Global Financial Market Watch : Global Financial Lawyer & Attorney : K&L Gates Law Firm : Government Enforcement, Investment Management

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By:  Daniel F. C. Crowley, Patrick G. Heck

Recent Policy Responses
The recent public policy responses to the credit crisis have been geared toward restoring liquidity in the credit markets, enhancing transparency, and prohibiting certain trading practices.   Foremost among these measures has been H.R. 1424, the Emergency Economic Stabilization Act of 2008   (“EESA” or “the Act”), in response to the Department of the Treasury’s (“Treasury”) request for authority to spend up to $700 billion to purchase illiquid assets.  The Act is intended to improve the capital positions of financial institutions and allow them to once again extend credit.  Other stop-gap measures by the regulatory agencies, as discussed elsewhere in this newsletter, have been geared toward reducing volatility and restoring orderly markets.

EESA, which was passed by the House and signed by President Bush on Friday, October 3, 2008, authorizes up to $700 billion for the Treasury for a troubled asset relief program (TARP) to purchase, and a Troubled Assets Insurance Financing Fund to insure, illiquid financial instruments. The Act allows Treasury to immediately use $250 billion, with an additional $100 billion if the president certifies such a need. The president would have to provide a written request for the remaining $350 billion, which could be subject to expedited congressional approval.

The Act

• Creates the Financial Stability Oversight Board, comprised of the Fed Chairman, the Secretaries of Treasury and HUD, the FHFA Director, and the SEC Chairman.
• Creates various reporting and oversight requirements.
• Waives FAR and provides for streamlined contracting procedures.
• Establishes a Congressional Oversight Panel in the legislative branch to “review the current state of the financial markets and the regulatory system.”
• Places limits on senior executive compensation for some participating financial institutions.
• Requires Treasury to develop programs to reduce foreclosures and encourage lenders to modify mortgage terms.
• Prohibits use of the Exchange Stabilization Fund for future money market guarantee programs.
• Authorizes the SEC to suspend mark-to-market accounting (FAS 157).
• Increases the federal budget debt ceiling to $11.315 trillion.
• Temporarily increases the FDIC insurance limit from $100,000 to $250,000.

The text of the Act and a section-by-section analysis may be found on the House Financial Services Committee website: http://financialservices.house.gov/.  

EESA Tax Provisions
EESA also contains a number of important tax provisions that have not received a great deal of attention. There are three tax provisions related to the rescue plan:

1. Extension of exclusion of income from discharge of qualified principal residence indebtedness.  Generally, when homeowners have parts of their mortgages forgiven, they immediately owe income taxes on the amount of indebtedness forgiven.   To prevent homeowners from facing higher tax bills, the housing relief bill passed by Congress earlier this year allowed homeowners caught up in the mortgage crisis to avoid paying tax on forgiven mortgage debts through 2009.  EESA will extend through 2012 the housing bill provision that forgives income from the cancellation of indebtedness.  The proposal does not extend the relief to home equity loans.  The Joint Committee on Taxation estimates that this provision will cost $362 million over ten years. 
   
    
2. Gain or loss from sale or exchange of certain preferred stock.  Federal law limits the allowable investments for banks, and many community banks therefore invested in Fannie Mae and Freddie Mac preferred stock – which became worthless when the government bailed out those companies.  EESA includes a proposal to allow financial institutions or financial institution holding companies to treat their Fannie and Freddie losses as ordinary losses. Applying to any preferred stock that was owned on September 6, 2008 or sold between January 1 and September 6, 2008, this provision will allow banks to claim the book benefit of the loss on their tax returns, therefore reducing the need to obtain additional capital from the FDIC or investors.  Policy makers believe that this proposal should also prevent some community banks from becoming insolvent.  The Joint Committee on Taxation estimates that this provision will cost $3.045 billion over ten years, with $2.7 billion of the cost occurring in 2009. 
   
    
3. Special rules for tax treatment of executive compensation of employers participating in the troubled assets relief program.  The EESA contains non-tax measures aimed at limiting executive compensation and “golden parachute” severance packages overall for companies and executives participating in the buyout.  Additionally, EESA modifies the tax treatment of executive compensation and severance packages.  The deductibility of executive compensation for companies participating in the troubled asset relief program will be cut in half – from the $1 million level in current law – to $500,000.  Performance-based compensation is included in the $500,000 limitation.  Companies will also lose deductions currently available for excessively large severance packages.  Executives receiving severance packages will continue to face a 20 percent excise tax on payments once they reach an excessive threshold, and that tax will now be due if the executive leaves for reasons other than a standard retirement for which they are eligible – not just if the company changes hands, as in current law.  The Joint Committee on Taxation estimates that the amount of revenue gain from these provisions is indeterminate as it will depend on how the underlying troubled asset program is implemented.     

In addition, the Act extends dozens of expired or expiring tax provisions (the so-called “tax extender package”), including the Alternative Minimum Tax and disaster relief, energy tax incentives and a host of other provisions.  Several of these provisions might be of interest to the financial services community.  For example, the package includes: 1) broker reporting of a customer’s basis in securities transactions; 2) an extension of tax-free distributions from IRAs to certain public charities through 2009; 3) an extension of the exception under Subpart F for active financing income through 2009; 4) an extension of the look-through treatment of payments between related CFCs under foreign personal holding company income rules; and 5) the modification of the tax treatment of offshore nonqualified deferred compensation for certain tax indifferent parties.  The package does not include a further delay in the implementation of the worldwide interest allocation rules.

Finally, in addition to the various tax provisions listed above, the package contains a provision that would lower the tax preparer standard for undisclosed positions from “more likely than not” to “substantial authority” (the same standard that currently applies to taxpayers) with the exception for tax shelters (reportable transactions to which section 6662A applies). 

The Long View
In the slightly longer term, these unprecedented market events will likely lead to the most significant revisions to the legal and regulatory framework for financial services since the Great Depression. 

• Revamping the structure of financial services regulation.   Beginning in January 2009, the 111^th Congress will consider comprehensive legislation to restructure the regulation of financial services.  A primary consideration will be the respective roles of the Treasury, the Federal Reserve Board, the SEC and the CFTC with respect to oversight of the capital markets.  Some of the proposals under consideration were outlined in the Treasury’s March 2008 “Blueprint for a Modernized Financial Regulatory Structure.”
  
   
• Regulation of previously unregulated products and entities. Current discussions also include new reporting and other regulatory requirements for a broad array of financial products and market participants that have, until now, been subject to relatively little regulation, including commodities, derivatives, hedge funds and sovereign wealth funds.  Some products that currently trade over-the-counter may soon be required to trade on exchanges and, more generally, all market participants with the potential to impact the economy will almost certainly be under increased scrutiny.
  
   
• Among the other issues that will likely be considered as part of this comprehensive reform effort are:
  • Credit rating agency reforms,
  • Enhanced government agency enforcement authorities, and
  • Recommendations of the Congressional Oversight Panel created by EESA. 
    
     
• Tax. With respect to federal tax issues relating to investments, determination of the appropriate tax rates on capital gains and dividends and the appropriate tax treatment of derivatives, as well as retirement savings incentives, will receive considerable attention.
  
   
• Retirement Plans. Finally, there will almost certainly be a renewal of efforts to increase disclosure with respect to defined contribution plan fees. 

Our Public Policy & Law group is closely monitoring these developments in order to provide insights to and effective advocacy on behalf of firm clients.