Client Alert: Emergency Economics Stabilization Act of 2008

In response to the credit crisis, President Bush recently signed into law the "bailout" bill, H.R. 1424, formally called the "Emergency Economic Stabilization Act of 2008" (the "Act"). The Act covers a broad range of topics, including the purchase of troubled assets (with details of the auction mechanism still to be worked out), an increase in Federal Deposit Insurance Corporation ("FDIC") insurance of certain bank deposits from $100,000 to $250,000, executive compensation, a tax credit for energy companies, exclusions from the alternative minimum tax, and a plethora of "earmarks" (including a tax credit for manufacturers of wooden arrows). The purpose of this alert is to call your attention to important aspects of the Act and other recent regulatory responses to the current financial crisis relating to: (A) Money Market Funds, (B) "Naked" Short Selling, (C) "Mark-to-Market" Accounting, (D) Executive Compensation and (E) "Golden Parachutes."

(A) Are Money Market Funds Protected by the Government? Watch-Out!

Money market funds that elect to participate in the Treasury Department's Temporary Guarantee Program remain safe for investors who purchased their shares on or before September 19, 2008, so find out if your money market fund is participating in the Temporary Guarantee Program. But beware: Shares of money market funds purchased or transferred after September 19, 2008, are not covered by the Temporary Guarantee Program.

  • On September 19, 2008, the Treasury Department announced its Temporary Guarantee Program for Money Market Funds. The Temporary Guarantee Program officially opened for eligible money market funds on September 29, 2008.
  • The Temporary Guarantee Program was not created by the Act. Rather, the Treasury Department, through the Exchange Stabilization Fund, is providing the guarantee.
  • The Exchange Stabilization Fund has approximately $50 billion in assets and was established by the Gold Reserve Act of 1934 to promote international financial stability.
  • All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940, that maintain a stable share price of $1 and whose shares are publicly offered and registered with the Securities and Exchange Commission ("SEC") are eligible to participate in the Temporary Guarantee Program.
  • The Temporary Guarantee Program covers money market mutual funds, as opposed to money market deposit accounts. Money market deposit accounts are interest-bearing bank accounts that are insured by the FDIC if the bank is an FDIC member.
  • Eligible funds for the Temporary Guarantee Program include both taxable and tax-exempt money market funds. The Treasury and the IRS have issued guidance confirming that participation in the Temporary Guarantee Program will not be treated as a federal guarantee that would jeopardize the tax-exempt treatment of payments by tax-exempt money market funds.
  • While the Temporary Guarantee Program protects the accounts of investors, each money market fund decides whether to sign up for the Temporary Guarantee Program. Investors cannot sign up for the Temporary Guarantee Program individually. To participate in the Temporary Guarantee Program, eligible money market funds must pay a fee and complete the required documentation.
  • The Temporary Guarantee Program guarantees to investors that they will receive $1 for each money market fund share held as of the close of business on September 19, 2008, unless such share was subsequently transferred, in which case the Temporary Guarantee Program would no longer apply.
  • Any increase in the number of shares held in an account after the close of business on September 19, 2008 will not be guaranteed. If the number of shares held in an account fluctuates, investors will be covered for either the number of shares held as of the close of business on September 19, 2008, or the number of shares held when the fund fails, whichever is less.
  • The guarantee will be triggered if a participating fund's net asset value falls below $0.995, commonly referred to as "breaking the buck."
  • In the event that a participating fund breaks the buck and liquidates, a guarantee payment will be made to investors through their fund within approximately 30 days, subject to possible extensions at the discretion of the Treasury.
  • The Temporary Guarantee Program will exist for an initial three-month term, after which the Secretary of the Treasury will have the option to renew the program up to the close of business on September 18, 2009.
  • The Securities Investor Protection Corporation ("SIPC") protects cash and securities held by customers at brokerage firms that are members of the SIPC. Unlike the FDIC, SIPC does not provide blanket protection for losses.
  • The purpose of SIPC protection is to replace securities that are stolen by a broker or are missing when a brokerage firm fails, up to a limit of $500,000 per customer. It will not reimburse for missing value of securities that have lost market value while missing, and therefore it may not sufficiently protect investors holding shares of money market funds that break the buck.

(B) Cover Up: Naked Short Selling Is Now Banned

The SEC recently prohibited naked short selling, by requiring short sellers to deliver on the settlement date (i.e., three days after the sale transaction date, or "T+3") securities to cover their short sales.

  • The SEC's previous guidance provided that, if a short seller had a legal right to call upon shares to cover, this was good enough in certain circumstances, so long as delivery was timely. Under this old regime, holders of convertible debentures, warrants or call options were able to cover close-outs of their short sales of the underlying equity securities, provided that they obtained the shares within a reasonable period of time.
  • Since the SEC's Emergency Order on September 17, 2008, however, short sellers must now deliver on the T+3 settlement date the securities that they have sold, or else they must close out their "fail to deliver" positions before the next trading day begins with borrowed or purchased securities "of like kind and quantity."
  • Broker-dealers will be penalized for their customers' failure to deliver shorted securities at settlement by being prohibited from further short sales in the same security - for any customer - unless the shares are both located and pre-borrowed.
  • The ban on naked short selling also applies to market makers in options, due to the repeal of an exception that had excluded them from the close-out requirement.
  • The SEC has extended this ban on naked short selling in temporary rule 240T under Reg SHO through October 17, 2008, and expects the ban to continue past then.
  • Naked short sellers who deceive broker-dealers or other market participants about their intention or ability to deliver securities in time for settlement are subject to civil and criminal penalties for violating the anti-fraud provisions of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder.

(C) "Mark-to-Market" Accounting

For the time being, "mark-to-market" accounting is still the "law of the land" for valuing assets, but its days may be numbered - at least in its present form.

  • Statement of Financial Accounting Standards No. 157, Fair Value Measurements ("FAS 157"), became effective on November 15, 2007. It imposes "mark-to-market" accounting, in which balance sheets reflect quoted market prices, when available, for the same or similar assets, unless the market is inactive or not orderly (such as in a sale of distressed assets), in which case non-market inputs may be used.
  • Many criticize the mark-to-market accounting of FAS 157 for requiring balance sheet write-downs of assets based on market valuations that may not reflect their actual long-term value to their holders, especially for assets with inactive or otherwise distorted markets. Proponents of mark-to-market valuation of assets, on the other hand, stress the need to avoid subjective criteria.
  • On September 30, 2008, 65 U.S. Representatives sent an open letter to SEC Chairman Cox urging: the immediate suspension of mark-to-market accounting; the issuance of new guidance "using a mark to value mechanism that better reflects the value of the asset"; and, in the meantime, that assets be valued from the point of view of the holder (as opposed to market participants).
  • Also on September 30, 2008, the SEC's Office of the Chief Accountant and staff of the Financial Accounting Standards Board ("FASB") released some "Clarifications on Fair Value Accounting": When measuring fair value in the absence of an active market, management may use "internal assumptions (e.g., expected cash flows)" and may consider broker quotes (although these are not necessarily determinative), as well as transactions in inactive markets (which are likely not determinative), but may not consider distressed or otherwise disorderly transactions.
  • One concern raised by the Act is that the auction process for the government's purchase of troubled assets may provide inaccurate market-based inputs that would artificially lower asset valuations, worsening the systemic financial crisis.
  • The Act reaffirms the SEC's authority to suspend FAS 157 and orders the SEC to conduct a study of FAS 157 within 90 days.
  • On October 10, 2008, the FASB is scheduled to vote on additional interpretive guidance by the FASB staff on valuing financial assets in an inactive market. Commentators expect the planned guidance to focus on an illustrative example of how the marketplace-based principles of FAS 157 would be applied in an inactive market. FAS 157 already permits "level 3" "unobservable inputs" in measuring fair value when level 1 or 2 observable inputs are not available, which may suggest scope for elaboration of the current framework for valuing assets in inactive markets.
  • We anticipate that mark-to-market accounting rules may be significantly relaxed, perhaps by elaborating on the role of level 3 unobservable inputs in a way that increases comfort in relying on such factors. If not, balance sheets of corporations may fluctuate wildly.
  • The question is: What would be substituted in place of mark-to-market? This is an area where our clients should engage their industry trade associations and lobbyists to advocate for their preferred valuation methodologies.

(D) Act Reduces Tax Deduction for Executive Compensation

Section 302(a) of the Act reduces the maximum tax deduction for executive compensation that a company selling more than a threshold amount of troubled assets to the government under the Act may claim under Section 162(m) of the Internal Revenue Code from $1,000,000 to $500,000 annually per executive.

  • A company triggers the lower tax deduction limit by selling any troubled assets through the auction process established by the Act and more than $300 million of troubled assets overall - including non-auction, direct purchase transactions with the government.
  • If a company triggers the lower tax deduction limit, it may deduct up to only $500,000 per year for compensation paid to each of the CEO, CFO or any of the other three highest paid employees - instead of $1,000,000, as Section 162(m) provides.
  • Executive compensation over $500,000 per year is, of course, not prohibited. The Act simply limits the tax deduction to the first $500,000 of an executive's annual compensation for companies that sell troubled assets pursuant to the Act over the threshold amount.
  • Note: A company that sells less than $300 million of troubled assets overall or does not sell any troubled assets through the auction process established by the Act does not trigger the lower tax deduction limit. In this case, Section 162(m) would still cap the deduction for executive compensation at $1,000,000 per year.

(E) Act Expands Scope of "Golden Parachute" Excise Tax

"Golden parachute" severance payments to executives are still permitted, with the approval of the board of directors. The Act simply extends the current coverage of Section 280G tax provisions to severance payments made upon an executive's termination from employment at companies participating in the Troubled Asset Relief Program above the threshold level. For companies that do not meet this condition, Section 280G tax provisions apply only to severance payments made upon a "change of control" of the company.

  • "Golden parachute" severance payments (and other forms of deferred compensation) are still permitted, upon the approval of the board of directors. The Act simply extends the coverage of Section 280G tax rules to severance payments to terminated executives by companies that sell more than the threshold amount of troubled assets to the government.
  • Section 302(b) of the Act limits the tax deduction of a company and imposes a 20% nondeductible excise tax payable by the executive under Section 280G of the Internal Revenue Code on a "golden parachute" paid to the CEO, CFO or any of the other three highest paid employees, if the company sells troubled assets pursuant to the Act over the threshold level.
  • Although Section 280G, as written, requires a "change of control" of the company, the Act treats an "applicable severance from employment" (e.g., getting "fired") of any of the five "covered executives" as a change of control for purposes of the golden parachute tax rules. The Act defines an "applicable severance from employment" as any severance from employment resulting from involuntary termination or in connection with the bankruptcy, liquidation or receivership of the company.
  • Under the Act, Section 280G would look back at an executive's compensation for the five years preceding the executive's "applicable severance from employment" with the company to set a threshold at three-times the average annual compensation during this period. Payments in excess of this threshold may not be deducted by the company and are subject to the excise tax payable by the executive.
  • Therefore, if the CEO, CFO or any of the other three highest paid employees of any participant (above the threshold level) in the Troubled Asset Relief Program undergoes an "applicable severance from employment", then any severance payments in excess of three-times the executive's average compensation for the prior five years would not be deductible by the company and would be subject to a 20% excise tax payable by the executive.
  • Companies that agree to pay severance in amounts that exceed the threshold for triggering application of the Section 280G tax rules to certain executives often also agree to pay to the executive additional severance "gross up" equal to the cost of the 20% excise tax. The Act's extension of the golden parachute deduction exclusion and excise tax will thus increase the expense of executive compensation to companies.

Schuyler Roche is prepared to meet client needs as they arise in conjunction with the issues discussed above. Please contact Jeffrey D. Barclay (312-565-8425,

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