PLC Global Finance update for February 2009: United States

Practical Law UK Articles 0-385-1686 (Approx. 10 pages)

PLC Global Finance update for February 2009: United States

by Shearman & Sterling LLP

Financial institutions

Executive compensation provisions of the American Recovery and Reinvestment Act of 2009

Doreen E. Lilienfeld, Amy B. Gitlitz and Veronica M. Wissel

On 17 February 2009, President Obama signed the American Recovery and Reinvestment Act of 2009. The Act expands restrictions on executive compensation applicable to entities that participate in the Troubled Assets Relief Program (TARP). The Act applies to all entities that have received or will receive financial assistance, but in certain instances permits entities to withdraw from TARP and avoid the new restrictions. Many of the new restrictions under the Act seemingly also apply to non-executive employees as well as to senior executive officers (SEOs).

Prohibition on severance. TARP recipients cannot make golden parachute payments to an SEO or any of the next five most highly-paid employees while the company has outstanding obligations to the government. A golden parachute is defined as any payment on a departure for any reason, other than payments for services performed or benefits accrued.
Limits on incentive compensation. TARP recipients cannot pay or accrue any bonus, retention award or incentive compensation other than "long-term restricted stock" that:
- does not fully vest until the government has been repaid;
- has a value not greater than one-third of the employee's total annual compensation; and
- complies with other terms and conditions set by the US Department of Treasury (Treasury).
The prohibition applies to a number of employees that is determined by the amount of assistance received. Notably, bonus payments to be paid under a written contract executed on or before 11 February 2009 are excepted.
Clawbacks. TARP recipients must adopt clawback policies to recover compensation paid to their SEOs and the next 20 most highly compensated employees if the pay is based on criteria later found to be materially inaccurate.
Prior payments. The Act requires the Treasury to review all compensation previously paid to the SEOs and the next 20 most highly paid employees of any TARP recipient to determine whether the payments were inconsistent with the Act or TARP, or were otherwise contrary to the public interest. In that case, the Treasury must negotiate with the TARP recipient and the employee for reimbursement of the compensation to the government.
Say-on-pay. TARP recipients must implement a say-on-pay policy, allowing for an annual non-binding shareholder vote on executive compensation.
Luxury expenditures. Each TARP recipient must adopt a policy related to the approval of excessive or luxury expenditures.
Other standards. TARP recipients must structure compensation arrangements to exclude both:
- incentives for SEOs to take unnecessary and excessive risks that threaten the value of the company; and
- benefits that "would encourage manipulation of the reported earnings."
Prohibition on hiring non-immigrant employees. The Act prohibits any company that receives assistance from hiring any non-immigrant workers under the H-1B visa program for two years unless the company qualifies as an H-1B-dependent employer.

New regulations providing further guidance on the Act are to be issued by the Treasury.

For more information on the Act and its implications for executive compensation planning, see Executive Compensation Restrictions on TARP recipients Under the Economic Stimulus Bill.

Investment fund regulation

Nathan J. Greene and Gretchen D. Liersaph

The current economic crisis and the international uproar over the Madoff scandal have brought with them a renewed scrutiny of the hedge fund (and to a lesser extent the broader private fund) industry, causing governments around the world to call for stricter oversight of these lightly regulated investment funds. With that backdrop, the industry is bracing itself for what now seems inevitable – that private funds and their managers will face some form of increased oversight in the near future. (For more information about possible areas of regulatory or legislative focus in the US, click here.)

There are, for example, bills in the US Congress that would impose various requirements on private investment funds and, in one case, would remove in its entirety the exception from US federal investment adviser registration for investment advisers with a limited number of clients. These bills, while purporting to focus on hedge funds, are written broadly enough to affect many other types of private investment funds, including LBO funds, venture capital funds and some real estate funds.

Hedge fund firms faced similar US registration requirements several years ago when the US Securities and Exchange Commission (SEC) proposed a rule requiring hedge fund managers to register with the agency as investment advisers under the US Investment Advisers Act of 1940. That rule was vacated by a US court in 2006 on grounds that the SEC had overstepped its authority and that action by Congress would be required to achieve the SEC's goals.

The Madoff scandal is also prompting the SEC's investment adviser inspections office to ramp up aspects of its regular inspection programs (often called "SEC examinations"). Already these examinations are including much more pointed questions about the custody of client assets. An SEC official has suggested that the agency's efforts to verify the existence of claimed assets will include direct contacts between the SEC and the custodians used to hold account assets. More controversially, they also may include "spot checks" in which the SEC examiners directly contact hedge fund investors for verification of their capital account balances.

The US is not the only country turning a watchful eye to private investment funds. At a recent meeting of representatives of the Group of Seven (G7) countries, increased regulation of the hedge fund industry made the agenda as German and French representatives pressed for increased oversight. Citing hedge funds' increasing influence on companies, Germany's Finance Minister continues to seek regulation of hedge funds and increased transparency requirements and has indicated his support for a French proposal that would seek higher capital reserve requirements for banks in the EU to reflect the risks created by hedge fund clients. The intended outcome of this proposal would be indirect regulation of the hedge fund industry through the improved transparency and internal controls that would result from increased regulation of their prime brokers. This notion of increased oversight and indirect regulation of hedge funds by monitoring the banks that lend them money – a task that some have noted will be easier than monitoring each individual investment fund manager – appears to be gaining some momentum and may be revisited at an upcoming meeting of representatives of the Group of 20 (G20) countries in London in April.

Finally, private fund regulation has been endorsed by the "Group of 30" – an international committee of current and former senior bankers and regulators. In itsreport published in January 2009, the group recommended a uniform international approach that would include registration of fund managers, limitations on leverage and limitations on some dealings between banks and private investment funds.

Financial instruments

Mitigating counterparty risk for OTC derivatives – recent developments in the use of collateral

Geoffrey B. Goldman and Kalin S. Velev

Recent events have highlighted the importance of counterparty risk in the OTC derivatives market. Many companies rely on this market to hedge their exposure to interest rate, currency, commodity and other risks. However, companies that use the OTC derivatives market are subject to the risk of a counterparty default. To prepare for a counterparty default scenario, in addition to updating internal risk control procedures, companies may wish to review their existing collateral documentation and arrangements and consider changes that can reduce their exposure to counterparty risk.

Understanding OTC derivatives collateral

Collateral for OTC derivatives is most commonly provided under an ISDA Credit Support Annex (CSA) or similar arrangement. (A distinction should be made between New York law CSA and UK law CSA. Under the form of CSA subject to New York law, the pledgor grants a security interest in the collateral transferred to the secured party. No security interest is granted when collateral is posted using a UK law CSA. Instead, full legal and beneficial ownership in the collateral passes to the collateral taker. Consequently collateral arrangements using a UK law CSA may pose additional issues if the counterparty defaults.) Where collateral has been posted by a counterparty under a collateral arrangement, the company will generally have the right if the counterparty defaults to liquidate such collateral and apply the proceeds to amounts payable by the failed counterparty under the derivative contract.

Where the company has posted collateral and the failed counterparty is holding the collateral, under the terms of the standard CSA, the counterparty must return the posted collateral if it defaults. If the collateral is not returned immediately, the company can set-off and withhold payment of any amounts payable by the company to the failed counterparty up to the amount of the collateral.

Rights to liquidate or set-off against the collateral for derivative contracts are protected by certain safe harbours under the US Bankruptcy Code and, for example, will generally not be subject to automatic stay (such set-off rights will be especially valuable if the company has a bilateral master netting agreement with the counterparty as it would be able to set-off payments across all derivatives agreements with the counterparty).

Complications can arise, however, where a bankrupt counterparty holds collateral in excess of the company's obligations to it. In that case, a key question is whether such excess collateral remains property of the company or is part of the bankruptcy estate of the defaulting counterparty, in which case the company may only have an unsecured claim for the return of its collateral.

One consideration is whether the company has granted rehypothecation rights to the counterparty (that is, the contractually negotiated right of a secured party under a CSA to sell, pledge, assign, invest, use, commingle or otherwise dispose of the posted collateral). If so, and if the counterparty has commingled the collateral with its own assets or transferred such collateral to a third party, the company's right to return will be subordinated to the third party's rights in the collateral and may be treated as an unsecured claim.

Similar concerns can arise even if the company has not granted rehypothecation rights, but the collateral has not been segregated and identified on the books of the counterparty as collateral of the company posted for the benefit of the counterparty as a secured party under the CSA.

These issues may be addressed by changes to the structure of the collateral arrangement and improvements to the underlying collateral documentation.

Changes to collateral arrangements

As a start, companies should consider whether their derivatives documents should provide for the counterparty to post to cover any exposure to it. Historically, many CSAs between companies and dealers were "one-way", with only the company posting collateral to the dealer. Many parties may want to update their documents to reflect the increased counterparty risk seen in recent months and consider other terms to mitigate collateral risk.

Another focus should be the benefits and risks of different types of collateral. Cash and US treasuries have been considered liquid and so widely accepted in collateral arrangements. Use of securities collateral poses certain risks, however. For example, because of valuation and liquidation timing issues, the collateral posted by the counterparty may not be sufficient to cover companies' total losses in connection with the default of the counterparty, particularly in volatile or declining markets.

As a result, some market participants prefer the use of standby letters of credit (LCs) instead of securities collateral. In the case of an LC, the company would generally not face concerns with the recovery of excess collateral. On the flip side, if the company is a beneficiary of an LC, the company will be exposed to the credit risk of the issuing institution. From a practical perspective, even if the issuing institution remains sound, the issuing institution may dispute its obligation to pay or may delay its payment. LCs could also be expensive, especially to institutions with a reduced credit profile.

Other approaches may help address the risk encountered with respect to excess collateral at a defaulting counterparty. One possibility is to use third party custodial arrangements to hold collateral instead of allowing the counterparty to hold collateral itself or through an affiliate. Under these arrangements, collateral is held by a third party custodian in an account in the name of the pledgor, and a security interest in the account, and the assets in it, is granted to the derivatives counterparty. On the bankruptcy of the counterparty, the collateral will not be part of the debtor's estate, and companies will be entitled to claim it back from the custodian or exercise set-off rights. Third party custody arrangements do have certain downsides, including additional expense and restrictions on the use of collateral. They also present the risk that the custodian will delay return or release of collateral if a party defaults or there is a dispute between the parties, pending judicial or other resolution of the dispute. Such arrangements are also subject to the risk of a custodian's default.

Companies that seek to enter into third party custody arrangements may wish to consider whether they should apply to all posted collateral or only "initial" or excess collateral. Such an approach may be more cost-effective yet still protect the excess margin, which presents the greater risk in a counterparty failure.

Another approach is to limit rehypothecation rights, either as a whole or on certain events, such as a counterparty's credit rating being downgraded or certain other credit events occurring with respect to the counterparty (such as widening spreads on credit default swaps and changes in the spread on its short-term commercial paper borrowings).

Another solution, which again may be easier with respect to initial margin than with respect to variation margin (that is, generally, collateral posted periodically to cover a secured party's mark-to-market exposure to the pledgor under а derivative contract), is to clearly segregate the initial margin on the books of the counterparty as being owned by the counterparty, together with a limit on rehypothecation.

Additional questions to consider in reviewing collateral documentation are how collateral is valued, what obligations are secured, in what jurisdiction and at which institution collateral is held and transfer timing.

All market participants could benefit from reviewing these and other collateral documentation issues in light of recent experience.

Restructuring and insolvency

SemCrude decision could spell the end to triangular set-off agreements

Michael H. Torkin, Solomon J. Noh and Tanya Sheridan

Background

The US Bankruptcy Court for the District of Delaware, in a decision in the SemCrude, L.P. (SemCrude) bankruptcy case that was announced on 9 January 2009, held that the Bankruptcy Code prohibits a triangular set-off of debts in bankruptcy in the absence of mutuality.

Set-off is a right that arises under state law or under contract that allows entities that are mutually indebted to each other to apply their mutual debts against each other, thereby avoiding "the absurdity of making A pay B when B owes A" (Citizens Bank of Maryland v. Strumpf, 516 US 16, 18 (1995)).

Triangular set-off arises where A, B and C agree that A may set off amounts owed by A to B against amounts owed to A by C.

Preservation of set-off rights in a bankruptcy case is advantageous to creditors because "every setoff by its very nature is a preference" (In re NWFX, Inc., 864 F.2d 593, 595 (8th Cir. 1989)), and exercising set-off rights often permits creditors to realise a greater recovery than otherwise similarly situated creditors.

The Bankruptcy Code itself does not create a right of set-off. Section 553 of the Bankruptcy Code merely recognises and preserves set-off rights that arise under applicable non-bankruptcy law, to the extent that such set-off rights meet the conditions set out in that section. Because the effect of recognising set-offs in a bankruptcy case is contrary to the Bankruptcy Code's policy of equality of distribution, courts have tended to strictly apply the conditions to valid set-off in section 553. The main issue to be decided by the bankruptcy court in the SemCrude case was whether section 553's requirement of mutuality rendered the contractual triangular set-off arrangement between the parties unenforceable in bankruptcy.

Facts

The facts of the case were as follows:

SemGroup, L.P., an Oklahoma based company that provides goods and services to the energy industry, and certain of its direct and indirect subsidiaries, filed voluntary petitions under Chapter 11 of the Bankruptcy Code on 22 July 2008.
Chevron USA, Inc. had entered into contracts for the purchase and sale of various petroleum products with three of SemCrude's subsidiaries (SemCrude, L.P., SemFuel L.P. and SemStream L.P), each of which was a party to the Chapter 11 proceedings.
Each of Chevron's contracts with these SemCrude affiliates was governed by a master agreement that contained the following netting provision:
"In the event either party fails to make a timely payment of monies due and owing to the other party, or in the event either party fails to make timely delivery of product or crude oil due and owing to the other party, the other party may offset any deliveries or payments due under this or any other Agreement between the parties and their affiliates." (Emphasis added).
As of the bankruptcy petition date, Chevron owed approximately US$1.4 million to SemCrude and was owed approximately US$10.2 million and US$3.3 million by SemFuel and SemStream, respectively.
All parties agreed that SemCrude, SemFuel and SemStream were "affiliates" for the purposes of the relevant master agreement.
On 21 August 2008 Chevron filed a motion seeking leave from the automatic stay to effect a triangular set-off of the amount owed to SemCrude against the amounts SemFuel and SemStream owed to Chevron.

Decision

The bankruptcy court denied Chevron's motion, holding that, for a set-off to be enforceable in bankruptcy, the debts to be off-set must be mutual, pre-petition debts. Chevron had argued that an enforceable, pre-petition agreement between a debtor, a creditor and one or more third parties (like the one between it and the three SemGroup affiliates) either satisfies section 553's mutuality requirement or is a recognised exception to the mutuality requirement.

Chevron cited a number of cases in support of its position. Although the bankruptcy court agreed that "at first blush," these cases seemed to support Chevron's argument, on closer analysis, it found that none of the cases Chevron cited actually enforced an agreement that allowed for a triangular set-off. Instead these decisions simply recognised such an exception in the course of denying the requested set-off or finding mutuality independent of the agreement.

The bankruptcy court therefore found that there was a complete absence of controlling or persuasive decisions on the question, and so set about examining two distinct questions.

The first was whether mutuality could be supplied by a multi-party agreement contemplating a triangular set-off. In answering this question, the bankruptcy court construed the definition of "mutuality" strictly. Although "mutuality" is not defined in the Bankruptcy Code, the bankruptcy court held that there is clear authority that debts are "mutual" only when "they are due to and from the same persons in the same capacity." The triangular set-off arrangement did not give rise to a debt owed by SemFuel and SemStream to Chevron. The set-off merely provided that SemCrude would see one of its own receivables reduced or eliminated. Likewise, the triangular set-off arrangement did not purport to give Chevron a right to collect from SemFuel and SemStream. This was not the type of arrangement that could be viewed as giving rise to debts due to and from the same persons in the same capacity. Thus, the bankruptcy court held that non-mutual debts cannot be transformed into mutual debts under section 553 by a multi-party agreement allowing for set-off of non-mutual debts between the parties to the agreement.

The bankruptcy court next examined the question of whether there was a contractual exception to the mutuality requirement. Focusing on the language of section 553 itself, the bankruptcy court found nothing on which to base a conclusion that there is a contractual exception to the mutuality requirement. The "great weight" of authority for the holding that there is no reason to extend the right of set-off beyond that provided for in the Bankruptcy Code also influenced the bankruptcy court's decision. The bankruptcy court further noted that its holding was consistent with the primary goal of the Bankruptcy Code, to ensure that similarly situated creditors enjoy an equality of distribution from a debtor unless there is a compelling reason to depart from this principle. The bankruptcy court thus held that parties could not contract around the mutuality requirement in section 553 by private agreement.

Comment

The SemCrude decision, if followed by other courts, could have implications for companies that attempt to manage their counterparty risk exposure to a corporate group through contractual provisions that allow that company to offset amounts it owes to one member of the group against amounts owed to it from that member's affiliates.

Although this was not addressed by the bankruptcy court, we do not believe that this decision would apply to safe harboured contracts. In fact, Chevron filed a motion for reconsideration on 20 January 2009, in which it argues that its contracts with the SemGroup debtors are "forward contracts" or "swap agreements" within the meaning of sections 556 and 560 of the Bankruptcy Code, respectively.

Chevron argues that section 561(a) of the Bankruptcy Code takes safe harboured contracts out of the scope of section 553, by providing that such contracts will not be stayed, avoided or otherwise limited by the operation of any provision in the Bankruptcy Code, a position that is supported by a leading authority on the Bankruptcy Code.

The hearing date on this motion is set for 12 March 2009.

Tax

The recently passed American Recovery and Reinvestment Tax Act of 2009 presents new opportunities for businesses

Bernie J. Pistillo and Derek Kershaw

On 17 February 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (Pub. L. No. 111-5) which contains the American Recovery and Reinvestment Tax Act of 2009 (2009 Tax Act). This permits taxpayers to elect deferred inclusion of certain cancellation of indebtedness income (CODI) realised in 2009 or 2010 over a five-taxable-year period that generally begins, for calendar-year taxpayers, in 2014.

Businesses should examine the opportunities available to them in the credit markets, as explained below, and carefully consider taking advantage of the tax incentives provided by the 2009 Tax Act in respect of their outstanding debt in 2009 or 2010.

General treatment of CODI under the Code

When a taxpayer purchases its debt for less than the adjusted issue price (this is generally the issue price of a debt instrument, increased by the amount of original issue discount previously includible in the gross income of any holder and decreased by the amount of any payment previously made on the debt instrument other than a payment of qualified stated interest) or otherwise restructures its debt in a way that results in a cancellation of all or part of the debt, the taxpayer generally must include the amount of debt discharged in its gross income for the taxable year during which the debt was cancelled.

Purchases of the taxpayer's debt by certain related persons (from a non-related person) are treated as purchases by the taxpayer for purposes of calculating CODI. Likewise, the exchange by a debtor of stock for its outstanding debt, or of new debt instruments for outstanding debt instruments, may produce CODI.

Furthermore, CODI can result from changes that are made to the terms of outstanding debt that is trading at a discount, where the changes are deemed "significant". Section 108(a) of the Internal Revenue Code of 1986, as amended, provides for the exclusion from the debtor's gross income of part or all of the CODI realised if the debt was cancelled in a US bankruptcy case or to the extent that the taxpayer was insolvent, among other things. The exclusion of CODI in these cases generally requires a corresponding reduction in the tax attributes of the debtor, including net operating loss carryforwards, general business credit carryforwards, and tax basis in assets.

Temporary relief under the 2009 Tax Act

The 2009 Tax Act permits debtors to elect to defer the inclusion of CODI that results from the "re-acquisition" of a debt instrument that was issued by a C corporation or otherwise in connection with the conduct of a trade or business. The 2009 Tax Act affects only the treatment of income that results from a cancellation occurring in 2009 or 2010 and results from a re-acquisition, meaning that the debt was acquired either by the debtor or by a person treated as related to the debtor for these purposes.

CODI will qualify for elective deferral if the debtor (or a related party) acquires the debt by transferring cash, a debt instrument, or stock or partnership interests (including interests deemed distributed under a contribution of the debt to the capital of the debtor). For example, a taxpayer may defer income that results from an exchange of debt for debt or equity for debt, provided that the debtor files an appropriate statement of election with the tax return for the year in which the exchange occurred.

CODI resulting from a significant modification of the terms of a debt instrument likewise is eligible for deferral, as is CODI from a complete forgiveness.

Once a debtor has elected to defer CODI resulting from the re-acquisition of a debt instrument, none of the CODI realised by the debtor from the cancellation of that debt instrument may be excluded in any taxable year under the standard exceptions of Section 108(a) (Internal Revenue Code of 1986, as amended) (that is, bankruptcy, insolvency, and so on).

The reduction of tax attributes that corresponds with CODI excluded under other Code provisions is not required in connection with the new election to defer CODI.

CODI that is deferred generally must be included in gross income ratably over a period of five consecutive taxable years of the debtor (inclusion period). In the case of a re-acquisition occurring in 2009, the first year of the inclusion period is the fifth taxable year of the debtor following the taxable year of the re-acquisition. In the case of a re-acquisition occurring in 2010, the first year of the inclusion period is the fourth taxable year of the debtor following the taxable year of the re-acquisition.

Generally, 20 percent of the deferred income is to be included in each taxable year of the inclusion period. Calendar-year taxpayers that elect deferral therefore generally will include deferred CODI starting in 2014, whether the income was realised in 2009 or 2010.

The amount of CODI ultimately to be included by the debtor is not affected by the 2009 Tax Act. If the debtor dies, ceases its business, or transfers substantially all of its assets in liquidation or in a sale (including in a title 11 case), the outstanding balance of the CODI being deferred under this provision is accelerated and included in gross income in the year when such event occurs (or, for a title 11 case, the day before the petition is filed).

In the case of electing partnerships or other pass-through entities that elect deferral, this rule also applies to a disposition of an ownership interest in the entity. The Secretary of the Treasury is authorised to prescribe regulations requiring the accelerated inclusion of deferred income in other appropriate circumstances.

If the debtor is a partnership, S corporation, or other pass-through entity, then the election to defer CODI from a re-acquisition of debt is to be made by the debtor entity, not by its owners. The deferred CODI of an electing partnership is to be allocated to its partners immediately before the cancellation in the manner in which such income would have been allocated if it were recognised at such time.

The 2009 Tax Act requires the debtor to defer deductions otherwise allowable for original issue discount (OID) accruing on any instrument issued, or deemed issued, in a transaction that is the subject of a CODI deferral election, to the extent of the amount of CODI that has been deferred. Deferred deductions are allowed ratably over the period of the inclusion of the deferred CODI. The situations in which an OID instrument is deemed to be issued in an exchange subject to a CODI deferral election include:

Where the proceeds of an OID debt instrument are used (directly or indirectly) to repurchase outstanding debt.
Where the taxpayer's debt is acquired by a related person at a discount.

In addition to the deferral of CODI arising from transactions in 2009 or 2010, the 2009 Tax Act provides that the so-called "AHYDO" rules, that defer or disallow interest deductions on certain high-yield obligations, do not apply to debt-for-debt swaps occurring after 31 August 2008 and before 1 January 2010, provided that the outstanding debt retired in the swap is not AHYDO debt. These rules ordinarily affect certain OID bonds with a term in excess of five years on which the yield to maturity equals or exceeds the applicable federal rate plus five percentage points.

Certain businesses may find that these temporary tax incentives justify pursuing a modification to their outstanding debt this year, after taking into account the credit opportunities available to them, the scheduled maturities of their debt obligations, and their assessment of future market conditions.

Conclusion

The 2009 Tax Act will enable many businesses to restructure their outstanding debt with generally favourable tax consequences during 2009 and 2010. Certain taxpayers who previously might have depended on the insolvency or bankruptcy exceptions to avoid CODI (and suffered the resulting reduction in tax attributes) could find more favourable results available under the 2009 Tax Act's CODI deferral regime. The new principle of matching CODI and OID deductions in many instances may eliminate or significantly reduce the adverse tax costs associated with a debt restructuring. Finally, the suspension of the AHYDO rules in connection with certain debt exchanges in 2009 may afford many taxpayers a significant planning opportunity, particularly given the likelihood that more instruments could meet the yield criteria for these rules, given current market conditions.

PLC Global Finance update for February 2009: United States | Practical Law