PLC Global Finance update for April 2009: United States

Practical Law UK Articles 8-385-9117 (Approx. 8 pages)

PLC Global Finance update for April 2009: United States

by Shearman & Sterling LLP

Financial institutions

Government guarantees for US money market funds expire in September: Is the industry ready?

Nathan J. Greene

After two large US money market funds collapsed in September 2008, many US money market funds experienced sharp spikes in shareholder redemptions. The resulting near panic was a reminder of the fact that money market funds are subject to "break-the-buck" risk (that is, they may not return to investors their expected dollar per share) when unexpectedly forced to liquidate assets to meet a concentrated run of redemptions.

(Money market funds are a closely regulated subset of the US mutual fund industry. They buy short-term, high-quality assets and regularly distribute any yields realised, thus allowing their shares to maintain a steady net asset value, typically US$1 per share. They are widely used as a savings vehicle and today represent almost US$4 trillion in investor assets.)

Following the disruptions of September 2008, the US Treasury quickly created the Temporary Guarantee Program for Money Market Funds, which guaranteed that fund shareholders who owned shares on 19 September 2008 would be protected if a money market fund liquidated. This program succeeded in calming investors and ending the run of redemptions, but it is set to expire in September 2009.

With that September deadline looming, US regulators and the money market fund industry are looking for a framework under which the funds can smoothly transition out of the insurance programme without again panicking investors. Many believe this requires structural change.

Current reform proposals generally fall into one of three categories:

Scrap money market funds in favour of bank money market accounts or something very much like them inside "special purpose banks".
Scrap money market funds in favour of floating, as opposed to steady US$1, net asset value (NAV) vehicles.
Fine-tune the present system.

The principal proposals have been made by the "Group of 30", an international committee of current and former senior bankers and regulators; the Investment Company Institute, the US mutual fund industry’s leading trade group; and by senior officials of the US Securities and Exchange Commission (SEC), as follows:

Group of 30. Under the Group of 30's proposal, money market funds that offer "bank-like services", including transaction account services, withdrawals, demand at par, and assurances of a steady US$1 NAV, would be required to reorganise as special purpose banks. The Group of 30 recommends that money market funds that do not offer bank-like services should offer an investment option with a floating NAV. Either approach would upend 30 plus years of practice.
Investment Company Institute (ICI). The ICI generally makes more modest recommendations, many of which can be implemented by funds voluntarily, including:
- shortening asset maturity requirements;
- maintaining specified liquidity cushions;
- enhancing internal credit analysis procedures;
- requiring money market funds to develop know your client procedures; and
- developing increased disclosure requirements.
More dramatically, the ICI has proposed rule-making to authorise money market fund directors to suspend redemptions and purchases by the money market fund for five days in the case of exigent circumstances.
Securities and Exchange Commission (SEC). SEC Chairman Mary L Shapiro testified in March before the US Senate Banking Committee that the SEC will focus on proposals to enhance the standards applicable to money market funds. In a speech given in April, SEC Division Director Andrew Donohue challenged the US$1 steady NAV because it is insensitive to changes in the value of money market fund portfolios and therefore signals risk only to the most sophisticated investors who are able to perform their own "shadow pricing" calculations. He suggested that a US$10 floating NAV could address this concern.

Each of the proposals above has aspects that represent meaningful change from the status quo. In some cases, they would alter the US money market fund industry beyond recognition. That such far-reaching changes are being discussed is testament in large part to the fact that economic events ranging far beyond money market funds have created a uniquely fluid policy environment.

Yet for industry watchers with long memories, some of the current proposals will be familiar, having been widely discussed in the late 1970s and early 1980s. It is perhaps not mere coincidence that those earlier proposals saw their heyday during the tenure of then-US Federal Reserve Chairman Paul Volcker and that today Mr Volcker chairs the Group of 30's Steering Committee responsible for its money market fund reform agenda described above.

For a more information about these matters, see US Money Market Fund Reform Initiatives: A $4 Trillion Question.

Executive compensation & employee benefits - Section 457A of the Internal Revenue Code

Doreen E. Lilienfeld, Amy B. Gitlitz and Elizabeth Roseman

On 3 October 2008, section 457A was added to the Internal Revenue Code in an effort to limit deferrals of compensation by US taxpayers employed by "tax indifferent" entities. Interim guidance on the application of section 457A was issued on 8 January 2009, but many questions remain unanswered. Corporations have until 1 July 2009 to take advantage of a limited transition rule that may reduce the impact of section 457A on existing deferral plans.

General Rule. Section 457A requires an individual to include compensation deferred under a nonqualified deferred compensation plan of a "nonqualified entity" in income when it is no longer subject to a "substantial risk of forfeiture". If, however, the amount of deferred compensation is not determinable at that time, the amount will be included in income when it becomes determinable, plus a 20% penalty tax and interest at the underpayment rate plus 1%.

Nonqualified entities. Section 457A applies to amounts deferred under a nonqualified deferred compensation plan sponsored by a "nonqualified entity". A nonqualified entity is:

Any non-US corporation unless all or substantially all or its income is:
- effectively connected with a US trade or business; or
- subject to a comprehensive foreign income tax.
Any partnership unless substantially all of its income is allocated to persons subject to a comprehensive tax scheme.

Whether an entity is a nonqualified entity is determined as of the last day of the service provider’s taxable year in which a deferred amount remains outstanding (generally, 31 December of each year).

Substantial risk of forfeiture. A substantial risk of forfeiture exists only if the compensation is subject to a requirement that the individual perform substantial future services (that is, time-based vesting conditions, but not performance-based vesting conditions).

Short-term deferrals. Amounts that are paid no later than 12 months after the end of the corporation's taxable year in which the amount is no longer subject to a substantial risk of forfeiture are not subject to section 457A.

Grandfathered amounts. Section 457A applies to amounts deferred that are attributable to services performed after 31 December 2008. To the extent a deferred amount was vested as of 31 December 2008, section 457A does not apply as long as the individual includes the amount in income in a tax year beginning before 1 January 2018 or the tax year in which the amount is not subject to a substantial risk of forfeiture, if later.

Transition relief. Service recipients may amend their existing deferred compensation plans to treat an on-going vesting condition as having lapsed on 31 December 2008. These amendments must be in writing and effective before 1 July 2009, and must be applied consistently to every service provider participating in the same or a substantially similar arrangement. The interim guidance does not clarify how this requirement will be applied.

Overlap of section 409A. Section 409A may also apply to deferred compensation subject to section 457A, and the interim guidance contains several provisions on this interplay. Generally, an amount will not be subject to section 409A if it is included in income under section 457A when the substantial risk of forfeiture lapses, since the amount will be paid within section 409A's "short-term deferral" rule. Service providers will need to be mindful of the potential impact of any section 457A changes made to deferral arrangements to ensure that they do not inadvertently trigger a section 409A violation.

Section 457A is broader than may appear at first blush and non-US corporations (including US companies with foreign subsidiaries) and US and non-US partnerships should work with their tax and employee benefits counsel to carefully analyse whether section 457A applies to their deferred compensation arrangements. If it does, they should work to identify the best course of action to avoid income inclusion (and potential penalty taxes) for service providers under section 457A.

For more information about section 457A, click here.

Restructuring and insolvency

Winstar decision increases risk that strategic partners/lenders could be subject to one-year look-back period for preferential payments

Michael H. Torkin, Solomon J. Noh and Randy Martin

The US Court of Appeals for the Third Circuit, in a decision in the Winstar Communications, Inc. bankruptcy case, recently held that a significant strategic partner and lender to a bankrupt company can be deemed to be an "insider" within the meaning of the Bankruptcy Code such that a one-year "look-back" period for the avoidance of preferential payments can be applied to such an entity (as opposed to the three-month period applicable to non-insiders).

Facts

Winstar, a large public telecommunications firm, had partnered with Lucent Technologies Inc. to facilitate the build-out of a substantial telecommunications network. Specifically, Winstar contracted with Lucent to procure equipment and services necessary for the network build-out. Lucent also agreed to provide financing for the project (including for the purchase of its own supplies) and entered into two credit agreements to provide Winstar financing for the construction project.

The second credit agreement, which allowed for up to US$2 billion of borrowing availability and supplemented an existing US$1.15 billion revolver from a syndicate of bank lenders, provided, among other things, that both:

Lucent could serve a "refinancing notice" at any time outstanding loans exceeded $500 million.
Any increases in the borrowings available under the revolver facility would be used to repay amounts borrowed under the Lucent facility.

Shortly before it was compelled to file for bankruptcy protection, Winstar was able to negotiate precisely such an increase in the revolver facility by arranging for the addition of Siemens to the lending syndicate. Under that arrangement, Siemens committed to lend an additional $200 million to Winstar and Winstar proceeded to borrow those funds, using the net proceeds of the loan to make an approximately $188 million prepayment of the Lucent loan.

During the course of Winstar's bankruptcy case, the chapter 7 trustee appointed to administer Winstar's estate asserted several legal claims against Lucent, including a claim seeking to characterise the $188 million repayment received by Lucent over four months prior to Winstar's bankruptcy filing as a preferential payment recoverable by the estate. The bankruptcy court found that the payment was indeed a preference and the decision was appealed to the Third Circuit Court of Appeals after having been affirmed by the district court.

Issues

The Bankruptcy Code allows for the "avoidance" (that is, the recovery) by a bankrupt estate of any payment deemed to have been a preference within the meaning of section 547 of the Bankruptcy Code. Assuming no applicable statutory defence applies, section 547 provides that a payment will be treated as a preference if it:

(1) was to or for the benefit of a creditor, (2) was for or on account of an antecedent debt owed by the debtor before such transfer was made, (3) was made while the debtor was insolvent, (4) was made within 90 days before the commencement date or, if the transfer was made to an insider, within one year before the commencement date, and (5) enabled the creditor to receive more than it would have received on its claim if the case was a chapter 7 liquidation (emphasis added).

Accordingly, the issue of whether the recipient of a pre-petition payment is or is not an "insider" within the meaning of the Bankruptcy Code can be critical in determining whether such payment was a preferential transfer. If the recipient is an insider, payments received as far back as a year can be clawed-back by the estate for distribution to other creditors. For non-insiders, the maximum time period for "preference risk" is three months prior to the debtor's bankruptcy filing.

The Bankruptcy Code provides that:

[t]he term insider includes… (B) if the debtor is a corporation— (i) director of the debtor; (ii) officer of the debtor; (iii) person in control of the debtor; (iv) partnership in which the debtor is a general partner; (v) general partner of the debtor; or (vi) relative of a general partner, director, officer, or person in control of the debtor.

Many courts have held that the Bankruptcy Code's use of the term "includes" with respect to these six categories clearly indicates that there must be an additional set of so-called "non-statutory insiders".

The court's decision

The Third Circuit Court of Appeals endorsed this interpretation of the statute and further stated that a non-statutory insider need not have actual control over the debtor and that it was sufficient that such entity have "a close relationship… and… anything other than closeness to suggest that any transactions were not conducted at arm's length." Ultimately, the Third Circuit Court of Appeals affirmed the lower courts' decisions that Lucent, by virtue of its close relationship with, and its exertion of commercial dominance over, Winstar, fell within the category of non-statutory insiders and therefore was subject to the extended one-year look-back period for preferential payments.

In determining that Lucent was an insider with respect to Winstar, the Court of Appeals drew upon several factual findings made by the bankruptcy court, focusing in particular on findings:

That Lucent had exerted commercial dominance over Winstar.
With respect to the alleged manipulation by Lucent of the timing of its exercise of rights under the Lucent credit agreement.

With respect to the charge of commercial dominance, the Court of Appeals focused on facts suggesting that Lucent had forced Winstar to make substantial purchases of equipment and software, often on terms designed to favour Lucent at Winstar's expense, and in transactions that could not be characterised as arm's length.

With respect to the charge of improper and opportunistic conduct regarding the Lucent credit agreement, the Court of Appeals focused on the findings by the lower court that Lucent had deliberately delayed issuance of the "refinancing notice" until such time as the Siemens loan had been consummated to avoid creating the appearance that Winstar was financially distressed and with the intent of capturing the benefit of the Siemens loan for itself.

The Third Circuit Court of Appeals affirmed that these facts were sufficient to support the finding that Lucent was an insider and that payments received by Lucent within the one year period prior to the Winstar bankruptcy filing should be returned to the estate.

Comment

Although highly fact-specific, the Winstar ruling could have an immediate and significant impact, not for active bankruptcy cases, but also for parties attempting to quantify and manage their exposure to distressed strategic partners and major customers.

As a result of Winstar, strategies for managing preference risk will be more complicated in situations where close commercial or financial relationships make it uncertain whether a party will be considered an insider if the business partner files for bankruptcy protection. These analytical challenges may be particularly acute and increasingly common in industries characterised by substantial strategic and financial integration, such as the automotive industry where captive supplier relationships similar to those described in Winstar are prevalent and where vendor financing is not uncommon.

The case also may cause some concern among financial lenders given the Third Circuit Court of Appeals' focus on the deliberate and strategically timed exercise of enforcement rights under a credit agreement. But this interpretation of the case may be limited by the Court of Appeals' suggestion that the "exercise of financial control…. incident to the creditor-debtor relationship" is not independently sufficient to make an entity an insider.

The Winstar decision can be helpfully contrasted with the Tenth Circuit Court of Appeals’ recent decision, on essentially the same issue, in Anstine v. Carl Zeiss Meditec AG (In re U.S. Medical, Inc.) 531 F.3d 1272 (10th Cir. 2008). In this case, the Court of Appeals found that a strategic business partner that held a significant equity stake and enjoyed an exclusive supply arrangement was not an insider for purposes of preference analysis. The key distinction in the case appears to have been that the defendant had taken careful steps to ensure fair dealing and arm's length transactions with its business partner prior to its insolvency. Accordingly, ensuring that conduct with business partners is conducted in an arm’s length manner would appear to be an essential best practice for businesses seeking to minimise their credit exposure to distressed partners.

Tax

Incentives for renewable energy in the American Recovery and Reinvestment Act of 2009

Mitchell E. Menaker and Derek Kershaw

The American Recovery and Reinvestment Act of 2009 (ARRA) included a number of significant benefits designed to encourage investment in renewable energy projects. The tax provisions of ARRA extended and enhanced currently available production tax credits for renewable energy projects (section 45(d), Internal Revenue Code of 1986, as amended (unless otherwise indicated, section references refer to the Internal Revenue Code of 1986 and the Treasury regulations promulgated under it); section 1101, ARRA)) as well as first year bonus depreciation (section 168(k); section 1201, ARRA).

Additionally, Congress re-introduced an incentive used over the years to encourage capital formation, the investment tax credit. The ARRA investment tax credit available for renewable energy projects is equal to 30 percent of the capital cost of a qualifying renewable project (sections 48(a)(5)(A)(ii) and 48(a)(2)(A)(i)). ARRA also created a 30% grant (section 1603, ARRA), designed to "mimic" the 30% investment credit (Joint Explanatory Statement of the Committee of Conference, H.R. 1, Division B, p. 115). The grant is a direct subsidy payable by the US Treasury. Qualifying renewable projects generally may select either the production tax credit, the investment tax credit or the grant.

Two investment structures generally suitable for third-party investments in renewable energy projects are partnerships and leases.

A partnership is not itself subject to tax, but the partners are taxed on their distributive share of the partnership's income, gain, loss, deduction and credit. Entities that are taxed as partnerships for federal income tax purposes, including general and limited partnerships and limited liability companies can be used in connection with investments using production tax credits, the investment credit or the grant (see, for example section 48(c)(5) (basis adjustments to partner's interest in partnership required upon recapture of investment credit or grant)) (IRS Rev. Proc. 2007-65, 2007-45 I.R.B. 967). The Internal Revenue Service (IRS) has issued a Revenue Procedure providing a "safe harbour" structure for wind energy partnerships (IRS Rev. Proc. 2007-65, 2007-45 I.R.B. 967).

Leasing structures can be used for projects using the new 30% investment credit or the grant but generally not the production tax credit (section 45(d) provides that the production credit is available to the owner; section 50(d)(5) provides that a lessor may make an election that permits the lessee to claim investment tax credits as though the lessee were the tax owner of the property. See also section 1603(f) of ARRA (making that rule applicable to grants)). The IRS also has outstanding a Revenue Procedure providing a safe harbour for leasing structures (IRS Rev. Proc. 2001-28, 2001-1 C.B. 1156).

The new renewables investment tax credit (and the new grant) carry many rules applicable to the "old" investment tax credit (section 50(d) (providing that certain rules in effect on the day before the date of enactment of the Revenue Reconciliation Act of 1990 apply to investment tax credits and other credits); section 1603(f), ARRA (making those rules applicable to grants)), which was generally repealed in 1986.

Many of these rules favour lease structures including rules allowing sale and leasebacks (section 50(d)(4)) and a "pass through" of the investment credit to the lessee (section 50(d)(5)).

Properly structuring transactions to use the incentives introduced in ARRA will raise many issues. Although many issues relating to the investment tax credit and leasing and partnership structures have been resolved over the years, there are also many that remain unresolved. For example, the level of economic profit required to claim the new investment credit remains an open issue. In today's highly politicised environment, investors will want answers to these open questions before committing to long-term investments the success of which depends on the availability of these newly enacted incentives.

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