EESA Limits on Executive Pay at Affected Institutions

On Oct. 3, the Emergency Economic Stabilization Act of 2008 (the EESA) became law.[1] The EESA authorizes the U.S. Treasury Department to acquire up to $700 billion in “troubled assets” from financial institutions.[2] It designates the overall program as the Troubled Assets Relief Program (TARP).

The authority of the Treasury to acquire troubled assets continues through Dec. 31, 2009 but the secretary of the Treasury can extend this authority for a period ending Oct. 3, 2010 upon certifying to Congress the need for the extension and its expected cost to taxpayers.

TARP Programs

Three TARP programs have been initiated thus far:

1. Capital Purchase Program (CPP).[3] This program applies to those financial institutions that enter into agreements pursuant to this program for the purchase by the Treasury of their preferred stock.[4] The executive compensation aspects of the program are derived from §§111 and 302 of the EESA, described, respectively, as “Executive Compensation and Corporate Governance” and “Special Rules for Tax Treatment of Executive Compensation of Employers Participating in the Troubled Assets Relief Program.” As of the date this column was written, it was reported that approximately 50 financial institutions had elected to participate in CPP.[5]

2. Troubled Assets Auction Program (TAAP).[6] This program will apply to auction purchases by the Treasury of troubled assets. The executive compensation criteria will be derived from the rules contained in the EESA §§111 and 302, noted above in connection with CPP.[7]

3. Program for Systemically Significant Failing Institutions (PSSFI).[8] This is a program outside of CPP but directed to financial institutions with whom the Treasury may negotiate individual arrangements for purchasing of assets and/or providing funding (such as, perhaps, through preferred stock purchases).[9]

This column will focus on the executive compensation limitations imposed by CPP. As already noted, CPP does not include the “auction purchase” criteria contained in the EESA §§111(c) and 302(a) and (b). Otherwise, the executive compensation requirements of CPP, as embodied in individual agreements with financial institutions, substantially reflect the provisions contained in the EESA §§111 and 302.[10]

Definitions

Following are some of the key definitions for purposes of CPP (reflecting definitions contained in the EESA):

1. “Senior Executive Officer” and “Covered Executive.” The executive compensation provisions of the EESA apply to senior executives of the financial institutions participating in the EESA program. The EESA §111 refers to the senior executives as “senior executive officers” (SEOs). SEOs are essentially the same senior officers that are named executive officers for purposes of the proxy statement rules issued by the SEC (or their counterparts in nonpublicly traded companies). Determination as to SEO status will be made annually just as is done for purposes of the SEC proxy statement rules.

“Covered executive” is the term used in the EESA §302, adding two new subsections to the Internal Revenue Code (Code): §162(m)(5) (the EESA §302(a)) and §280G(e) (the EESA §302(b)). The definition of “covered executive” is very much the same as that for SEO. The definition, however, refers to the CEO, the CFO and the other three highest-paid executives, rather than in the case of the SEO, to the named executive officers as determined annually under proxy statement rules. Also, a “covered executive,” once determined to be a “covered executive,” remains a “covered executive” as to the financial institution in question. Thus, over a period of years, in contrast to SEOs, the number of “covered executives” in respect of a particular financial institution may increase.

2. “Golden Parachute Payments.”[11] These “payments” – compensation and benefits (including vesting of entitlements thereto) – are basically the same as “parachute payments” within the meaning of Code §280G prior to the enactment of the EESA. (Previous Code §280G(e) is redesignated by the EESA §302(b) as §280G(f) and, as previously noted, a new §280G(e) is inserted.) Payments given “golden parachute status” by new §280G(e) under the EESA are those triggered on account of (A) an involuntary termination (described by the statute as a “severance” and without reference to any change in control) or (B) a termination in connection with a bankruptcy filing, liquidation or receivership of the employer. The restrictions imposed by CPP on such severance payments (“golden parachute payments”) only apply to such payments that exceed 2.99 times the executive’s “base amount.” “Base amount” is calculated in the same manner as traditionally used under Code §280G in cases of changes in control – that is, the average of the executive’s annual compensation over the five preceding taxable years (or lesser period of employment, if applicable).

3. Financial Institutions. At this stage, the EESA applies to financial institutions which, under the EESA §3, cover a broad range of institutions including, without limitation, banks, insurance companies, broker dealers and savings associations subject to federal, state or certain territorial regulations (but excluding any central bank of, or institution owned by, a foreign government). As already noted, a financial institution to which CPP applies is one that has entered into an agreement covering the purchase by the Treasury of preferred stock in that institution.

Compensation Requirements

Following are the four basic executive compensation requirements under CPP, each of which is derived from counterparts in the EESA §§111 and 302. These provisions are set forth in the Interim Final Rule announcing CPP published at 73 Federal Register 62005, as noted in footnote 3 of this column. It should be noted that different time periods apply to different requirements under the EESA.[12]

1. Prohibition of Risky Incentives. Reflecting §111(b)(2)(A) of the EESA, financial institutions participating in CPP must agree to “exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the secretary holds an equity or debt position in the financial institution.” According to the Interim Final Rule, this standard requires the compensation committee of the financial institution to review incentive compensation plans for SEOs to ensure that these plans do not encourage unnecessary and excessive risks, and then to certify to having done so in the company’s Compensation Discussion and Analysis required under Item 402(b) of Regulation S-K.

Comment on Risky Incentive Prohibition: CPP, like its statutory source, the EESA §111(b)(2)(A), gives considerable discretion to corporations’ compensation committees to assess whether their own companies’ plans meet the EESA standard, and therefore the extent of this provision’s impact will depend on how strictly compensation committees interpret it and how aggressively the government enforces it. In many cases, compensation committees may be reluctant to subject SEOs to different incentive standards than non-SEOs. In some cases, this may incline compensation committees to make an interpretation that is more “liberal” (that is, favoring SEOs) as to an incentive in order to avoid subjecting its SEOs to a standard different from that applicable to other executives participating in the same incentive program.

On the other hand, some compensation committees may take the opposite approach, modifying incentive standards not only for senior executives but for other executives as well.

2. Clawback of Bonuses Based on Mistaken Financial Statements. Section 111(b)(2)(B) of the EESA provides that a financial institution participating in CPP is to recover “any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.” This provision is reflected in §30.6 (Q-6) of the Interim Final Rule.

Comment on Clawback of Bonuses Based on Mistaken Financial Statements: While similar to the clawback provision in §304 of Sarbanes-Oxley, this provision has several significant differences, including its application not only to the CEO and CFO but also to the three other most highly compensated officers as reported under SEC proxy statement rules; also, it applies to both public and private companies.[13]

3. No Golden Parachute Payment Permitted. Section 111(b)(2)(C) of the EESA provides that a financial institution participating in CPP is prohibited from making “any golden parachute payment” to a senior executive officer “during the period that the secretary holds an equity or debt position in the financial institution.” This provision is reflected in §§30.8 and 30.9 (Q-8 and Q-9) of the Interim Final Rule.

Comment to No-Golden-Parachute-Payment Provision: Even though limited to covered termination payments in excess of 2.99 times the “base amount,” this provision will no doubt have a significant “bite” in the case of many SEO severances from participating financial institutions. As just noted, the period for which the no-golden-parachute-payment restriction applies is the period for which the Treasury continues to hold preferred stock and/or other assets acquired from the financial institution (which could be a significant period of time). A question might exist if a termination payment in excess of the golden parachute limit, 2.99 times the “base amount,” was agreed to during the period the Treasury holds such stock and/or other assets, with its becoming payable only after such period has expired.

Comment: Severance (“Golden Parachute Payment”) versus Deferred Compensation. CPP’s golden parachute rule does not appear to prevent deferred compensation per se, even if that compensation exceeds 2.99 times the executive’s base amount and is paid out upon any termination (not just on an involuntary termination).

For example, if, instead of a traditional severance plan, a company had a deferred compensation program in which contributions by the employer become fully vested in the executive at the end of that period and pursuant to which the full amount was paid upon termination of employment, whether voluntary, involuntary, due to death or due to disability, such a payment does not appear to be a payment “on account of . . . [an] applicable severance from employment.” Code §280G(e)(1)(B) as amended by the EESA §302(b). “Applicable severance from employment” is defined as including an involuntary termination but none of the other terminations listed above. Code §280G(e)(2)(B) as amended by the EESA §302(b). If, on the other hand, the Treasury did not agree with this position, a financial institution might provide for the deferred compensation to be paid in any event on a fixed date such as five years from the date awarded to the executive.

4. $500,000 Limit on Deductible Compensation. Finally, a financial institution participating in CPP must agree not to claim a federal tax deduction for compensation of a covered executive in excess of $500,000 during taxable years that fall within the period that the Treasury holds equity or other assets acquired pursuant to CPP. (Again, as noted in footnote 12, the applicable period under the EESA §302(a) (adding new Code §162(m)(5)), except for purposes of CPP, is the period during which the Treasury has its authorities as granted under the EESA §101(a).)

Comment on $500,000 Limit on Deductible Compensation: As in the case of current §162(m) requirements (which, absent an the EESA situation, continue to provide for a $1 million deductibility cap (not $500,000) on nonperformance based compensation), at least some employers subject to the new the EESA requirements will decide to forgo the deduction rather than cut back the compensation of its covered executives.

Special Note as to Parachute Payment under New Code §280G(e) as added by the EESA §302(b). As noted above, the EESA §302(b) introduces a new concept, a severance payment (unrelated to a change in control) be treated as a “golden parachute” for purpose of the EESA. The EESA §302(b), by inserting a new Code §280G(e), causes a loss of deduction for “parachute payments” in excess of the 2.99 times the “base amount” safe harbor coming within new Code §280G(e) (just as Code §280G has in the past taken away a deduction for “excess parachute payments” in connection with changes in control) and results in an excise tax under Code §4999 of 20 percent on the executive receiving or otherwise becoming entitled to such excess parachute payments. As noted above, the same “safe harbor” concept (2.99 times the “base amount”) would appear to apply in determining a “golden parachute” tax status under Code §280G(e) without regard to individual agreements with financial institutions, whether under CPP or PSSFI (the other EESA program presently contemplating such individual agreements with financial institutions).

Long-Term Impact

• Of the EESA, CPP and Other Programs Under the EESA.

The ultimate effect of the EESA, including CPP, on executive compensation generally is difficult to predict. Most of the immediate impact will be on senior executives of covered institutions and not on executives at those institutions that are below the very top level and not at institutions not covered by the EESA. Nonetheless, there may be implications for executive compensation that go beyond the immediate impact of the EESA and, in particular, CPP.

1. There may be a “trickle down” effect to lower-level executives at corporations subject to CPP and other EESA programs in the future.

2. The definition of financial institution in §3 of the EESA is so broad that it likely will be extended beyond banks.

3. The principles embodied in the EESA may be extended to other institutions than those within the original intent of the EESA. This could happen in a number of ways. Some congressional leaders already have indicated such principles should apply to executive compensation more generally (not just to financial institutions).[14]

4. Some nonfinancial institutions may themselves decide to implement some of the standards, perhaps encouraged by shareholder activists as a matter of “good corporate governance.”

As to the EESA itself, the same congressional leaders calling for broader executive compensation limitations generally have suggested “tightening” the EESA provisions. They have suggested that the “safe harbor” limitations on severance payments constituting “golden parachute payments” (the 2.99 times-base-amount test) be eliminated and that the limitation be applied to any severance payments.[15] It is also possible, for example, that the new president and the new Congress may extend the EESA’s principles beyond Wall Street.[16]

Endnotes:

[1] Emergency Economic Stabilization Act of 2008, Division A of Public Law 110-343, 12 U.S.C. 5201 et seq.
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[2] Pursuant to §115 of the statute, the Secretary of Treasury was authorized to spend up to $250 billion as of the date the EESA was enacted. That amount may be increased to $350 billion if the President submits written certification to Congress that such authority is needed by the Secretary of Treasury. After that point, it can be increased further to a total of $700 billion if the President submits a written report to Congress detailing the Secretary of Treasury’s plan to use the additional amount, unless Congress enacts a joint resolution disapproving the expansion within 15 days of receiving the President’s report.
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[3] Interim Final Rule, 31 CFR Part 30, 73 Fed. Reg. 62205 (Oct. 20, 2008) (original announcement of the rule was made Oct. 14, 2008).
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[4] The investments in the financial institutions take the form of fixed rate cumulative perpetual preferred stock, paying dividends at 5 percent per annum for 5 years and then 9 percent per annum. The designated preferred stock has no voting rights except when certain dividends are not paid and certain changes occurred that affect the designated preferred stock holders. The investment includes ten year warrants to purchase common stock. Among other terms, there are limitations on dividends that can be paid to other stockholders and on redemptions that can be made (both as to the designated preferred stock held by the Treasury and stock held by others).
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[5] The Wall Street Journal reported that as of Nov. 7, 2008 52 financial institutions were participants in CPP. This includes the nine institutions originally required by the Treasury (at a meeting held on Oct. 13, 2008) to participate. Public financial institutions not already in the program have until the end of the business day on Nov. 14, 2008 to submit applications. The Treasury also intends to establish application forms and deadlines for private institutions.
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[6] Treasury Notice 2008-TAAP (Oct. 14, 2008)
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[7] TAAP, it is important to note, reflects the auction purchase provisions of the EESA Sections 111(c) and 302(a) and (b), which contain threshold requirements of $300 million in auction purchases (or in a combination of auction and direct purchases) of $300 million before those provisions apply.
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[8] Treasury Notice 2008-PSSFI (Oct. 14, 2008).
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[9] The executive compensation standards applied to financial institutions participating in this program would be similar to those applied to companies taking part in CPP, except that the severance payment (golden parachute) provision, discussed later in the text of the column, is not limited to “payments” in excess of 2.99 times a “base amount.” Under PSSFI, a covered severance payment – that is, a “golden parachute payment” – is any compensation paid to a senior executive on account of a termination that is involuntary or due to the employer’s bankruptcy, insolvency, or receivership. There is no “safe harbor” of 2.99 times the executive’s “base amount” as there is in CPP and TAAP. Any severance payment made on account of such a termination is prohibited under PSSFI.
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[10] Specific examples of individual agreements (virtually identical to one another) can be found in attachments to 8-Ks filed by such institutions as Citigroup, JPMorganChase, Goldman Sachs, Morgan Stanley and others. In addition, there is a model agreement reflecting the provisions contained in the actual individual agreements, which is available at www.ustreas.gov/initiatives/eesa.
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[11] This terminology is used in the EESA Sections 111(b)(2)(C); §111(c) refers to a contract providing a “golden parachute” and §302(b) is entitled “Golden Parachute Rule.”
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[12] The EESA basically contains two different time periods to which executive compensation provisions may apply, depending on which section of the statute is applicable. CPP itself changes one of the applicable time periods from that otherwise applicable under the statute, as noted below.

First, the EESA §111(b), setting forth certain standards applicable in the case of direct purchases by the Treasury (purchases such as those applicable in the case of CPP), provides that the limitations imposed under §111(b) (i.e., on risky incentives, clawbacks of incentives based on certain inaccuracies and, finally, making golden parachute payments) apply throughout the period that the Treasury holds an equity or debt position in the financial institution.

Second, the provisions of (i) the EESA §111(c) (prohibiting a new employment contract with a “golden parachute” provision), (ii) §302(a) (limiting deductible compensation to $500,000 for a taxable year) (but see below for an exception in the case of CPP) and §302(b) (extending Code §280G to involuntary terminations and terminations in connection with any bankruptcy, liquidation or receivership) are applicable during the period that the authorities under §101(a) of the EESA are in effect (i.e., the period from Oct. 3, 2008 to Dec. 31, 2009 or, if extended, the period from Oct. 3, 2008 to a date no later than Oct. 3, 2010). An exception to the statutory period under the EESA §302(a) as just noted, is made by CPP which adopts the first approach, that is, the period during which the Treasury holds an equity or debt position in the financial institution, for purposes of the limitation of deductible compensation under new Code §162(m)(5) to $500,000 per taxable year.
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[13] Other differences between the EESA and Sarbanes-Oxley in this respect include EESA §111(b)(2)(B)’s applicability even if no accounting restatement is being conducted, the lack of any limit on the recovery period, and according to the Interim Final Rule, its being triggered by “not only material inaccuracies relating to financial reporting but also material inaccuracies relating to other performance metrics used to award bonuses and incentive compensation.” See Interim Final Rule at 73 Fed. Reg. 62205, 62209.
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[14] See letter dated Nov. 8, 2008 sent to Treasury Secretary Henry Paulson from Speaker of the House Nancy Pelosi and Senate Majority Leader Harry Reid urging aid for the auto industry.
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[15] See letter dated Oct. 29, 2008 sent to the Treasury Secretary Paulson from Speaker Pelosi and Senate Majority Leader Reid.
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[16] Another example of the scrutiny being given to executive pay in the financial services industry is that of New York State Attorney General Andrew M. Cuomo. Mr. Cuomo has attacked incentive awards and other forms of executive compensation at participating financial institutions. He has demanded further information as to executive pay from these institutions. Mr. Cuomo’s statements have received a great deal of attention in the press. It is possible he may expand this attention beyond financial institutions with troubled assets to other businesses as well.
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