Highlights of Treasury Department Guidance on Executive Compensation Restrictions in the Emergency Economic Stabilization Act of 2008

October 17, 2008

On October 15, 2008, the Treasury Department (the “Department”) issued four pieces of guidance implementing the executive compensation restrictions contained in the Emergency Economic Stabilization Act of 2008 (EESA). In general these restrictions apply only to senior executive officers of financial institutions which sell troubled assets through auction or direct purchase to the Department under the Department’s “Troubled Asset Relief Program” (TARP). The Department’s authority to purchase troubled assets under TARP became effective October 3, 2008 and will expire on December 31, 2009, unless extended until a date no later than October 3, 2010 (the “TARP Effective Period”).

EESA’s executive compensation restrictions depend on whether troubled assets are sold directly or through an auction program under TARP, and the discussion below is organized accordingly. A few themes are common to all the pieces of guidance, including:

  • Controlled Group Rules: For purposes of applying the new requirements, controlled group aggregation rules similar to the rules that apply to qualified retirement plans apply, except that the rules for brother-sister and combined groups are disregarded.
  • Senior Executive Officers: A “senior executive officer” (SEO) is the principal executive officer (PEO), the principal financial officer (PFO) and any of the three highest compensated executive officers of the financial institution other than the PEO and PFO, using the rules for determining “named executive officers” under SEC proxy disclosure rules (Item 402 of Regulation S-K). Analogous rules apply for purposes of determining the SEOs of financial institutions that do not have a class of federally registered securities. Regulation S-K requires executive compensation disclosure based on annual compensation for the company’s prior fiscal year, but SEO status is determined during the current year. As a result, SEO status may need to be determined in the middle of a year (for example, the date an employment arrangement is entered into). In this case, financial institutions are directed to use their “best efforts” to identify the three most highly compensated employees.

Practice Note: The requirement that this definition be applied based on current year compensation and position will mean that an institution’s SEOs may change during the course of the year. For those institutions that participate in the Capital Purchase Program described below, it may be advisable to more broadly identify a group of executives who may later become SEOs and thus subject to requirements of that program, such as the requirement that their compensation arrangements be modified or terminated to the extent necessary to comply with specific restrictions of that program. The modifications could be contingent on the person becoming an SEO.

  • Mergers and Acquisitions: Special rules apply in the case of mergers and acquisitions, reflecting the fact that some of the participants in these programs are currently in the process of completing mergers or may in the future be parties to such a transaction. In general, when one company (acquirer) acquires another company (target), EESA requirements that applied to the target prior to the transaction do not automatically apply to the acquirer by virtue of the transaction itself. For example, an acquirer does not have to aggregate any troubled asset sales by the target prior to the merger or acquisition with its own sales for purposes of applying the $300 million threshold discussed in Sections II.b. and II.c. below.

The individual aspects of each set of restrictions are discussed in detail below.

I. DIRECT PURCHASES

a. Capital Purchase Program

EESA requires financial institutions from which the Department directly purchases troubled assets (through a program the Department calls the “Capital Purchase Program” or CPP) and in which as a result of such purchases it acquires a meaningful equity or debt position to meet appropriate standards for executive compensation and corporate governance. The standards will apply for as long as the Department holds such a position, which may include periods beyond the end of the TARP Effective Period. Neither the statute nor the Department’s guidance defines the term “meaningful” for this purpose.

By statute, the standards must specifically include (a) eliminating incentives for senior executive officers (SEOs) of financial institutions to take unnecessary and excessive risks that threaten the value of the institutions, (b) recovering bonuses paid to SEOs based on materially inaccurate earnings or other financial measures, and (c) prohibiting institutions from making any golden parachute payments to SEOs.

In its recent guidance, the Department added one additional requirement, prohibiting any financial institution from claiming a deduction for federal income tax purposes for remuneration that would not be deductible if the EESA-related changes to Section 162(m) applied to the institution. This requirement effectively extends these new Section 162(m) restrictions, which by statute only apply to institutions that sell troubled assets through auction, to institutions that sell troubled assets directly to the Department as well. As a result, financial institutions which sell troubled assets directly to the Department will not be able to deduct compensation in excess of $500,000 (including any “deferred deduction” compensation) paid to an SEO for a given year for as long as the Department holds a meaningful equity or debt position in the institution. The limits are pro-rated for any portion of a year in which the Department holds a meaningful equity or debt position. See Section II.b. below for additional discussion of the new Section 162(m) requirements contained in EESA.

Excessive Risk Review. To comply with the requirement that a financial institution eliminate incentives for its SEOs to take unnecessary and excessive risks that threaten the value of the institution, the compensation committee of a financial institution participating in CPP must:

  • Within 90 days) after a purchase under the CPP, the compensation committee must review the SEO incentive compensation arrangements with such financial institution’s senior risk officers to ensure the SEO incentive compensation arrangements do not encourage SEOs to take unnecessary and excessive risks that threaten the value of the institution.
  • At least annually thereafter, the committee must meet with senior risk officers to discuss and review the relationship between the financial institution’s risk management policies and practices and the SEO incentive compensation arrangements.
  • The committee must certify that it has completed the reviews of the SEO incentive compensation arrangements required above in the institution’s Compensation Discussion and Analysis in its annual proxy statement (if the institution is subject to those rules).

Practice Note: The standards for determining “unnecessary and excessive risks” are very vague. In the absence of any further guidance, compensation committees and risk officers will need to carefully consider appropriate interpretations of this standard. Consideration will need to be given to both the nature of performance criteria on which compensation is based, as well as the manner and level at which targets tied to those criteria are set.

Practice Note: Under SEC rules, the compensation committee does not have any responsibility for the Compensation Discussion and Analysis (CD&A). The compensation committee report under the proxy rules is “furnished” and not “filed”. However, the CD&A is filed which creates a higher level of securities law responsibilities and potential liabilities. It is not clear whether including this new certification in the CD&A is intended to raise the certification to filed status like the rest of the CD&A.

Clawback Rule. The requirement to recover bonuses paid to SEOs based on materially inaccurate earnings or other performance metrics is similar to the requirement under Section 304 of the Sarbanes Oxley Act, but is more restrictive in several respects, including that it applies to all SEOs (not just the PEO and PFO), applies to both public and private institutions, and does not limit the recovery period to 12 months following an accounting restatement.

Golden Parachute Restriction. A “golden parachute” payment is defined similarly to an “excess parachute payment” under Section 280G—any compensatory payment, other than a payment under a qualified retirement plan, to the extent the aggregate present value of the payment equals or exceeds three times the employee’s base amount. However, unlike Section 280G, a “golden parachute” payment under EESA is any payment triggered by an applicable severance from employment, without regard to whether there has been a change in control of the financial institution. An “applicable severance from employment” means an SEO’s severance from employment with the financial institution by reason of involuntary termination of employment or in connection with any bankruptcy, insolvency or receivership of the financial institution. “Involuntary termination” means any termination due to the independent exercise of the employer’s unilateral authority to terminate the SEO’s services, including any “good reason” termination that is treated as an involuntary termination for purposes of Section 409A and any voluntary termination where the facts and circumstances indicate that the financial institution would have terminated the SEO’s employment but for such voluntary termination.

Practice Note: The definition of “good reason” under Section 409A is narrow. Payments to an SEO that are not by reason of an involuntary termination (including a “good reason” termination that does not meet the requirements under Section 409A) are presumably excluded from this prohibition.

Whether a golden parachute payment is “on account of” severance from employment is also determined under rules similar to the rules under Section 280G for determining whether a payment is an account of a change in control.

More stringent restrictions on golden parachute payments apply to financial institutions who participate in the Department’s troubled asset purchase program for “systematically significant failing institutions,” which are discussed in detail below.

b. Systematically Significant Failing Institutions

If the Department purchases troubled assets directly from a financial institution that is a “systematically significant failing institution,” the same requirements discussed above apply, except that the provisions relating to “golden parachute payments” are more restrictive. Like the normal program discussed above, a financial institution participating in the “systematically significant failing institution” program must prohibit any golden parachute payment to an SEO while the Department holds a meaningful equity or debt position in the institution. However, unlike the normal program, a “golden parachute payment” is defined as any compensatory payment to an SEO on account of severance from employment (i.e., not just payments in excess of three times the SEO’s base amount).

What is a “systematically significant failing institution” will apparently be addressed in subsequent guidance.

II. AUCTION PURCHASES

a. Prohibition on “New” Golden Parachute Agreements

EESA prohibits any financial institution from which one or more troubled assets are purchased through an auction under TARP from entering into a new employment agreement that provides a golden parachute to a senior executive officer on account of an applicable severance from employment (as defined in Section I.a. above). This prohibition is effective only once the total amount of the assets purchased (including direct purchases) from the financial institution exceeds $300 million and ends as of the end of the TARP Effective Period. The prohibition applies only to financial institutions that sell troubled assets through an auction program.

For purposes of this prohibition, the term “golden parachute” payment and related concepts are substantially the same as described above in Section I.a, Capital Purchase Program.

A covered employment agreement may be oral as well as in writing and is “new” if entered into on or after the date the financial institution has sold at least $300 million in troubled assets under TARP, where at least some of the sales were through an auction program. An employment agreement that is renewed or materially modified after such date is also considered a “new” arrangement for this purpose.

b. Modifications of Sections 162(m) and 280G

Prior to the changes made by EESA, Section 162(m) generally placed a $1 million cap on the deduction for federal income tax purposes of compensation (other than performance-based compensation and certain other excludable amounts) paid to certain executives (excluding the PFO) of publicly traded corporations. Section 280G generally limited the deductibility of excess parachute payments made on account of a change in control of certain corporations and also imposed a 20% excise tax on the executive for such amounts, which could be avoided however if the corporation’s shareholders approved the payment. EESA places substantial new restrictions under Section 162(m) and Section 280G on financial institutions from which the Department purchases at least $300 million of troubled assets under TARP, at least some of which are through an auction program.

Section 162(m). EESA modifies Section 162(m) in four significant ways for those financial institutions that it applies to:

  • Reduces the annual deduction cap from $1 million to $500,000
  • Eliminates any exclusion from the limit, such as for “performance-based compensation” and commissions
  • Applies Section 162(m) to private employers as well as publicly traded ones, and to employers other than corporations
  • Includes the financial institution’s PFO as a “covered employee” for Section 162(m) purposes

The new Section 162(m) restrictions only apply to financial institutions from which the Department purchases assets in excess of $300 million in the aggregate, at least some of which are purchased under an auction program. (However, a financial institution from which the Department purchases troubled assets only through direct purchases is effectively subject to the same restrictions, pursuant to the Department guidance discussed above in Section I.a.). Once the $300 million threshold is met, the new restrictions apply for that taxable year and each subsequent taxable year that includes any portion of the TARP Effective Period (each an “applicable tax year”). In addition, the restrictions with respect to “deferred deduction executive compensation” (discussed below) continue to apply until the compensation is fully paid.

The new Section 162(m) restrictions apply to any SEO of the financial institution, including the PFO. If an executive is subject to the restrictions for any taxable year, he or she remains a “covered executive” for all future taxable years, regardless of whether the executive would independently be a covered executive for such future year.

The new Section 162(m) restrictions prevent employers from avoiding the $500,000 limitation by deferring the payment of executive compensation beyond the end of the TARP Effective Period. EESA provides that any “deferred deduction executive compensation,” defined in the Department guidance as any compensation that would be compensation for services performed during the taxable year but for the fact the deduction is deferred to a subsequent taxable year, is non-deductible to the extent it exceeds unused “room” left in the $500,000 cap for the year in which the services are performed.

Example: Executive E is paid $400,000 in salary by a covered financial institution in 2009 and obtains a legally binding right to $250,000 for services performed in 2009 to be paid in 2015. There is $100,000 in “room” left under the $500,000 cap for 2009. In 2015, only $100,000 of the $250,000 in deferred compensation is deductible.

Compensation earned under a formula that relates to a specific period of time is allocated to that specific period; otherwise, compensation is considered earned for this purpose in the year in which the legally binding right to the compensation arises. If the right is subject to a substantial risk of forfeiture created by a requirement to perform substantial future services, then the compensation is allocated on a ratable basis over the service period.

Section 280G. EESA modifies Section 280G in the following ways:

  • Expands the definition of “parachute payment“ to include any compensatory payments made to covered SEOs on account of an applicable severance from employment (as defined in Section I.a. above)
  • Denies the deduction and applies the excise tax to covered payments regardless of whether the payments have been approved by a financial institution’s shareholders, and regardless of whether the financial institution is an eligible small business corporation for purposes of Section 280G

The new Section 280G restrictions only apply to payments made during an applicable tax year (as defined in Section II.b.i. above) on account of an applicable severance from employment that occurs during an applicable tax year. If a payment would otherwise be an excess parachute payment under Section 280G without regard to the new restrictions, the new restrictions are disregarded and the payment is treated as an excess parachute payment under the normal Section 280G rules.

The McGuireWoods executive compensation team is ready to assist you with these complex new regulations. For additional information, please contact the authors.

Subscribe
Back to top