Author:Choi, Albert H.
  1. REGULATORY RESPONSES TO THE FINANCIAL CRISIS 9 A. The Troubled Asset Relief Program 11 B. Federal Reserve Emergency Lending 14 C. Ad Hoc Interventions 16 1. The Bear Stearns Merger 16 2. Support for AIG 17 3. Chrysler and GM Bankruptcy 18 II. A TAX RESPONSE TO THE FINANCIAL CRISIS 19 A. Section 382 of the Internal Revenue Code 19 B. Notice 2008-83 and Its Aftermath 22 III. THE EFFECTS OF SECTION 382: ECONOMIC THEORY and an Example 27 A. The Basic Setup 28 B. No Section 382 Limitation Regime 28 C. Section 382 Limitation Regime 30 D. Comparison 31 IV. EMPIRICALLY MEASURING THE EFFECTS OF THE NOTICE 32 A. Identification 33 B. M&A Activity During the Notice Period 34 C. Post-Merger Performance 37 D. Strategic Recognition of Loan Losses 38 V. Making Tax Law in a Crisis 39 A. Cottage Savings and the S&L Crisis 40 B. Balancing Short-Term and Long-Term Efficiency in a Crisis 42 C. Who Should Do the Balancing? 47 1. Legislators 47 2. Agency Rulemakers 50 3. Courts 52 CONCLUSION 53 APPENDIX: A MODEL OF THE EFFECTS OF CODE SECTION 382 ON MERGERS 66 INTRODUCTION

    There is an old adage that hard cases make bad law, (1) but what about hard times? In times of crisis, regulators face enormous pressure to bend rules and stretch regulations, sometimes to the breaking point. Thousands of pages have been written on the response of bank regulators to the 2008 financial crisis. In the aftermath of the crisis, scholars of financial regulation have sought ways to contain regulators' discretion in times of crisis while also facing the reality that aggressive intervention during a financial panic might stave off economic disaster. Tax law has been largely overlooked in this discussion. This Article examines a critical change to tax law that was made to support the banking sector during the financial crisis but that has not attracted scholarly attention. By studying this intervention, we shed light on both the importance of the underlying tax provision and the usefulness of tax law in responding to an economic emergency.

    At the height of the financial crisis in the fall of 2008, the Internal Revenue Service (IRS) released a remarkable piece of administrative guidance. Issued on September 30th of that year and less than a page long, IRS Notice 2008-83 (the Notice) was styled as a mere interpretation of existing law. (2) Nevertheless, the Notice had a dramatic effect on the value of banks' tax assets. (3) The Notice effectively turned off an aspect of Code section 382 that restricts the ability of a corporation to use unrecognized tax losses from underperforming loans to offset taxable income from other sources if that corporation undergoes a significant change in equity ownership, including an acquisition. The purpose of Code section 382 is to discourage tax-motivated corporate acquisitions, but during the financial crisis this policy objective came into conflict with the urgent need to encourage consolidation in the financial sector and inject capital into distressed banks.

    The direct result of the guidance was that the unrecognized losses on target banks' loan portfolios, which otherwise would have been impaired following an acquisition, could be fully utilized by an acquirer, thereby making banks with distressed loans much more attractive to potential acquirers. There was also a distributional consequence of freeing up tax assets for potential acquirers: acquisition targets with these tax assets became more attractive to more profitable acquirers, because the more profitable an acquirer is the more rapidly it can exploit those tax assets to offset their taxable income. This implication played out only a few days after the Notice was issued when Wells Fargo re-entered negotiations for the acquisition of Wachovia and outbid Citibank after determining that its ability to utilize Wachovia's tax assets would allow it to acquire Wachovia without FDIC assistance. (4) One estimate placed the value of the Notice in respect of Wachovia's tax assets to Wells Fargo at roughly $20 billion. (5) Controversy over the Notice, including whether it was a proper exercise of the Treasury Department's authority and whether it was issued specifically to favor Wells Fargo, followed quickly and the Notice was overruled when the American Recovery and Reinvestment Act was signed into law in early 2009. (6) Thus, there was a window of roughly three and a half months in which the Notice was in effect and part of Code section 382 was disabled with respect to banks.

    While it may be easy to overlook in the dramatic history of the 2008 financial crisis, the quiet release of a one-page Notice on a Friday afternoon in late September, styled as an interpretation of an obscure and convoluted provision of corporate tax law, sent Shockwaves through the tax world. Among scholars, reactions were generally negative on account of its perceived illegitimacy and undermining of the rule of law. Although described as an interpretation of Code section 382, most observers viewed it as a substantive change in law of the kind that requires congressional action. Among economic and business observers, the most dramatic effect of the Notice was that it enabled Wells Fargo's 11th-hour bid for Wachovia, setting in motion a sequence of events that is now a case study published by Harvard Business School. (7) Lost in the questions about the legal authority for the Notice, (8) the effects of the Notice on the rule of law, (9) and the high drama of the Wachovia sale, were the effects of the rule change itself. Section 382 is a much-maligned provision of the Code. Its detractors argue that it imposes burdensome costs on corporations that must track ownership of their stock to avoid triggering its draconian consequences, and further argue that it can be triggered by ordinary business transactions that do not pose a risk of the abusive "loss trafficking" that motivated the adoption of Code section 382 in the first place.

    This is the first Article to examine the impact of Notice 2008-83 and, more generally, the effects of Code section 382. The adoption and subsequent repeal of the Notice presents a unique opportunity to explore the significance of taxes in the merger decision and contribute to a literature with mixed results on the importance of taxes in that context. (10) In general, the evidence suggests the effects of taxes (including shareholder-level taxes) on the frequency of acquisitions are modest, but the effects of taxes on the price and structure of corporate acquisitions are robust. (11) Understanding these effects is important, not least because tax rules such as Code section 382 that target tax-motivated acquisitions also impose compliance and monitoring costs and create other distortions in merger decisions. (12) If taxes have little effect on merger activity to begin with, then a reconsideration of these rules may be in order. Our study exploits the unexpected nature of the Notice to disentangle cause and effect in the relationship between tax assets and merger activity. The Notice was a surprise to just about everyone (13) and was issued without the notice and comment process ordinarily required when the Treasury Department promulgates regulations. (14) As we discuss in Part IV, this surprise provides a natural experiment for testing the effects of Code section 382.

    The Notice also provides lessons about how tax law might be used by policymakers during times of economic stress. The Notice was not the first time that substantive tax law changed during a crisis, and not even the first time that tax law changed in a way that facilitated infusions of cash from the Treasury to distressed financial institutions. Twenty-seven years earlier, the U.S. Supreme Court decided Cottage Savings v. Commissioner, (15) a decision that inaugurated the modern "hairtrigger" rule for the realization of gains and losses on the disposition of property. Under current law, the exchange of property results in the realization (i.e., taxable inclusion of income or, generally, deduction of loss) of gains and losses even if that property is exchanged for other property that is virtually indistinguishable in terms of its economic risks and rewards. The important consequence of this rule is that taxpayers can selectively recognize losses on property that has fallen in value while deferring the taxation of their gains. Whatever the merits of this rule as a general matter, the most immediate effect of the Court's decision was to allow Savings and Loan (S&L) institutions during the S&L crisis of the 1980s and 1990s to recognize their tax losses without running into the regulatory difficulties that would have ensued if they had actually sold the distressed loans that they owned.

    Crisis-driven tax law is not a new phenomenon, particularly for financial institutions. It is crucial to understand the broader context of the financial crisis to understand the pressure to make crisis-driven tax law, and so we provide a sketch of the context for the Notice in Part I. In Part II, we explain the significance of Code section 382 and how it operates to deter tax-motivated corporate acquisitions, as well as the timeline leading up to, and following, the Notice. We then present a simple numerical example in Part III that illustrates the theoretical effect of the Notice on bank mergers. This numerical example is derived from a more general model of corporate acquisitions that we include in the Appendix. Part IV reports the results of our study on the Notice. We use data from bank regulators and merger data from the Federal Reserve to measure changes in bank mergers around the time of the Notice. We compare mergers during the Notice window to pre-Notice mergers and examine whether the determinants of mergers differed before and during the Notice window. We also present data on the post-merger performance of Notice and pre-Notice mergers, and we present evidence about strategic decisions made by banks to choose the...

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