Financial Services Alert - October 7, 2008 October 07, 2008
In This Issue

FASB Staff and SEC Propose Clarifications on Fair Value Determinations in Inactive Markets

The staff of the Financial Accounting Standards Board (“FASB”) and the SEC’s Office of the Chief Accountant issued a joint press release, and FASB has proposed complementary interpretative guidance, on how to determine the fair value of a financial asset when the market for that asset is inactive. 

Neither the joint press release nor FASB’s proposed interpretative guidance, if adopted as drafted, are designed to change the fair value measuring principles currently articulated in Financial Accounting Statement 157 (“FAS 157”).  FAS 157, among other things, defines fair value as the price at which a transaction would occur between market participants at the measurement date, and it establishes a framework for measuring fair value under U.S. generally accepted accounting principles (GAAP).  Generally, under FAS 157, in a situation where there is little, if any, market activity for an asset, the asset’s fair value price should be equal to the price that the holder of the asset would receive in an orderly transaction at the measurement date.  The joint press release and the FASB’s proposed interpretative guidance, among other things, clarify that management, under certain circumstances, would be permitted to (a) use its internal assumptions, including expected cash flow, as inputs in measuring fair value when relevant market evidence relating to the asset does not exist, and (b) consider, but not rely exclusively on, various observable market factors (i.e., those observable market factors would not necessarily be determinative) if an active or orderly market for the asset does not exist, including if observed transaction prices are a result of distressed or forced liquidation sales.

Comments on FASB’s proposed interpretative guidance are due by October 9, 2008, and, recognizing the importance of this issue, FASB has indicated that it expects to review the comments and finalize its guidance on October 10, 2008.

In a related development, the SEC announced additional details of the study of “mark-to-market” accounting the SEC is required to conduct in consultation with the Secretary of the Treasury and the FRB under the terms of the Emergency Economic Stabilization Act of 2008.  Specifically, the Act calls for a study of mark-to-market accounting as provided for in FAS 157, as those standards apply to financial institutions, including depository institutions, with a focus on:

  • the effects of  mark-to-market accounting standards on a financial institution's balance sheet
  • the impacts of mark-to-market accounting on bank failures in 2008
  • the impact of mark-to-market accounting standards on the quality of financial information available to investors
  • the process used by FASB in developing accounting standards
  • the advisability and feasibility of modifications to mark-to-market accounting standards
  • alternative accounting standards to those provided in FAS 157
The SEC must complete the study by January 2, 2009.

IRS Issues Notice to Assist Banks Following an Ownership Change

The Internal Revenue Service (the “IRS”) on September 30, 2008 issued Notice 2008-83 to provide guidance to banks in the current volatile economic environment.  Notice 2008-83 provides that properly allocable deductions by a bank of losses on loans or loan loss reserves will not be treated as attributable to periods prior to an ownership change pursuant to section 382(h) of the Internal Revenue Code (the “Code”).  In general, Section 382 of the Code limits a corporation’s deduction for net operating loss carryovers and recognized built-in losses subsequent to an ownership change.  An ownership change, as defined in section 382(g) of the Code, is, generally, a change of 50% or more of the ownership of a corporation within a three-year period.

Prior to Notice 2008-83, losses recognized by banks on the disposition of loans and bad debt deductions could have been treated as attributable to the period before the ownership change.  Such losses and deductions would then have been subject to the limitations proscribed in Section 382.  The new guidance removes a potential barrier to new equity ownership of struggling banks by assuring banks that the IRS will not challenge deductions as being attributable to periods prior to the ownership change.

Banks may rely upon this notice until the IRS issues further guidance.

FRB to Pay Interest on Depository Institutions’ Required and Excess Reserves; FRB Issues Interim Final Rule Amending Regulation D

The FRB was granted authority to pay interest on reserves commencing on October 1, 2011 by the Financial Services Regulatory Relief Act of 2006.  Section 128 of the Emergency Economic Stabilization Act of 2008 accelerated, from October 1, 2011 to October 1, 2008, the FRB’s authority to pay interest on depository institutions’ required and excess reserve account balances with the FRB. 

The FRB announced that it will now begin to pay interest on depository institutions’ reserve accounts, effective with the reserve maintenance period beginning October 9, 2008.  The FRB stated that “the payment on excess reserve balances will give the [FRB] greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.”

To implement the change, the FRB issued an interim final rule (the “Rule”) that amends the FRB’s Regulation D, “Reserve Requirements of Depository Institutions.”  The Rule is effective October 9, 2008 and comments are due by November 21, 2008.

Federal Banking Agencies Propose Rule that Would Permit Banking Organizations to Deduct Goodwill Net of Associated Deferred Tax Liabilities from Regulatory Capital

The FRB, FDIC, OCC and OTS (the “Agencies”) issued a joint notice of proposed rulemaking (the “NPR”) under which banks, banking holding companies and savings associations (“Banking Organizations”) would be able to reduce the amount of goodwill that a Banking Organization must deduct from Tier 1 capital by the amount of any deferred tax liability associated with that goodwill.  Under the Agencies’ current regulatory capital rules, Banking Organizations may net the value of associated deferred tax liabilities from many assets, but such netting is generally not permitted for goodwill or other intangible assets arising from a taxable business combination.

The Agencies said that the change proposed in the NPR would “permit a [B]anking [O]rganization to effectively reduce its regulatory capital deduction from goodwill to an amount equal to the maximum regulatory capital reduction that could occur as a result of the goodwill becoming completely impaired or derecognized.”  The Agencies requested comments on all aspects of the NPR, including: (1) the impact that the NPR could have on a Banking Organization’s regulatory capital ratios; and (2) whether the Agencies should consider similar treatment for intangible assets, other than goodwill, that are currently required to be fully deducted by a Banking Organization from its Tier 1 capital.  Comments are due no later than October 30, 2008.

FDIC Deposit Insurance Coverage Increased Temporarily

The FDIC increased the limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor pursuant to Section 136 of the Emergency Economic Stabilization Act of 2008 (the “EESA”).  The increase in coverage became effective immediately upon President Bush’s signing of the EESA on October 3, 2008.  The basic deposit insurance limit will return to $100,000 on December 31, 2009.  The FDIC authorized insured depository institutions (“DIs”) to add the following statement to a DI’s signage and customer information materials:

“On October 3, 2008, FDIC deposit insurance temporarily increased from $100,000 to $250,000 per depositor through December 31, 2009.”

Delaware Chancery Court Issues Opinion Concerning the Application in M&A Context of MAE Condition and Covenants to Use Reasonable Best Efforts

The Delaware Chancery Court (the “Court”) issued a ruling that addressed some common M&A agreement provisions, particularly “material adverse effect” closing conditions and covenants to use “reasonable best efforts.”  The opinion highlighted the difficulty that acquirers will face in calling off merger transactions, even if difficult economic conditions have rendered the transaction inadvisable or difficult to finance.  Hexion Specialty Chemicals, Inc. v. Huntsman Corp. involved a dispute over whether the acquirer, Hexion Specialty Chemicals, Inc., a portfolio company for a large private equity group (“Hexion”), could be excused from closing its proposed acquisition of Huntsman Corp. (“Huntsman”).  The parties entered into a merger agreement in July 2007 prior to the onset of the credit crisis.  After that time, Huntsman’s financial results weakened.  Hexion asserted that it was not obligated to close the merger because a “material adverse effect” or “MAE” had occurred with respect to Hunstman.  If that were the case, Hexion would have no liability to Huntsman for such termination.  Alternatively, Hexion argued for termination of the merger agreement on the basis that the necessary financing was impossible to obtain because, post-transaction, the combined company would be insolvent.  In that situation, Hexion asserted that its liability was limited to $325 million.

First, the Court ruled that no “material adverse effect” had occurred with respect to Huntsman.  The Court held that, as the party invoking the MAE condition, Hexion bore the burden of proving that an MAE had occurred.  The weight of this burden was highlighted by the Court’s reminder that Delaware courts have never found an MAE to have occurred in the context of a merger agreement.  In the Court’s view, MAE conditions are aimed at “protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner.”  In other words, the adverse impact must be shown to “be expected to persist significantly into the future.”  In light of the fact that the deal was all-cash, the Court also held that EBITDA was the appropriate metric for assessing the existence of an MAE in this case, because earnings per share was dependent on a company’s capital structure and acquirers may or may not be assuming the target’s existing debt.

Second, the Court rejected Hexion’s assertion that the projected insolvency of the combined company could be a basis for terminating the agreement.  The merger agreement was not conditioned on Hexion being able to obtain its financing, i.e., there was no “financing out.”  Hexion had entered into a commitment letter with its lenders that conditioned their loan of the necessary funds on delivery of a certificate that the combined company would be solvent.  An inability to deliver such a certification would excuse the lenders from lending the funds, but did not excuse Hexion from closing the merger.

Nevertheless, under the terms of the merger agreement, Hexion’s liability to Huntsman for not closing was limited to the $325 million termination fee unless it had “knowingly and intentionally” breached the merger agreement, which the Court interpreted as the taking of a deliberate act that in and of itself constitutes a breach (regardless of whether the party knows that the action constitutes a breach).  The Court focused on Hexion’s obligation to use reasonable best efforts to obtain the necessary financing and analyzed in detail Hexion’s actions leading up to its decision to terminate the merger agreement.  Hexion was not required to ignore its own interests, but was required to consider whether it had commercially reasonable options short of termination.  The Court determined that Hexion’s failure to discuss alternatives with Huntsman constituted a failure to use reasonable best efforts and showed a lack of good faith.

The Court ordered Hexion to specifically perform its covenants but held that the merger agreement did not allow for an order to close the merger based on a strict reading of the merger agreement.  In light of the finding that it knowingly and intentionally breached the merger agreement, however, Hexion could face uncapped contract damages for not closing.

Treasury Issues Notices Soliciting Financial Agents to Provide Infrastructure, Securities Asset Management and Whole Loan Asset Management Services for Troubled Assets Relief Program

The Treasury posted on its website solicitations for financial agents to provide services for the troubled asset relief program (the “TARP”) created by the Emergency Economic Stabilization Act of 2008 (see the AlertOctober 3, 2008 for more detail on the TARP and the Act).  (In contrast to a contractor engaged by the Treasury, a financial agent’s relationship with the Treasury is not governed by the Federal Acquisition Regulation.)  The notices indicate that the Treasury will select a single institution to provide infrastructure services for the entire portfolio of assets acquired under the TARP and  will select asset managers of securities separately from asset managers of mortgage whole loans.  Securities asset managers will handle Prime, Alt-A and Subprime residential mortgage backed securities (“MBS”), commercial MBS, and MBS collateralized debt obligations; they may also handle other types of securities if the Treasury determines that the acquisition of those securities will promote market stability.  Whole loan asset managers will handle a range of products, including residential first mortgages, home equity loans, second liens and commercial mortgage loans; they may also handle other types of mortgage loans if the Treasury determines that the acquisition of those loans will promote market stability.  The complete notices, which include additional information on eligibility, qualifications, information to be submitted and other requirements are available at:

Institutions interested in being considered for selection as financial agents must submit their requests by 5pm (EDT) on October 8, 2008.  The Treasury expects to announce the results of the first phase of the selection process next week.