(Editor’s Note: This post is based on a client memorandum by Jonathan C. Dickey and Aric H. Wu of Gibson, Dunn & Crutcher LLP.)
What began in late 2006 as a disruption in the market for subprime mortgage-backed securities, collateralized mortgage obligations (“CMOs”), and collateralized debt obligations (“CDOs”) has metastasized into a global financial crisis that has plunged much of the world into recession and brought down some of the world’s largest financial institutions. These adverse developments have generated a wave of private securities litigation, as well as regulatory inquiries by federal and state authorities.
In September 2008, the government takeover of mortgage giants Fannie Mae and Freddie Mac was followed by the collapse of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and an $85 billion (and now $170 billion) government investment in American International Group. With the stock market in freefall, the Treasury Department proposed a $700 billion “Troubled Asset Relief Program” (“TARP”) to buy toxic assets from the nation’s banks in order to shore up their balance sheets and restore confidence to the financial system. The proposal was initially rejected by the House of Representatives, but passed in early October in a modified form that initially released $350 billion, with Congress retaining the discretion to release or withhold the remainder. As of February 6, 2009, nearly 400 financial institutions had received assistance under this program.
Concluding that prior government responses to the financial crisis were “late and inadequate,” the Obama administration in February 2009 announced a comprehensive “Financial Stability Plan.” The plan provides for the establishment of a Financial Stability Trust, a Public-Private Investment Fund designed to “cleanse” financial institutions’ balance sheets of legacy assets, and initiatives to support loan securitization and community lending while preventing foreclosures. The Financial Stability Plan also promises to impose accountability and transparency on financial institutions that receive government aid by subjecting them to a “stress test” before they may participate in the Financial Stability Trust and requiring them to limit executive compensation and dividends, mitigate foreclosures and expand public reporting. The initial reaction of the markets to the Financial Stability Plan was underwhelming. On the day the plan was announced, the Dow Jones Industrial Average dropped 4.6%.
On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act (the “Stimulus Act”), which provides $787 billion in government spending and tax cuts and also codifies (and in some cases expands) the Treasury Department’s restrictions on executive compensation. Under the Stimulus Act, recipients of TARP funds must eliminate incentives that encourage executives to “take unnecessary and excessive risks” or manipulate reported earnings; recover any bonus or other compensation awarded based on financial statements later found to have been materially inaccurate; eliminate “golden parachute” payments to top executives; limit most bonuses to top executives to one-third of an executive’s total annual compensation; and permit nonbinding shareholder votes on executive compensation. Originally, all recipients of TARP funds were to be subject to the Stimulus Act’s executive compensation restrictions. Following the signing of the Stimulus Act, the Treasury Department announced that the requirements would not apply to recipients of TARP funds through the Term Asset-Backed Securities Loan Facility (“TALF”), which is designed to increase lending to consumers and small businesses on more favorable terms by encouraging investment in highly-rated asset-backed securities. The decision to exempt TALF participants from the Stimulus Act’s executive compensation restrictions appears to have been made out of concern that the requirements could chill participation in TALF. Following the signing of the Stimulus Act, the Obama administration announced it also would spend $75 billion to encourage home mortgage lenders to modify loans for borrowers in foreclosure or at risk of foreclosure, and up to $200 billion to allow homeowners to refinance through Fannie Mae or Freddie Mac.
In the meantime, activist shareholders are on the warpath. In December 2008, after the Securities and Exchange Commission (“SEC”) concurred in the exclusion of shareholder proposals seeking greater disclosure of risks related to mortgage investments at Washington Mutual, a coalition of over 60 investors called on then President-Elect Obama to limit the ability of companies to exclude shareholder proposals related to corporate risk evaluation. The corporate governance challenges for the companies being targeted by these activist shareholders no doubt will be intense for the foreseeable future.
…continue reading: Subprime-Related Securities Litigation: Early Trends