sweeping changes in recent weeks, unrivaled in magnitude and significance since the financial crises occurring 80 years ago surrounding the Great Depression. These changes have affected many of the largest and most well-established U.S. financial institutions: Lehman Brothers filed for bankruptcy, Bank of America acquired Merrill Lynch in the face of questions surrounding the latter s viability, AIG was rescued by the federal government through a loan and guarantee program that in effect provides that the federal government will own and operate AIG and most recently, Wachovia and Wells Fargo unveiled plans to merge, sparking a potential takeover battle to acquire Wachovia between Wells Fargo and Citigroup. Amid lingering concerns over the global effects of the spreading credit crisis, and its possible impact on remaining market participants, and following rancorous political debate, Congress enacted financial bailout legislation on October 3, The legislation includes the Emergency Economic Stabilization Act of 2008 (the Act ) which establishes the Troubled Assets Relief Program (the Plan ). The Plan represents the end result of draft legislation (the Proposal ) initially submitted by Secretary of the U.S. Department of the Treasury (the Treasury ) Henry Paulson (the Secretary ) to Congress. The Proposal was heavily revised by Congress, which believed the Proposal was severely flawed. The Act closely resembles the bill drafted by the U.S. House of Representatives (the House ) that failed in a close vote on the House floor on September 29, The House s bill was revised by the U.S. Senate (the Senate ) to increase its appeal across Congressional party lines, and was attached to other packages that extend many individual and business tax breaks, including production and use tax credits for renewable energy sources and a one-year alleviation of the effects of the Alternative Minimum Tax. The Plan is intended to rescue the crippled U.S. financial markets by permitting the Treasury to purchase up to U.S.$700 billion worth of distressed assets, primarily mortgage-backed securities, to be bought from financial institutions, and eventually either to hold such assets to maturity or to re-sell such assets to the private sector. Under the Plan, the U.S.$700 billion will be available in installments, as further described below. The Act also places restrictions on compensation received by executives at firms that participate in the Plan, including bans on incentives that encourage excessively risky behavior, the claw-back of bonuses paid out for earnings that fail to materialize, and limits on so-called golden parachutes, or generous severance packages. Furthermore, it raises the Federal Deposit Insurance Corporation ( FDIC ) deposit insurance cap from U.S.$100,000 to U.S.$250,000 through the end of If all goes as the U.S. government envisions, this large-scale governmental intervention into the market will mitigate the financial institutions struggles to raise and maintain capital and return some normalcy to the economy, including the real estate market. This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2008 Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ and such persons are either solicitors, registered foreign lawyers or European lawyers. September

2 This Briefing is intended to summarize the Act, the initial reaction to it including uncertainties surrounding it, and certain market-related issues. Summar y of the Plan Fundamentals of the Plan: Purchase of Troubled Assets: The Act authorizes the Secretary to establish the Plan to purchase, on terms generally left up to his discretion (subject to the limits summarized below), Troubled Assets, which are defined as residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to mortgages, that were originated or issued on or before March 14, 2008, plus any other financial instrument that the Secretary determines the purchase of which is needed to promote financial market stability (the Troubled Assets ). Under the Act, the Secretary will establish an Office of Financial Stability within the Treasury Department to implement the Plan. The Secretary is authorized to take certain actions including designating financial institutions as financial agents of the federal government to carry out the purposes of the Act. Pricing of Troubled Assets and Purchase Procedures: The Secretary is authorized to establish guidelines (within two business days of the first purchase or, at the latest, 45 days after enactment) of the Act setting forth the mechanisms for purchasing Troubled Assets, pricing and valuing methods for Troubled Assets, procedures for selecting asset managers, and criteria for identifying Troubled Assets for purchase. Generally, the Secretary may not purchase a Troubled Asset at a price higher than what the Seller paid to purchase the asset. The Secretary is required to use market mechanisms for purchases whenever possible to maximize the efficiency of taxpayers resources, including by holding auctions and reverse auctions, and shall pay the lowest price that the Secretary determines to be consistent with the purposes of the Plan. The Treasury may purchase Troubled Assets directly from individual financial institutions where such market mechanisms are not feasible or appropriate, provided the prices paid for such assets are reasonable and reflect the underlying value of the Troubled Assets. Eligible Sellers: The Troubled Assets can be purchased from any eligible financial institution. The term financial institutions is defined to include any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company established and regulated under the laws of the United States or any state and having significant operations in the U.S. As defined, eligible financial institutions appear to include many U.S. subsidiaries, branches and agencies of foreign banks if they are "established and regulated" in the United States, but excludes any central bank of, or institution owned by, a foreign government. Although the definition does not on its face cover affiliates of covered institutions, the phrase including but not limited to will give the Secretary the power to define covered institutions in rules and guidelines. The Secretary is prohibited from discriminating against sellers with respect to their size, geography, form or organization, or the size, type, and number of assets eligible for purchase. 2

3 Insurance of Troubled Assets: Alongside the purchase program under the Plan, the Secretary must establish an insurance program (the Insurance Program ) to guarantee financial institutions' Troubled Assets. Any financial institution that decides to participate in the Insurance Program is required to pay the government a premium (that varies according to risk) at least at a level necessary to create reserves sufficient to meet anticipated claims (as determined by the Secretary). The Insurance Program can only guarantee Troubled Assets in amounts not greater than 100% of the amount of the payment of principal and interest on the Troubled Assets. The amount the Treasury spends to cover losses, minus the premiums collected under the Insurance Program, will be deducted from the U.S.$700 billion the Treasury is authorized to spend under the Plan. Many of the details of the Insurance Program are left to the Secretary s discretion. Considerations: In exercising authority under the Act, the Secretary is required to take into account a number of considerations, including protecting the taxpayers interests, preventing disruption to financial markets, minimizing the impact on the national debt, preserving homeownership, protecting the retirement security of Americans, ensuring the needs of all financial institutions regardless of size or other characteristics, and the needs of local communities. The Act also requires the Secretary to examine the long-term viability of an institution in determining whether to directly purchase assets from an individual financial institution. Resale of Troubled Assets: The Secretary may exercise any rights received in connection with Troubled Assets purchased under the Act at any time. The Secretary has authority to manage Troubled Assets, and sell or enter into any financial transactions in regard to any Troubled Assets. The profits from the sale of Troubled Assets shall be paid into the Treasury for reduction of the national debt. Conflicts of Interest: The Secretary is required to issue regulations or guidelines to manage or prohibit conflicts of interest in the administration of the program including conflicts arising in the selection or hiring of asset managers and the purchase or the management of the Troubled Assets. Coordination with Foreign Authorities and Central Banks: The Secretary shall coordinate with foreign authorities and central banks to establish programs similar to the Plan. To the extent that such foreign financial authorities or banks hold Troubled Assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such Troubled Assets qualify for purchase by the Secretary under the Act. Graduated Funding Authorization: The Act authorizes the full U.S.$700 billion as requested by the Treasury Secretary for implementation of the Plan, but this total is available only in installments. It allows the Secretary to immediately spend up to U.S.$250 billion. Upon a Presidential certification of need, the Secretary may access an additional U.S.$100 billion. The remaining U.S.$350 billion may be made available after the President transmits a written report to Congress detailing the Secretary s plan to exercise the remaining authority. The Secretary may use this additional 3

4 authority unless within 15 days Congress passes a joint resolution of disapproval which may be considered on an expedited basis. Recoupment: Five years after the date of enactment, if the Plan is running a shortfall, the President will be required to submit a legislative proposal to Congress that recoups for taxpayers the amount of the shortfall from the financial industry. Term: The Act provides that the Treasury's authority to purchase or guarantee Troubled Assets under the Plan terminates on December 31, 2009, but may be extended to expire not later than two years from the date of enactment of the Act upon the submission of a certification of need by the Secretary to Congress Source of Funding: Funding for the asset purchases will be provided by U.S. taxpayer dollars, and the Act increases the U.S. federal debt limit from U.S.$10 trillion to U.S.$11.3 trillion. Mark-to-Market Accounting: The Act restates the authority of the U.S. Securities and Exchange Commission (the SEC ) to suspend the application of so-called mark-tomarket accounting rules under FASB Statement No. 157 and requires the SEC, in cooperation with the Treasury and the Federal Reserve, to conduct a study on the effects of mark-to market accounting on balance sheets and the quality of financial information. Exchange Stabilization Fund Reimbursement: The Act provides that the Secretary shall reimburse the Exchange Stabilization Fund 1 for any losses incurred due to the temporary money market mutual fund guarantee. The Act also prohibits any future use of the Fund for any guarantee program for the money market mutual fund industry. Taxpayer Protections: Minimization of Long-Term Costs and Maximization of Benefits for Taxpayers: The Secretary is required to use his authority under the Act in a manner that will minimize any potential long-term negative impact on the U.S. taxpayer, taking into account various factors including the direct outlays, potential long-term returns on assets purchased and overall economic benefits of the program. Market Mechanisms: In making purchases of the Troubled Assets, the Secretary shall use market mechanisms to the extent possible, as described above. Warrants: The Act requires sellers under the Plan to provide non-voting warrants to the Secretary so that U.S. taxpayers gain an ownership stake and benefit from any future growth of any financial institution selling assets to the 1 The Exchange Stabilization Fund (the ESF ), which now amounts to U.S.$50 billion, authorizes the Secretary to conduct interventions in foreign exchange markets. On September 19, 2008, President Bush approved use of the ESF by the Secretary to establish a temporary guaranty program for the U.S. money market mutual fund industry. For the next year, the Treasury will insure the holdings of any publicly offered eligible money market mutual fund (both retail and institutional) that pays a fee to participate in the program. 4

5 government. Specifically, the Secretary may not purchase any Troubled Assets unless the Secretary receives from the seller a warrant to receive nonvoting common stock or preferred stock in a seller that is a financial institution that is traded on a national securities exchange, or a warrant for common or preferred stock, or a senior debt instrument, from a seller that is not traded on a national securities exchange. Warrants must provide the government with reasonable participation in equity appreciation and provide additional protection against loss in the sale of the assets. They must also contain anti-dilution provisions of the type employed in capital market transactions, as determined by the Secretary. No warrants are required for purchases of less than U.S.$100M from any one financial institution for the duration of the Plan. FDIC Insurance Cap Increase: The Act temporarily raises the FDIC limit on insured bank deposits to U.S.$250,000 per account from U.S.$100,000, a level that had been in place since This increase will expire on December 31, The Act temporarily allows the FDIC to borrow unlimited amounts of money from the Treasury in connection with such extension, in order to ensure depositors can be repaid if their banks fail. Executive Compensation Limits: The Act places restrictions on compensation received by executives at firms that participate in the Plan. 2 The executive compensation provisions of the Act apply to two different types of financial institutions: (1) those firms in which the federal government engages in a direct purchase of Troubled Assets, and in connection with the transaction takes a meaningful equity or debt position ( Direct Purchases ) and (2) firms that sell at least U.S.$300 million in Troubled Assets to the Treasury through an auction process ( Auction Purchases ). For each firm in which the federal government takes a meaningful equity or debt position through a Direct Purchase, the Secretary will require that, with respect to with any of its top five most highly-paid executives, the firm (1) not provide incentives to take unnecessary and excessive risk during the period in which assets are held by the Treasury, (2) claw back bonus or incentive compensation based on criteria that are later proven to be materially inaccurate, and (3) not make any golden parachute payments during the period in which the Treasury holds such position. Firms that sell at least U.S.$300 million in Troubled Assets to the Treasury (including both Auction Purchases and Direct Purchases) are subject to a prohibition on any new employment contract with any of its top five most highly-paid executives that provides for a golden parachute severance payment in the event of an involuntary termination, bankruptcy filing, insolvency or receivership. 2 While a detailed discussion is beyond the scope of this Briefing, the Act also includes (separately from the Plan), new Section 457A of the Code, which restricts the ability to defer compensation under a non-qualified deferred compensation plan of a foreign entity that is essentially not subject to taxation (e.g., fee deferrals by U.S. managers of a Cayman Islands based fund). 5

6 Firms that sell at least U.S.$300 million in Troubled Assets to the Treasury (not including Direct Purchases, if no Auction Purchases have been made from that employer) are subject to new deduction limits added by an amendment to subsection 162(m) of the U.S. Internal Revenue Code (which prohibits publicly held corporations from taking a deduction for amounts paid to covered employees in excess of U.S.$1,000,000) to include a tax deduction cap for covered executives (the CEO, CFO, and any of the top 3 highest-paid officers) of such firms of U.S.$500,000 in compensation for any year (including any deferred compensation for that year). The exceptions under 162(m) for performance-based compensation, commissions, and certain grandfathered contracts do not apply. In addition, such firms are subject to amendments to Section 280G of the U.S. Internal Revenue Code, which operate to deny a deduction to such companies for golden parachute severance payments to covered executives in the event of an involuntary termination, bankruptcy filing, insolvency or receivership. These amendments will result in covered executives being subject to a 20% excise tax on these payments under Section 4999 of the U.S. Internal Revenue Code. Oversight and Transparency: Financial Stability Oversight Board: The Act establishes the Financial Stability Oversight Board (the Board ) to review and make recommendations regarding the exercise of authority under the Act, such as establishing the Plan and the Insurance Program. In addition, the Board will ensure that the policies implemented by the Secretary are in the economic interests of the United States and consistent with protecting taxpayers. The Board is comprised of the Chairman of the Board of Governors of the Federal Reserve System, the Secretary, the Director of the Federal Home Finance Agency, the Chairman of the SEC and the Secretary of the Department of Housing and Urban Development. Reports: (1) Monthly Reports: within 60 days of the first exercise of authority under this Act and every month thereafter, the Secretary is required to report to Congress his activities under the Plan, including detailed financial statements reflecting all agreements and insurance contracts made, all transactions occurred, the nature of purchased assets and the valuation or pricing model used. (2) Tranche Reports: for every U.S.$50 billion in assets purchased, the Secretary is required to report to Congress a detailed description of all transactions, a description of the pricing mechanisms used, and justifications for the financial terms of such transactions. (3) Regulatory Modernization Report: prior to April 30, 2009, the Secretary is required to submit a report to Congress on the current state of the financial markets, the effectiveness of the financial regulatory system, and to provide any recommendations regarding (a) whether any other participants of the financial markets should become subject to the regulatory system and (b) enhancement of the clearing and settlement of over-the-counter swaps. Transparency: The Act requires the online posting of a description, amounts, and pricing of assets acquired under the Act within two business days of purchase, trade, or other disposition of the Troubled Assets. The Secretary must determine whether the public disclosure required for financial institutions with respect to off-balance 6

7 sheet transactions, derivatives instruments, contingent liabilities, and similar sources of potential exposure is adequate. If such disclosure is not adequate for in that context, the Secretary shall make recommendations for additional disclosure requirements to the relevant regulators. Oversight and Audits: The Act requires the Comptroller General of the United States to conduct ongoing oversight of the activities and performance of the Plan, and to report every 60 days to Congress. The Comptroller General is required to conduct an annual audit of the Plan. In addition, the Act mandates a Government Accountability Office (GAO) presence at Treasury to oversee the program and conduct audits to ensure strong internal controls and prevent fraud, waste and abuse. Study and Report on Margin Authority: The Comptroller General is obligated to undertake a study to determine the extent to which leverage and sudden deleveraging of financial institutions was a factor behind the current financial crisis and deliver a report by June Judicial Review: The Secretary s actions will be set aside only if they are found to be arbitrary, capricious, an abuse of discretion or a violation of law. No injunctions are permitted that relate to the purchase of assets, the Insurance Program, management and sale of assets, of foreclosure mitigation efforts. No suits by any financial institution seller are permitted unless such right is expressly provided in a contract with the Secretary. The Plan establishes an independent Inspector General, appointed by the President, to monitor the Secretary s activities and to coordinate audits and investigations of these actions. The Inspector General is required to submit a quarterly report to Congress summarizing its activities and a detailed statement of all purchases, obligations, expenditures and revenues associated with the purchase and guarantee of the Troubled Assets by the Secretary under the Act. Congressional Oversight Panel: A Congressional Oversight Panel is established, and will review the state of the financial markets, the regulatory system and the use of authority under the Plan. The panel will report to Congress every 30 days, and is required to submit a report on regulatory reform no later than January 20, 2009, the date the next U.S. President takes office. Membership will be composed of five outside experts appointed in bipartisan fashion. Homeownership Preservation: Foreclosure Mitigation Efforts: For Troubled Assets acquired through the Plan, the Secretary must implement a plan to maximize assistance for homeowners and to minimize foreclosures by way of encouraging servicers of mortgages to modify loans through Hope for Homeowners 3 and other programs. In addition, the Secretary is authorized to use loan guarantees and credit enhancement to avoid foreclosures and must coordinate with other federal entities that hold Troubled Assets in order to 3 Hope for Homeowners is a program created by the Congress under the HOPE for Homeowners Act of 2008" within Federal Housing Administration (FHA) to back FHA-insured mortgages to distressed borrowers. The new mortgages offered by FHA-approved lenders will refinance abusive loans at a significant discount for homeowners facing difficulty meeting their mortgage payments. 7

8 identify opportunities to modify loans, and to permit bona fide tenants to remain in their lease homes. Assistance to Homeowners: The Act requires federal entities that hold mortgages and mortgage-backed securities, including the Federal Housing Finance Agency, the FDIC, and the Federal Reserve to develop a plan to maximize assistance for homeowners and to minimize foreclosures. Those federal entities are required to work with servicers to encourage loan modifications and encourage greater use of existing governmental rent subsidies, taking into account net present value to the taxpayer. The Plan extends a provision contained in previous legislation that blocks tax liability on mortgage foreclosures. Issues Surrounding the Proposal The Plan s language leaves many questions unanswered, the outcome of which may have significant effects on the market. These uncertainties include: Which financial institutions will the bailout be available to? As mentioned in the Summary, the Plan broadly defines the types of financial institutions that are allowed to participate in the bailout program. This definition appears to capture U.S. bank subsidiaries, branches, and agencies of foreign banks, as these entities are established and regulated in the United States. However, it is unclear what activities will satisfy the requirement that a financial institution must have significant U.S. operations. It is noteworthy that under special circumstances, the Secretary can purchase Troubled Assets from foreign financial institutions and central banks (if such an entity holds Troubled Assets as a result of financing a financial institution that has failed or defaulted on such loans). When considering whether to engage in a direct purchase from an individual financial institution, the Secretary must gauge the long-term viability of such entity when determining whether the purchase is the most efficient use of funds under the Plan. Is it possible that this provision will prevent the most deeply troubled banks from participating in the Plan, resulting in a kind of triage? What class of assets will the Treasury be able to purchase? The Plan permits Troubled Assets to be purchased or insured under the Plan. This term includes not only mortgage-related assets, the purchase of which the Secretary determines promotes financial market stability, but also financial instruments that are not mortgage-related, provided that the Secretary (1) determines that their purchase promotes financial stability and (2) consults with the Chairman of the Federal Reserve. However, approval for such purchases of non-mortgage assets is not required by the Chairman or the Financial Stability Oversight Board. Therefore, the range of assets that can be purchased is seemingly limitless and is another example of the wide discretion granted to the Secretary under the Plan. 8

9 How will the Troubled Assets be valued and what prices will be offered, especially given the breakdown of the market? The Plan permits the Secretary to establish guidelines (after the enactment of the Plan) on mechanisms for purchasing the Troubled Assets, pricing methods, and procedures for selecting Troubled Assets. Although the Secretary is explicitly granted the authority to use market mechanisms to purchase Troubled Assets, such as reverse auctions (whereby the sellers would bid against each other to sell their securities to the Treasury at the lowest price), the Secretary can engage in direct purchases. The Plan contains only limited constraints related to the pricing and purchase of Troubled Assets, thereby granting the Secretary broad discretion: for example, the Secretary must make purchases at the lowest price that [he] determines to be consistent with the purposes of the [Plan]. Because such purposes explicitly include restoring liquidity and stability to the U.S. financial system and protecting economic growth, there is no requirement to purchase Troubled Assets for the lowest possible price. Similarly, although the Act prohibits the Secretary from purchasing a Troubled Asset at a price higher than what the seller paid to purchase the asset, the Act permits the Secretary to purchase assets at prices above current market value. Because the bailout plan likely will only succeed if financial institutions can remove distressed assets from their balance sheets at prices that are high enough to prevent additional losses, the Secretary may be able to pay prices that are well above the lowest available price, if he determines it is necessary to achieve the Act s goals. Such actions, however, may help financial institutions at the expense of taxpayers and may conflict with the Plan s vague requirement that the Secretary must take actions that maximize profit or minimize the eventual losses to the federal government. Sellers out? under the Plan must issue equity or debt to the government, but how will this play Financial institutions that sell Troubled Assets to the government must issue (1) equity, in the form of warrants (in the case of entities whose stock is traded on a national securities exchange) or (2) equity, in the form of warrants, or debt instruments (for all other entities) to the Secretary. This provision is designed to give the government and taxpayers a chance to capture profits if sellers under the Plan experience financial success. However, the Secretary has broad discretion in deciding the quantity and value of the equity or debt he receives; the requirement is merely that the Secretary receives a reasonable participation in equity appreciation (or a reasonable interest rate premium in the case of debt instruments). It is possible that some companies may be discouraged from participating under the Plan due to these conditions. What will be the effect of permitting the SEC to suspend the application of FASB Statement No. 157? This accounting rule requires banks to report on the market value of their assets. The Plan permits the SEC to suspend application of such mark-to-market accounting rules 9

10 with respect to any issuer or class or category of transaction, if the SEC determines it is necessary or appropriate in the public interest. This provision may therefore be expected to elicit strong lobbying efforts in favor of suspension. What will the Plan s effect be on prices in the private sector market? Prices paid under the Plan may set a floor, over which private investors would be unwilling to bid. This could further devalue the distressed assets. However, some believe that the conditions imposed on sellers under the Act may give financial institutions an incentive to take lower bids from the private sector. Though the Secretary may offer higher prices, the contingencies that come along with the higher prices may be a turnoff. Sellers will have to determine whether it is more effective to sell on the open market or to the government. Key Political Issues When the Proposal was being considered by Congress, the Treasury, the Federal Reserve and President Bush had stated their belief that the Proposal should be enacted without delay or substantial change in order to minimize further damage to the financial markets. However, the Plan was reworked and contains many provisions not contained in the Proposal that represent Congressional efforts to rework what it viewed as flawed legislation. The following summarizes certain key issues related to the Plan and the extent to which Congress reactions to the Proposal were incorporated in the Plan: Lack of Transparency and Accountability: As originally drafted, the Proposal granted the Secretary almost limitless discretion to effectuate the bailout plan: the Treasury had asked for U.S.$700 billion with few restrictions as to the purchase and sale process or the management of purchased assets. Furthermore, the Proposal prohibited judicial or administrative review of the Secretary s decisions. This lack of transparency and oversight was one of the most troubling aspects of the Plan in Congress eyes. Speaker of the U.S. House of Representatives Nancy Pelosi spoke for many within Congress when she stated that the Proposal, in effect, had appeared to be a request by the Treasury for a blank check with few conditions. Bipartisan support for additional oversight of the bailout plan led to the substantial number of such features contained in the Plan, including the establishment of the Financial Stability Oversight Board, appointment of an Inspector General and limited judicial review of the Secretary s decisions. However, as mentioned throughout this Briefing, the Secretary is still granted broad authority and discretion with respect to many aspects of the Plan. Also, it remains to be seen if the various oversight bodies are able to peacefully and efficiently coexist, despite their political nature and multi-layered structure. Furthermore, in order to gain more influence under the Plan, many lawmakers pushed for the Plan s funds to be disbursed in installments, a key feature of the Plan. However, this mechanism provides the opportunity for further political disputes and dissatisfaction down the road. Executive Compensation: Strong measures relating to executive compensation had been proposed in the House and the Senate and were supported by Democrats including presidential candidate Senator 10

11 Barack Obama; supporters of these measures believed the bailout program should not permit corporate executives to be the recipients of taxpayer dollars. The presidential administration and most Republicans within Congress had opposed many of these proposals, stating that such measures may limit participation in the plan and thereby make it even harder to value distressed assets. The Executive Compensation provisions of the Act, while the result of bipartisan compromise, are really a victory for the Democratic point of view. It is noteworthy in this regard that the say on pay provision that was under consideration by both the House and Senate did not find its way into the Act. The Mandatory Insurance Program: Many within Congress, especially House Republicans, feel the Plan s intrusion into the private sector violates free market principles. The Insurance Program required to be set up under the Plan represents a victory by such lawmakers, who feel the financial institutions themselves should shoulder some of the burden, in this case in the form of their premium payments. However, because the insurance premiums required to be charged will be market rates, based on a credit risk assessment, very few entities may decide to participate in the Insurance Program. This is because the cost of premiums will likely be extremely high, since mortgage-related securities are currently a very high risk asset. Assistance to Taxpayers and Homeowners: The Proposal did not contain any provisions specifically designed to help troubled homeowners or ease the burden on ordinary taxpayers. Both parties viewed this omission as a serious flaw and sought to introduce measures that benefited their respective agendas. Each party succeeded in incorporating certain items on their agenda in the Plan. Republicans within Congress were able to ensure that the government s profits from the resale of Troubled Assets and sale or exercise of warrants are set aside to reduce the federal deficit. Many Democrats preferred to see profits earmarked in other ways, such as for affordable housing funds, but conceded on this point. However, many other homeowner and taxpayer protections did make their way into the Plan, including: the requirement that the Treasury and other federal agencies modify troubled loans to the extent possible to reduce the incidence of foreclosure, the ability of the government to purchase troubled assets from pension plans and small banks that serve low- and middle-income families, and provisions helping small businesses that need credit by permitting small, local banks to deduct losses from investments in Fannie Mae and Freddie Mac stocks. On the other hand, the House Democrats were unable to succeed in having a cramdown provision included in the Plan that would have given bankruptcy judges discretion to adjust the terms of mortgages subject to bankruptcy court proceedings, due to strong resistance from others within Congress that believe this measure would violate the sanctity of contracts, encourage litigious behavior, and further complicate the mortgage-backed security valuation process. The increase in the FDIC guarantee is designed to calm consumer fears about the economy and prevent bank runs, which have contributed to market turmoil, including the collapses of IndyMac and Washington Mutual Inc. This provision particularly appealed to centrists in both major parties. 11

12 The Future The bailout plan is certain to have wide-ranging effects, both domestically and on an international scale. It will be interesting to see the extent to which the Secretary asks other countries to consider following the United States lead (and if such countries take similar steps). The guidelines that the Secretary is required to issue will also provide important details as to how some of the programs and bodies constituted under the Act will operate in fact. Perhaps most importantly, financial market participants, and even average U.S. taxpayers, will be watc hing closely to see whether and how quickly the Plan achieves its intended goal of restoring conf idence to the U.S. financial markets. 12

13 Please address any queries to any of your usual Linklaters contacts on , or to any of the following: Contact Address Structured Finance and Derivatives Gary Barnett Caird Forbes-Cockell Adam Glass Stan Renas Corporate/Capital Markets Joshua Berick Jeff Cohen Ray Fisher Edward Fleischman Jon Gray Nick Rees Scott Sonnenblick Larry Vranka Executive Compensation Bindu Culas Heidi Schmid Tax Stephen Land Litigation Paul Alfieri Larry Byrne 13