Executive Compensation —Treasury Tightens Financial Institutions’ Purse Strings

October 31, 2008 at 4:10 pm Leave a comment

Overview. The U.S. Department of the Treasury (Treasury) has issued an interim final rule (New Compensation Restriction Rules) implementing the executive compensation provisions of the Emergency Economic Stabilization Act of 2008 (EESA). The New Compensation Restriction Rules apply to the senior executive officers of any financial institution participating in any part of the Treasury’s Troubled Assets Relief Program (TARP), including, the Capital Purchase Program (CPP), the Program for Systemically Significant Failing Institutions (PSSFI) and the Troubled Asset Auction Program (TAAP). Although the extent of the Compensation Rules’ impact will depend upon the program in which a particular financial institution chooses to participate, most institutions (even private ones) will be required to comply with one or more of the following rules:

  • Ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks;
  • Recover any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that prove to be materially inaccurate;
  • Refuse to make any golden parachute payment to a senior executive officer during the period that the Secretary holds an equity or debt position in the institution;
  • Forego federal income tax deductions on executive compensation exceeding $500,000 in a given tax year. Note: not a restriction on compensation levels, but on deductibility; and
  • Senior executives covered by the New Compensation Restriction Rules include the chief executive officer, chief financial officer and the three other most highly compensated executive officers (SEOs).

When do these new rules apply? The applicability of the New Compensation Restriction Rules depends upon several factors, including the value of the assets sold by the institution to the Treasury and the method by which the Treasury acquires those assets (directly or via auction). Consider the following:

  • The Compensation Restriction Rules apply to every financial institution along with its control group parent or subsidiaries (Subject Entity) that (a) participates in CPP, (b) sells more than $300 million of assets via the TAAP or (c) becomes part of the PSSFI.
  • For participants in the CPP, the New Compensation Restriction Rules apply only during the time period that the Treasury holds an equity or debt position in the financial institution. For participants in the TAAP, the New Compensation Restriction Rules apply at least through December 31, 2009 and possibly through October 3, 2010, depending on whether Treasury extends the program.
  • The New Compensation Restriction Rules apply only to SEOs. To implement this requirement, the New Compensation Restriction Rules look to Item 402 of Regulation S-K, applied under federal securities laws in connection with public offerings and public company periodic reporting. The Item 402-based determination of SEOs applies whether the institution is public or private.

    Item 402 states that executive officers (other than the CEO or CFO) must make at least $100,000 and the determination as to which executive officers are the most highly compensated shall be made by reference to total compensation for the last completed fiscal year. However, the New Compensation Restriction Rules require Subject Entities to use “best efforts” to determine the three most highly compensated executive officers prior to having year-end compensation data for the current year. Also, Item 402 states that executive officers may include one or more executive officers or other employees of subsidiaries. Under limited circumstances, a Subject Entity may exclude an individual, other than its CEO or CFO, who is otherwise one of the most highly compensated executive officers, due to the payment of amounts of cash compensation relating to overseas assignments attributed predominantly to such assignments.

Restrictions By Specific TARP Program. As noted above, the effect that the New Compensation Restriction Rules will have on a given financial institution will depend upon which TARP program the institution chooses. The following paragraphs explain in greater detail the compensation restrictions associated with a given TARP program.

  • Capital Purchase Program – This program allows the Secretary to purchase assets directly from financial institutions in exchange for a meaningful debt or equity position in the institution. The New Compensation Restriction Rules place several compliance requirements on financial institutions participating in the CPP.

    First, the institution’s compensation committee, in conjunction with the institution’s senior risk officers, must ensure that SEO compensation packages do not prescribe incentive compensation that promotes unnecessary and excessive risks. The first such review must be completed within 90 days of the institution’s initial participation in the CPP, and a similar review must occur annually (but only while the Secretary holds a debt or equity interest in the institution pursuant to CPP). After these reviews, the compensation committee must certify that the reviews have been completed. Note the rules provide no guidance, other than consultation with risk management officers, as to what constitutes risk-promoting compensation. And, although the rules require the compensation committee to certify that SEO contracts comply with the prohibition on risky compensation pay, the certification will not be provided until after the Treasury has purchased troubled assets from the Subject Entity. The New Compensation Restriction Rules are not clear on what would happen if an existing contract did not comply with the Secretary’s guidelines.

    Second, any financial institution participating in the CPP must require SEOs to repay any bonus or incentive compensation previously received if such compensation was based on statements of earnings, gains or other criteria that prove to be materially inaccurate. Note, although similar in many respects to Section 304 of Sarbanes-Oxley, this provision is in reality much broader. This provision applies to both public and private institutions, is not triggered exclusively by an accounting restatement, has an unlimited recovery period and covers not only material inaccuracies in financial reporting, but also material inaccuracies relating to other performance metrics used to award bonuses and incentive compensation.

    Third, a financial institution cannot make any golden parachute payments to any SEOs while the Secretary holds an equity or debt position acquired under the CPP. For purposes of this rule, the term “golden parachute” payment refers to any compensation, other than a payment under a qualified retirement plan, with an aggregate present value that equals or exceeds 300% of the employee’s base salary. While that definition is similar to the term “excess parachute” payment set forth in § 280G of the Internal Revenue Code, “golden parachute” payments subject to EESA include all payments triggered by an applicable severance from employment, regardless of whether there has been a change in control of the financial institution, and encompass most any compensation paid on account of an SEO’s involuntary termination from employment, including terminations associated with the institution’s bankruptcy, insolvency or receivership.

    Fourth, the financial institution must agree to forego any federal income tax deduction on the compensation in excess of $500,000 paid to any SEO.

  • Programs for Systemically Significant Failing Institutions – Under this program, the Treasury provides direct assistance to certain failing financial institutions on terms negotiated on a case-by-case basis. These standards are similar in all respects to the New Compensation Restriction Rules applicable to the CPP, except that the definition of “golden parachute payment” is defined even more broadly. Like the CPP program discussed above, a financial institution participating in the PSSFI must prohibit any golden parachute payment to a SEO while the Treasury holds a meaningful equity or debt position in the institution. But unlike the CPP, for purposes of PSSFI, 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 300% of the SEO’s base amount).
  • Troubled Asset Auction Program – Under this program, the Treasury purchases troubled assets from a financial institution through an auction format. As prescribed by EESA, any financial institution that sells more than $300 million of troubled assets to the Treasury via auction would be prohibited from entering into new executive employment contracts that would provide a golden parachute payment to an SEO in the event of the SEO’s involuntary termination, or in connection with the financial institution’s bankruptcy filing, insolvency or receivership. The employment agreements subject to this rule will be considered “new” agreements if entered into on or after the date the financial institution has sold at least $300 million in troubled assets under TARP, provided that some of the asset sales were conducted through TAAP. An employment agreement that is renewed or materially modified after such date is also considered a “new” arrangement for this purpose. In addition, EESA precludes any financial institution from receiving any federal income tax deduction for any compensation in excess of $500,000 paid to an SEO.

Entry filed under: Client Alerts, EESA, Executive Compensation, Financial Institutions, TARP.

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