Atlanta partner and head of the firm’s Office & Industrial Real Estate practice group Mark Elliott was quoted extensively in an online January 27 Financial Markets Regulatory Wire transcript of the committee hearing held at Georgia Tech by the Congressional Oversight Panel to Oversee the Troubled Asset Relief Program (TARP).

Chairwoman of the Congressional oversight panel, Elizabeth Warren, was in Atlanta January 27 to hold a hearing among several real estate, business and governmental players on the role and impact of TARP in addressing the state of commercial real estate lending.

Elliot stated before the committee, “I have never seen more distress in the market here than I have in the last year in my 30 years of practice. …We dropped by 95 percent, and that distress is remarkable and it’s having catastrophic effects on the service providers in the industry. And I think there are two reasons for this. It relates from problems on the supply side and problems on the demand side.”

“I think the commercial office market, if you look at the life of an office building, it’s almost like an aircraft carrier. You can’t brake it on a second’s notice and you can’t accelerate it on a second’s notice,” he added.

According to the Panel, $1.4 trillion in commercial real estate loans will mature between 2010 and 2014. Due to market decreases in commercial property values borrowers currently owe more than their property is worth on nearly half of these commercial real estate loans. The Panel noted that the impact of this decrease in value is particularly troubling with respect to small and midsize banks, which are expected to bear an estimated $200 to $300 billion in losses.

The Panel recognized that proactive steps in regulatory enforcement, accounting practices, capital enhancement and removal of risky assets from bank balance sheets should be coordinated to lessen the potential impact that the commercial real estate crisis might have on local communities, small businesses and individuals.  The Panel noted that one potential means to address this issue is to speed the availability of TARP funds to these small and mid-size financial institutions or to legislatively make other sources of funds available to such entities. Whether such action would be approved by Congress, however, is unclear. The text of the report is at http://cop.senate.gov/reports/library/report-021110-cop.cfm.

Troutman Sanders partner Mark Elliott provided testimony at the Atlanta Field Hearings on Commercial Real Estate on January 27, 2010, and our firm regularly represents commercial lenders and financial institutions involving TARP and commercial real estate issues.

CONTACT

John C. Lynch
Financial Services Litigation Team Leader
757.687.7765

David N. Anthony
Financial Services Litigation Team Leader
804.697.5410

Jake Lutz
Financial Institutions Group Leader
804.697.1490

Under the Proposal, a community bank would need approval from its primary federal regulator before it could participate in the SBLF.  Once it obtains regulatory approval, the community bank would be eligible to receive capital investment either (1) up to 5% of its risk-weighted assets, if the bank has less than $1 billion in assets, or (2) up to 3% of its risk-weighted assets, if the bank has between $1 billion and $10 billion in assets.  Community banks that participated in the Capital Purchase Program (CPP) would be eligible to convert their CPP capital to SBLF capital.

Capital investments made through the SBLF as proposed would incentivize small business lending through lower dividend rates and no TARP restrictions.  Community banks could decrease the dividend rate they pay on SBLF capital by increasing small business lending over a baseline set using 2009 lending data.  According to the Proposal, SBLF capital would carry an initial dividend rate of 5%, which would decrease by 1% for every 2.5% increase in “incremental business lending” achieved by the community bank over a two year period.  The minimum dividend rate on SBLF capital would be 1%.  However, after five years the dividend rate on SBLF capital would increase to encourage “timely repayment.”  Importantly, the SBLF as proposed would not involve any TARP restrictions such as restrictions on executive compensation.

The Proposal, which would require approval by Congress, has drawn open support from some Democratic Congressmen, Senators on both sides of the aisle have voiced criticisms ranging from concerns regarding the cost of the SBLF to calls for the President to create the SBLF under the TARP program to more expeditiously provide capital to community banks.  No specific terms or conditions of the SBLF will be available until the Proposal is enacted by Congress and implemented by the Obama Administration.

We will monitor the Proposal’s progress through Congress.  The Administration has published a fact sheet discussing the SBLF, which may be found at http://www.whitehouse.gov/sites/default/files/FACT-SHEET-Small-Business-Lending-Fund.pdf.

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The foregoing is only a summary of one of the many significant issues affecting financial institutions.  If you have any questions about the foregoing or about other financial institution issues, please direct them to your regular contact at Troutman Sanders LLP or to any of the persons listed in the sidebar to this release.

CONTACTS

Jake Lutz
Practice Group Leader
804.697.1490

Tom Powell
404.885.3294

Jerome Walker
212.704.6286

CONTRIBUTOR

Seth Winter
804.697.2329

• Bank management must be actively involved with the risk management process related to CRE loan workouts.  A prudent CRE loan workout process requires enhanced legal, collection and asset valuation skills and a strong risk management process to ensure that prudent loan disposition decisions are made.  The loan workout process should be independent from the original underwriting decision.

• A prudent CRE loan workout process requires a thorough review of the borrower, guarantors and CRE project.  This review includes realistic assessments of the borrower’s debt requirements, debt capacity and repayment ability and an accurate, current valuation of the CRE project.

• During bank examinations, examiners will review and consider all stages of the CRE loan workout process.  Examiners will balance their review of the workout process with the realistic options of the borrower and will not criticize workout activities performed after substantial review by the bank.

• Classification of multiple note workout structures should be based on the borrower’s actual payment history and normal debt coverage standards, and lenders should not consider any pro forma financial information relating to the borrower or CRE project during the classification process.

• As part of a collateral portfolio management program, banks should implement policies to address the frequency, scope and quality of appraisals in light of the risk posed by CRE collateral, valuation trends and other market data.  Large complex CRE projects that pose higher risks or require collateral liquidation for loan repayment are more likely to require more frequent appraisals.

This Workout Guidance presents banks with an excellent opportunity to review CRE and restructured loans in a manner that will have the least impact on the bank consistent with safe and sound loan practices. The FDIC will publish on its website a transcript of the telephone seminar on or about December 10, 2009.

For additional information regarding the Workout Guidance, please see the Troutman Sanders Client Alert “FDIC Releases Commercial Real Estate Loan Workout Guidelines”, released on November 3, 2009. The Financial Institutions Practice Group at Troutman Sanders will continue to monitor developments regarding the Workout Guidance.

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The foregoing is only a summary of one of the many significant issues affecting bank holding companies and other financial institutions.  If you have any questions about the foregoing or about other financial institution issues, please direct them to your regular contact at Troutman Sanders LLP or to any of the persons listed in the sidebar to this release.

CONTACTS

Jake Lutz
Practice Group Leader
804.697.1490

Tom Powell
404.885.3294

Jerome Walker
212.704.6286

CONTRIBUTOR

Seth Winter
804.697.2329

The SIGTARP’s report describes its Investigation Division as a matured, sophisticated white-collar investigative agency, and advises that it has 35 ongoing criminal and civil investigations, an increase of 15 matters since the April 2009 report. Only two matters are public: An indictment for an $11 million fraud in purported pooling of funds to purchase TARP-guaranteed debt and an abuse on the internet of the Making Home Affordable program.

The SIGTARP report also criticizes the Treasury Department for not accepting his recommendation to install a wall between fund managers of Public-Private Investment Funds (PPIF) and employees of the firms acting as managers; he criticizes Treasury for not reporting the value of its TARP investments; he announces two investigations for members of Congress; and he announces a project to determine whether Bailout recipients’ repurchase of warrants given for Bailout funding we made at fair market value for the securities.

As he indicated in his initial appearances and emphasizes frequently before Congressional committees, Barofsky envisions his role as an unrestricted overseer of all TARP activities. He will undoubtedly be active at least as long as the Bailout funds are outstanding.

In addition to providing substantial additional funding for investigation and enforcement, the FERA enhances prosecutors’ statutory tools for charging fraud by adding private mortgage lenders to the definition of financial institutions, specifically covering TARP and Recovery Act recipients under the fraud statute, adding commodities fraud to the securities fraud statute, clarifying the comprehensive scope of the money laundering statute, and expanding the reach of the False Claims Act.

The Drivers of FERA and SIGTARP

As the economy began to falter in early 2008 and the Department of Justice shifted resources from national security to fraud investigations, it admitted that its backlogs were too large to allow increased attention to new cases.  Provisions to add anti-fraud funding to the American Recovery and Reinvestment Act (“Recovery Act”) were stricken before its passage.  Congress has now responded by authorizing substantial funding increases for 2010 and 2011 to the Department of Justice ($165 million), the Securities and Exchange Commission ($40 million) and other agencies in the housing and financial sectors ($80 million).  The intended effect is to add 300 federal agents  to the current 250 FBI agents, 200 more prosecutors, and 200 forensic analysts. 

The legislation, styled the Fraud Enforcement and Recovery Act (“FERA”), also specifically includes all recipients under the Emergency Economic Stabilization Act of 2008 (“EESA”) and the Recovery Act as subject to all federal fraud laws, including the False Claims Act.  And, to assure that none of the participants in the housing meltdown escape the full range of regulatory examination, the statute includes mortgage brokers and initial lenders in the definition of “financial institution.”

This legislation comes on the heels of the establishment and recent additional powers of the Special Inspector General for the Toxic Asset Recovery Program (“SIGTARP”), who has auditing, investigative and criminal referral authority over every recipient and participant in TARP funding programs, including, not only the Department of Treasury’s capital enhancement funding activities, but entities created under the Term Asset-Backed Loan Program (“TALF”): the Legacy Loan Program and the Legacy Security Program under the Public-Private Investment Program (“PPIP”).  SIGTARP Neil Barofsky has initiated a monthly average of 10 criminal investigations and numerous audits in the first quarter of his activities.

Details of the FERA Provisions Expanding Coverage of the Criminal Code

Private Mortgage Lending Added Under the Criminal Code

• The definition of “financial institution” in 18 U.S.C. §20 is expanded to include a mortgage lending business, defined (in a new provision, 18 U.S.C. §27) as “an organization which finances or refinances any debt secured by an interest in real estate, including private mortgage companies and any subsidiaries,” whose “activities affect interstate commerce.”  Thus, federal criminal code provisions now reach private mortgage firms and their affiliates.
• The current provision criminalizing false statements in loan and credit applications, 18 U.S.C. §1014, is revised to include specifically false statements made to influence any action by a mortgage lending businesses.  Coupled with the definitional changes, this amendment clarifies that the statute will extend beyond its current reach of frauds affecting federal agencies, banks and credit unions to include those affecting private mortgage brokers and companies.

TARP, Stimulus Programs Added Under the Criminal Fraud Statute

• The federal criminal code is also amended in18 U.S.C. § 1031, prohibiting fraud against the United States, to include both funds received under the various TARP programs and funding under the Recovery Act.

Commodities Fraud Added to the Criminal Securities Fraud Statute

• The securities criminal fraud statute (18 U.S.C. § 1348) is expanded to include fraud involving commodities options or futures, which the Committee report notes have included derivatives and other financial products that contributed to the current financial crisis.

All Proceeds of Money Laundering Are Covered

• The money laundering statute is revised to reverse the Supreme Court’s Santos decision that suggested that “proceeds” of unlawful activity included only actual profits.  The definition of “proceeds” is amended to confirm that it includes the entire gross receipts of illegal activity, not just the “profit” component.
• Movement of money across international borders in furtherance of tax evasion is now subject to money laundering statute.

Civil False Claims Act (FCA)

• The current FCA is expanded to reach any request or demand for payment that is presented to contractors, grantees or others if the money is to be spent or used on the government’s behalf, or “to advance a government program or interest” if the U.S. has provided any portion of the money or will reimburse the recipient.
• Treble damages actions can now be based on the use of any false records or statements that are “material to” the submission of a false claim.  Previously the FCA reached only those false statements “made or used” to get a false claim paid, a narrower category of actionable false statements.
• These amendments are designed to reverse the effects of the Supreme Court’s decision in Allison Engine Co. v. U.S. ex rel. Sanders, holding that the government must prove that a defendant specifically intended that the government itself would pay a claim, and the D.C. Circuit decision in United States ex rel. Totten v. Bombardier Corp., which held that false claims liability required presentment of a claim to an officer or employee of the government and not to a grantee.
• The “reverse” false claims provision is revised by adding a section that includes any action designed to conceal, avoid, or decrease a payment obligation to the government, expanding the current provision that reaches only the making, use, or causing the use of a false record.  “Obligations” of the government are now defined to include not only fixed but also contingent obligations, codifying existing Department of Justice policy.  A specific statement is added that retention of overpayments is an “obligation” for purposes of the FCA.
• The conspiracy provision of the FCA is expanded to include conspiracies to violate any requirement of the statute, not only conspiracy to get a false claim paid as provided in the current statute.
• The existing scienter standard is retained:
  • Liability will attach for the “knowing” submission of a false claim, use of a false statement or record in making a claim or in reducing an amount otherwise owed, or retention of money due and owing to the government.
  • “Knowing” is defined as a person acting, with respect to information, with actual knowledge that the information is false, or with deliberate ignorance or reckless disregard of the truth or falsity of the information.
  • No specific intent to defraud is required.
     

First, capital management and balance sheet restructuring are of critical importance in surviving a stress test. Although options for new capital are limited, there are strategies available for enhancing capital, including private equity, and government programs that could make the difference between survival and government intervention. Further, balance sheet restructuring, including a model for shrinking the institution’s balance sheet while maintaining consistent capital levels, results in enhanced capital ratios. This is an important strategy for achieving targeted capital levels.

In addition, effective and timely regulatory communications and negotiations are essential for the survival of many institutions. Institutions should focus on accurate and timely reporting of facts balanced against advocacy of the institution’s position on key management and business issues. Management needs to focus on the common ground it can find with regulatory agencies for purposes of improving the institution’s prospects of remaining viable.

A third area of significant importance is an active engaged senior management team and board of directors. Management focus on business and strategic plan implementation is closely observed by regulators. In addition, involvement of the institution’s board of directors through supervision of management and implementation of strategic plan is also closely observed. Institutions that demonstrate the ability to manage through the crisis stand a greater chance of survival.

Finally, documentation of the bank’s good faith efforts to comply, including transparent and robust regulatory communications and active involvement of management and the board of directors, will be key in demonstrating that management and the board of directors have met their duties in managing the institution through the crisis. This is of importance when defending claims by third parties, including shareholders, other stakeholders or regulatory agencies that may in the future maintain that management or the board breached its duties.

Troutman Sanders works with financial institutions of all sizes in addressing these challenges and implementing solutions. Our team is ready to assist with regulatory negotiations, capital and strategic planning, strategic plan implementation, documentation of efforts, and other challenges facing financial institutions.

Contact:

Jake Lutz
Practice Group Leader
804.697.1490

Tom Powell
404.885.3294

Jerome Walker
212.704.6286

 In his April 21, 2009 report to Congress, SIGTARP Neil Barofsky reported two particular criticisms of the Treasury Department’s handling of TARP: (1) that Treasury regarded SIGTARP’s proposed inquiry to TARP recipients on their use of TARP funds as impossible, impractical or a waste of time; and (2) that Treasury was not sufficiently responding to a dozen SIGTARP recommendations, including the issuance of regulations concerning limitations on executive compensation.  Treasury had twice taken the position in writing that the executive compensation limitations did not apply to TARP Term Asset-Backed Securities Loan Facilities Program (“TALF”) participants.  

Three days after the SIGTARP report, Congress and the President responded in Public Law 111-15 with amendments to the Stabilization Act by expanding the SIGTARP’s powers to include:

• Specific authority for SIGTARP to audit the use of TARP funds by each recipient and to report his findings to the Congress by September 1, 2009;
• Direction to the Treasury Secretary to “take action to address deficiencies identified” by the SIGTARP and to certify that action to Congress.

This Congressional and White House action confirms both the strong support the SIGTARP has from Congress, and his power to broaden his jurisdiction and powers to the extent he thinks appropriate in overseeing the TARP program.

 There is a natural tension between the SIGTARP and Treasury.  SIGTARP is concentrating on fraud risk and prevention; Treasury is focusing on use of federal funds, agencies and guarantees to thaw the credit markets.  As SIGTARP investigates recipients’ use of TARP funds and executive compensation limitations imposed by the provision added for TARP in the American Recovery and Reinvestment Act of 2009 (the “Recovery Act”), Treasury is designing new programs to attract private investors and money managers into its mission. 

 TARP Rescue Morphs into Public-Private Programs

 Initial Troubled Asset Recovery Program (“TARP”) funding to assist financial institutions (Capital Purchase Program (“CPP”), Capital Assistance Program (“CAP”), Targeted Investment Program (“TIP”), Asset Guarantee Program (“AGP”)), to AIG (Systemically Significant Failing Institutions (“SSFI”)) and to the auto industry (Automobile Industry Financing Program (“AIFP”), Auto Supplier Support Program (“ASSP”) and Auto Warranty Support Program (“AWSP”)) are all direct-infusion rescue plans designed to avoid failure of important domestic sectors and businesses.  For the Treasury Department, how TARP funds were specifically used has been less important than prospective success of its rescue efforts and their presumed beneficial effect on the revival of credit markets for businesses and consumers.  Concerned that TARP funds have only been applied to proper uses, SIGTARP has asked thes 364 TARP recipients to provide a narrative on how they used their federal assistance.  The recipients’ responses have given a wide range of uses from adding to capital, to reducing debt, to purchasing mortgage-backed debt, and increasing loans. 
 Pursuing its mission of moving toxic loans and securities off the books of financial institutions and hopefully into a market, the Treasury Department has solicited the private sector to participate in the process by expanding the Term Asset-Backed Loan Program (“TALF”) to include a Public-Private Investment Program (“PPIP”), whereunder private investors would provide one element of the equity funding for a special purpose vehicle (“SPV”) to purchase toxic assets, the Federal Reserve would provide funding for a substantially larger equity element, and additional federal lending would be available.  Because there is no direct Treasury payment of TARP funds in this structure, the issue arose whether the executive compensation limitations added to TARP funding in the Recovery Act apply to the private investors or money managers of the SPV.  Treasury has formally concluded that they do not.  SIGTARP has recommended, however, that Treasury should issue regulations for executive compensation limitations under TALF.

Some Preliminary Guidance

 Because SIGTARP acts as an independent entity with three constituencies – the Treasury Department, the Congress and the American public – its mission is broader than Treasury’s alone, and its requests for information have reflected that.  How one responds to SIGTARP inquiries, however, depends on the context.  Where SIGTARP is seeking generic information for which there is no specific reporting or record requirement – as his inquiry about the use of TARP funds – recipients can fashion a response that is as explicit or general as their particular situation indicates.  As with all such responses, care should be taken for accuracy, as SIGTARP will usually require certification of the response.  In circumstances where the Treasury and SIGTARP appear to have different views on applicable law – as with the application of executive compensation limitations to PPIP programs – participants in programs designed by Treasury may be faced with SIGTARP inquiries that presume a different rule than Treasury.  Before submitting a response, prudence counsels ascertaining how firm and explicit the positions of each agency are.  The recipient can then decide how best to craft its response.  Where SIGTARP requests documents or information that must or should be maintained by the recipient, care should be taken to be thorough, accurate and timely in the response.

Contact:

Stu Pierson

For these purposes, a “covered TARP recipient” means (i) any person who receives (and has not repaid) after December 31, 2007, capital infusions in the aggregate in excess of $5 billion under the Emergency Economic Stabilization Act of 2008, also known as TARP; (ii) the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation; (iii) an affiliate (as defined in Section 1504 of the Internal Revenue Code of 1986, as amended (“Code”), without regard to certain exclusions) of persons described in clauses (i) and (ii); and (iv) any partnership if more than 50% of its capital or profits interests are owned directly or indirectly  by one or more persons described in clauses (i), (ii), or (iii).  It is important to note that clauses (iii) and (iv) of this definition greatly expand the universe of persons that may be subject to this tax.  For example, managers of private equity funds, mutual funds, and hedge funds may be subject to this tax depending on the funds’ ownership.

The surtax is applicable to any retention or incentive payment or other bonus which is in addition to a person’s regular salary, received after December 31, 2008, and to any gross-up of the surtax.  The surtax will not apply to (i) payments that are commissions, welfare or fringe benefits, or expense reimbursements and (ii) otherwise applicable bonuses that are waived or returned by the employee before the close of the taxable year in which such bonus payment is due. 

S. 651
On the same day, Senate Finance Committee Chair Max Baucus (D-Mont.) and ranking minority member Chuck Grassley (R-Iowa) introduced the Compensation Fairness Bill of 2009 (S. 651), imposing surtaxes with respect to certain bonuses, which is broader in scope and a somewhat less onerous than H.R. 1586, described above.

In general, S. 651 is applicable to any institution accepting more than $100 million in TARP funds, except for institutions that qualify as small banks under the Code.  S. 651 will impose a 35% excise tax on both employers and employees on retention bonuses and other bonuses.  It will also cap the amount of income which employees of these TARP recipients are allowed to defer tax free.

The taxes imposed under S. 651 are applicable to bonuses earned or paid on or after January 1, 2009.  As provided in H.R. 1586, an employee may avoid the excise tax if the bonus is returned to the institution.

May Taxes Be Enacted With Retroactive Effect?
Yes.  Tax rate increases were enacted and applied to a prior taxable year pursuant to the Revenue Act of 1918 (which was enacted on February 24, 1919, and applicable to income earned beginning in the 1918 calendar year).  Since that time, tax rates increases have not been made effective with respect to taxable years prior to enactment, and have only been increased on a nominally retroactive basis, i.e., to the beginning of the year, in 1938, 1944, and 1993.  For example, the Revenue Reconciliation Act of 1993 was signed into law in August of 1993, and the increased tax rates were effective for taxable years beginning after December 31, 1992.

CONTACT
Mark A. Goldsmith
Practice Leader
212.704.6255

Robert A. Friedman
Partner
212.704.6048