In summer 2007, the US experienced a sudden reduction in the general availability of credit, variously described in the media as a credit squeeze or credit crunch. By October 2008, it had escalated to a full blown financial crisis.

The credit crunch was triggered by the bursting of the US housing bubble that had encouraged speculation by house builders, homebuyers and mortgage lenders. House price increases had been fuelled by cheap credit extended to risky (subprime) borrowers on a large scale as lenders competed against each other to achieve best available yield on their loans.

Mortgage originators extended subprime mortgages. Financial institutions used securitization to pool these mortgages together in "bankruptcy remote" special purpose vehicles that issued mortgage-backed securities to investors.

Subprime mortgage borrowers, faced with adjusted (higher) interest rates, began to default on their payment obligations and this set the course for a chain of events that would lead to a downward spiral in the financial markets.

By August 2008, financial institutions around the world had recognized subprime-related losses and write-downs exceeding $501 billion, according to figures from Bloomberg. September 2008 brought a series of market-transforming events, including the federal government taking Fannie Mae and Freddie Mac into conservatorship, Lehman Brothers' bankruptcy, Bank of America's acquisition of investment bank Merrill Lynch and the federal government's bailout of insurance giant AIG. Further bank consolidations were to come and two investment bank giants, Goldman Sachs and Morgan Stanley, converted to bank holding companies rocking the financial industry.

For more on the causes of the financial crisis, see Article, Financial Crisis Series: Causes and Effects.

The US government has responded to the financial crisis with a range of measures intended to loosen credit markets and increase investor confidence, including expanding banks' cash sources, giving banks some protection against borrower defaults, and providing credit relief to consumers and small businesses.

For example, the Emergency Economic Stabilization Act (EESA) was enacted on October 3, 2008 (H.R. 1424; Public Law No. 110-343). EESA put in place a rescue package for troubled financial institutions, with the intention of restoring stability and confidence to the financial markets. Since then, the US Treasury expanded its plan under EESA and the US Treasury and Federal Reserve introduced other measures to help restore confidence in the US banking system.

The response has evolved to take account of the changing situation. For example, the US Treasury introduced a capital purchase program for troubled financial institutions and made investments in certain automobile manufacturers. For more on the US government's response to the financial crisis, see Articles, Financial Crisis Series: Causes and Effects and Financial Crisis Series: Impact on Loans and Credit Markets.

It is far from clear whether government measures will be sufficient to thaw the credit freeze or effectively respond to the financial crisis. There are some promising indications (for example, in the commercial paper market) but there are continuing concerns that banks may continue to hoard bailout funds or use them to make acquisitions rather than extend credit.

Non-financial companies such as automobile manufacturers have also benefited from government aid. A key challenge the US government now faces is where to draw the bailout line and how to ensure bailout funds are used effectively to stimulate the economy.

For more on the effects of the US government's response to the financial crisis, see Articles, Financial Crisis Series: Causes and Effects and Financial Crisis Series: Impact on Loans and Credit Markets.

The financial crisis has affected all sources of financing including syndicated loans, leading to decreased liquidity, decreased lending and higher borrowing costs.

Companies must free up cash and draw down on longer-term financing to repay commercial paper that has fallen due. Loans are trading at a significant discount (as low as 60 cents on the dollar) in the secondary market.

To secure their anticipated future cash needs, some borrowers are preemptively drawing down existing lines of credit. Lenders are reluctant to extend new long-term financing to even the most creditworthy borrowers. Where they are doing so, it is often at an original issue discount, so that the borrower in practice receives less than the total principal it has borrowed.

So far as possible, borrowers are avoiding giving lenders the opportunity to renegotiate terms of existing credit agreements. By contrast, lenders are demanding strict compliance with covenants and looking to invoke "market disruption" provisions where interest rates have failed to cover their actual cost of funds.

For more on the impact of the financial crisis on loans and credit markets, see Article, Financial Crisis Series: Impact on Loans and Credit Markets.

The consequences depend on the type of bank:

In general, borrowers of failed banks remain obligated to repay loans (and fees) under their credit agreements. However, lenders to the failed bank do not have to continue funding during bankruptcy or receivership. Other lenders under a syndicated loan agreement remain obligated to lend their pro rata share of the loan under the credit agreement, but syndicate members are not responsible for the failure of a failed bank to fulfill its obligation. For more information on the legal consequences if a bank fails, see Article, Financial Crisis Series: Impact on Loans and Credit Markets: What are the Legal Consequences if a Bank Fails?

In the short term, the SEC introduced rules to protect investors against naked short selling (that is, selling stock short without making arrangements to borrow it in time for delivery to the buyer) and placed additional disclosure and other requirements on credit rating agencies.

Follow-on offerings and financial sector equity issuances dominated the capital markets in 2008, while initial public offerings (IPOs) were at their lowest volume since 2003 and at a 30-year low in number of issues (Thomson Reuters). There is little appetite for debt in general, with investors demanding record spreads for high-yield debt.

To the extent that public companies are raising capital, they are doing so in a much tighter time frame. There is an emerging practice whereby certain eligible issuers who already have an effective shelf registration statement on file with the SEC bring a limited number of potential investors "over the wall" to market a deal before announcing the deal publicly.

For more on the impact of the crisis on capital markets, see Article, Financial Crisis Series: Impact on Capital Markets.

Credit default swaps (CDS) were believed to spread the risk of defaults, making the financial system more secure and efficient. However, the CDS market was largely unregulated. There were no limits on the number or value of CDS a financial institution could sell, and no capital requirements on CDS sellers.

As credit events increased, it became clear that CDS amplified the risks to the financial system and created new risks by increasing the number of parties affected by one defaulting reference entity. CDS also created uncertainty in the market. Once a CDS is sold, both the initial buyer and seller can trade their parts of the CDS in the market. This meant that the market had no information on who owned which CDS or who had what credit exposure to whom. Dramatic fluctuations in CDS prices added to the uncertainty and created a sense of panic in the market. Exposure to CDS losses was a key factor behind the government interventions in Bear Stearns and AIG.

In November 2008, the President's Working Group (PWG) on Financial Markets announced a series of initiatives to strengthen oversight and transparency in the over-the-counter derivatives market, including the establishment of central counterparties.

For more information on CDS, see Article, Financial Crisis Series: Impact on Capital Markets: What are CDSs and Why are People Talking about Them?

The financial crisis prompted immediate but piecemeal new regulation of certain activities in the financial sector, including short selling and CDS.

While some of the measures are designed to be temporary, permanent solutions involving more extensive regulation are likely to be put in place in 2009.

A key area for increased regulation is likely to relate to the use of leverage in the financial sector. Under EESA, the Comptroller General must report on methods of monitoring and regulating leverage in the financial sector on June 1, 2009. In addition, EESA imposes certain restrictions, including curbs on executive pay, for financial institutions that receive government aid.

There is also likely to be wide support for regulations increasing market transparency, including greater disclosure and new margin requirements and leverage limitations for hedge funds.

Regulators will likely pay more attention to the adequacy of the internal risk models in the future. The use of complex models to predict cash flows from securities with the aim of controlling risk in a variety of market conditions has been shown to be generally inadequate. This kind of risk modelling did not take into account the risk of widespread collapse of liquidity in many assets.

Alongside formal regulation, the federal government's response to the financial crisis has given it a new role as an equityholder in the US's largest financial institutions; a role that will have a lasting impact on the activities of these entities.

For more on regulatory implications for financial institutions, see Articles, Financial Crisis Series: Causes and Effects and Financial Crisis Series: Long-Term Implications.

Before a customer files for bankruptcy or otherwise alerts the company that it is in financial difficulty, the company can take practical steps to protect against the possibility of a key customer defaulting, including:

If a customer files for bankruptcy, the size of any potential losses should help determine whether it is worth exerting time and money to pursue recovery. The company might take steps including:

If there is indication that a supplier is in distress, a company might consider securing alternative suppliers for key products and services and building inventory of critical supplies.

For more on steps to take when a major customer or supplier is in financial difficulty, see Article, Financial Crisis Series: Impact on Companies: What Steps should Companies take if Major Customers or Suppliers are in Financial Difficulty?

Companies in financial difficulty have a range of restructuring options, all of which present opportunities for investors in distressed assets (see Article, Financial Crisis: Impact on M&A and Private Equity). Companies may use one or a combination of the following techniques when restructuring out of court: exchange offers, debt/equity swaps, debt restructuring, debt tender offers, spin-offs, asset sales and capital raising. Bankruptcy itself offers a number of restructuring options including traditional Chapter 11 proceedings, prepackaged bankruptcy (or prepacks) and prearranged bankruptcy.

See Article, Financial Crisis Series: Impact on Companies: What are the Restructuring Options for Financially Distressed Companies?

When entering new contracts, companies should try to negotiate credit arrangements that reflect current market conditions and seek to negotiate payment arrangements in the company's favor. For example, a company might seek to receive cash-advance payments where possible and ensure it has appropriate contract termination rights. Larger customers might consider requesting a letter of credit, obtaining a guaranty from the customer's parent company or affiliate, or taking out credit insurance to insure against the risk of the customer's default.

To protect against the risk of supplier financial difficulty, a company might consider arranging for consignment or obtaining a security interest. The Uniform Commercial Code (UCC) outlines filing and notice requirements for each of these arrangements.

If the company is itself a supplier and is supplying a component of a larger product made by a different supplier (for example, the engine to a car manufacturer), the company might arrange to be paid directly by the end user or set up an escrow account to receive payments for the company's portion. See Article, Financial Crisis Series: Impact on Companies: What Steps should Companies take if Major Customers or Suppliers are in Financial Difficulty?

If a customer is in financial difficulty and cannot meet all its payment obligations, the supplier that it is in most contact with is often the first paid. It is therefore good practice to have the accounts receivable department follow-up with customers regularly to help increase the chances of the company getting paid ahead of other potential creditors.

If a customer stops making payments, consider taking permissible set-offs against any amounts the company owes to them. It is important to advise accounts receivable, customer service and sales departments of this action so that they are prepared to communicate with the customer (see Article, Financial Crisis Series: Impact on Companies: What Steps should Companies take if Major Customers or Suppliers are in Financial Difficulty?).

A repurchase program may be effected through one or more open market transactions, privately negotiated transactions, transactions structured through investment banking institutions or a combination of all three.

If a company's board of directors decides that the company's outstanding securities (equity or debt) may be repurchased on favorable terms, the directors must authorize a maximum dollar amount of securities to be repurchased. A company can conduct a simultaneous stock and debt repurchase program.

Examples of stock repurchase programs include:

Examples of debt repurchases include:

See Article: Financial Crisis Series: Impact on Companies: Are any Companies Buying Back Their Own Stock or Debt?

Initial litigation concentrated on acquisitions affected by market events (see Article, Financial Crisis Series: Impact on M&A and Private Equity). Private equity buyers claimed a right to avoid closing because a material adverse effect (MAE) occurred at the target company or that their damages for terminating the transaction for any reason are limited to the reverse break-up fee.

In 2009, the focus will likely shift to financially distressed companies (see Article, Financial Crisis Series: Impact on Companies). In particular, the scarcity of DIP financing may result in more liquidations rather than successful reorganizations (see Article, Financial Crisis Series: Impact on Loans and Credit Markets: What Impact has the Financial Crisis Had on DIP Financing?).

The focus will likely also move to parties that have suffered losses as a consequence of the financial crisis (including stockholders, borrowers, employees and the US government) and the market participants to whom they attribute the blame (including ratings agencies, mortgage lenders, directors and officers, and investment banks).

See Article, Financial Crisis Series: Causes and Effects: What litigation is going to come out of the financial crisis?

The following two cases involve a private equity firm attempting to get out of a pending deal and a debt exchange offer withdrawn after the strategy was found impermissible:

For further discussion on litigation, see Article, Financial Crisis Series: Impact on M&A and Private Equity: Impact of the Financial Crisis.

In 2008, private equity sponsored buyouts were down about 74% from 2007 (Thomson Reuters). Private equity buyers that counted on refinancing acquisition debt to pump cash into operations and increase returns are largely unable to obtain affordable debt.

In some cases, private equity buyers (and their lenders) tried to get out of deals that were signed before the financial crisis. Private equity buyers alternatively claimed a right to avoid closing because an MAE occurred at the target company or that their damages for terminating the transaction for any reason are limited to the reverse break-up fee.

See Article: Financial Crisis Series: Impact on M&A and Private Equity: Impact of the Financial Crisis.

The immediate effect of the financial crisis on M&A has been a dramatic reduction in the leveraged buyout activity that dominated headlines in 2005-07. The crisis has led to an unprecedented number of renegotiated and terminated deals, several of which ended up in court before being resolved. Litigation in relation to matters such as reverse break-up fees and MAE provisions is expected to change the way parties negotiate and document acquisitions.

The shift to a buyers' market has triggered several other changes in market practice, with buyers looking for greater flexibility to walk away from deals, while at the same time forcing sellers to accept less freedom to do so. Where deals have taken place, they have tended to be considerably smaller. However, challenging economic conditions that are pushing an increasing number of companies into financial difficulty present attractive opportunities for buyers of distressed companies or assets.

See Article, Financial Crisis Series: Impact on M&A and Private Equity: What Impact has the Financial Crisis had on Private Equity and Leveraged M&A Deals?

Buyers should consider the principal risks common to all methods of purchasing the assets of distressed or bankrupt companies, namely:

A buyer purchasing the assets of a distressed or near-bankrupt company (but not yet bankrupt) will generally choose one of three structures:

A buyer purchasing the assets of a bankrupt company will generally choose one of the following two structures:

For more information on buying assets of distressed companies and the advantages and disadvantages of the various purchase structures, see Article, Financial Crisis Series: Impact on M&A and Private Equity: What Special Considerations Apply when Buying Assets of Distressed Companies?

Although no new restrictions have been imposed on foreign ownership or investment, foreign investment in US businesses can trigger many US regulatory requirements and considerations, such as having to clear the transaction through the Committee on Foreign Investment in the United States (CFIUS). The CFIUS and the CFIUS clearance process allow the US government to safeguard national security in the US without closing the door to foreign investment.

The Foreign Investment and National Security Act of 2007 (FINSA) formally established CFIUS and codified its structure, role, process and responsibilities. FINSA also formalized the process by which the CFIUS conducts its review of relevant M&A transactions. See Practice Note, Clearing Foreign Investment in US Businesses through the Committee on Foreign Investment in the United States.

Regulatory authorities in the US do not have the power to waive any competition/antitrust requirements. Depending on the financial condition of the target company, however, special considerations may apply to distressed deals. If the target company is deemed a "failing firm", the regulatory agencies will not consider a proposed merger to be anti-competitive.

To use the failing firm defense, the merging parties must generally show that the target's competitive assets would exit the relevant market absent the merger (see Practice Note, How Antitrust Agencies Analyze M&A: Failing Firm [3-383-7854]) and that no less restrictive option exists for keeping the assets competitive.

The failing firm defense has a very high burden of proof and is rarely met. It is more likely the case that parties will assert that as a result of the target company's financial condition, its future competitive significance is lower than typical analytical measures (such as market share) might suggest. This argument, often referred to as the "flailing firm" or "weakened competitor" argument, could persuade the agencies that a proposed merger will not result in competitive harm.

In September 2008, the IRS issued a notice creating a major tax incentive for investments in and acquisitions of US banks (IRS Notice 2008-83 (September 30, 2008)). Many US banks have significant built-in losses in their loan and debt portfolios because the tax basis in those assets now exceeds their fair market value.

Before the notice, in many cases, use of built-in losses was limited after a more than 50% change in stock ownership over a three-year period (a 50% ownership change) (Section 382, Internal Revenue Code (IRC)). The notice provides that, after a 50% ownership change, a US bank's built-in losses in its troubled loan and debt portfolios are not subject to the limitations in Section 382 of the IRC.

This means that, depending on how an acquisition of a US bank is structured, the buyer may be able to offset its own taxable income with the US bank's pre-acquisition built-in losses in its loan and debt portfolios without a Section 382 limitation. In addition, if there has been a 50% ownership change because of a new investment in a US bank (rather than because of a whole bank acquisition), the US bank can generally continue to use its pre-ownership change built-in losses in its loan and debt portfolios to offset its taxable income without a Section 382 limitation.

However, Notice 2008-83 may be prospectively repealed as part of a series of measures under the stimulus bill currently under discussion in Congress. See Article, Financial Crisis Series: Impact on M&A and Private Equity: Are there any Tax Incentives for Buying or Investing in US Banks?

Regardless of a company's financial position, the board of directors is required to act in the best interests of the company and its stockholders. In taking any action, the board owes fiduciary duties to the company's stockholders including duty of care and duty of loyalty. A company in financial difficulty may be considered to be in the "zone of insolvency". If so, the board may also need to consider the interests of the company's creditors.

The board of a company experiencing financial difficulties should re-evaluate and more actively monitor the company's risk profile and risk management. Directors should consider what risks the company has taken on, its appetite for risk and how it manages that risk in practice. Specifically, directors should review the company's financial position (including its liquidity and capital resources), its public disclosure (if applicable), its relationships with third parties and its corporate governance practices.

Many of these items are actions that directors should already be considering on an ongoing basis as part of their obligations as directors, regardless of a company's financial condition. Other items are actions that are ordinarily obligations of the audit committee. However, in the financial crisis, directors should pay special attention to these actions, as stockholders are more likely to second-guess director decisions or question whether the directors satisfied the duties owed to them.

For further information on the legal issues directors of distressed companies face, see Article, Financial Crisis Series: Impact on Companies: What Issues should Directors of a Company in Financial Difficulty Bear in Mind?

A company's board should ensure that it holds regularly scheduled meetings and all directors attend these meetings. The directors should ensure that they have the opportunity to ask questions of management and the company's auditors; this may necessitate separate executive sessions with individual members of management or the auditors.

The directors should review and discuss the board's oversight of the company's risk assessment and risk management policies. Directors may want to consider setting up either a new board committee or a new subcommittee under the audit committee to deal with risks, or enhancing the audit committee's duties to be more involved in evaluating the company's risk profile.

See Article, Financial Crisis Series: Impact on Companies: What Issues should Directors of a Company in Financial Difficulty Bear in Mind?

Under EESA, institutions participating in the Troubled Asset Relief Program (TARP) are subject to limitations on executive pay including:

In January 2009, the Treasury issued an interim final rule which provided additional provisions and further guidance relating to executive compensation requirements (see Legal Update, Additional Executive Compensation Rules Issued Under TARP).

For further information on present and possible restrictions on executive pay, see Articles, Financial Crisis Series: Causes and Effects: The Impact of the Government Rescue Efforts and Financial Crisis Series: Long-Term Implications: What are the Long-Term Implications of the Financial Crisis for Banks and Markets?