Monthly Archives: October 2009

Deal Certainty – The Fallacy of a New Market

This post is based on a memo by David Fox and Daniel E. Wolf of Kirkland & Ellis LLP.

In the aftermath of the economic crisis that began in mid-2007, much ink has been spilled on the lessons learned by buyers and sellers regarding the pitfalls of deal certainty and the development of new paradigms for both financial and strategic buyers. Many assert that in the post-crash M&A market there has been substantial crosspollination between the traditional deal structures used by those two categories of buyers in the pre-2007 period, with financial buyers being forced to accept deal terms that were once only demanded of strategic buyers and with strategic buyers demanding some of the looser deal commitment terms that previously benefited only financial buyers.

We argue that any attempt to identify a simplified new paradigm or market for basic deal certainty terms is an overly simplistic view of the deal market in these early days of recovery — rather, we believe that the perceived departures from traditional deal structures are largely a reflection of a complex equation of a dozen or so contractual variables that interact with overall deal dynamics, including company-specific and secular market conditions, to produce a deal-specific outcome in the relevant post-crash transactions.

Before outlining this proposition in greater detail, it is useful to briefly trace the history of divergence between deal terms in cash deals for strategic buyers and financial, or private equity, buyers.

Before 2005

Historically, there was a wide divergence between deal models for strategic and financial categories of buyers. Strategic buyers, with the backing of their balance sheets, were expected to commit fully to the completion of an announced cash acquisition backed by a provision providing for a specific performance remedy of the buyer’s obligation to close. Sellers were comfortable relying on the potential to obtain such an order of specific performance to force a closing combined with an assumption that alternatively they would be able to collect lost premium in a damages action against a reneging buyer (noting that the validity of this assumption, at least under New York law, proved somewhat tenuous with the 2005 decision in the Northeast Utilities case).

By contrast, financial buyers were able to proceed with much looser legal commitment to the completion of a cash buyout. Financial sponsors, whose business model depended on borrowing a significant portion of the purchase price in order to leverage their equity investment, often benefited from the inclusion of a “financing condition” in their purchase agreements, meaning they were able, as a theoretical contractual matter, to walk-away from closing, usually without consequence, in the event debt financing was not available. At the time of signing, the financial buyer often delivered a negotiated debt term sheet and/or a “highly confident” letter from debt
financing sources, with such documents providing little if any legal assurance that the debt in fact would be funded. A shell entity created by the financial buyer was the only party to the contract with the seller, meaning that, absent veil-piercing, any specific performance remedy would be largely ineffective.

Sellers accepted the financial buyer’s argument that, as a repeat acquiror, the reputational damage associated with it walking away from any deal were so great that the optionality inherent in the deal terms was a negligible risk. With the very low incidence of failed deals, mostly a function of rational deal terms and levels of leverage and available liquidity in the debt markets, the effectiveness of reputational concerns as a constraint on financial buyers was never really tested.


Credit Derivatives Are Not ‘Insurance’

The superficial similarity of credit derivatives to typical insurance products, like property or life insurance, has caused some politicians and pundits to argue that credit derivatives are a form of insurance and should be regulated as such. The former director of the Commodities Futures Trading Commission (CFTC), which regulates most derivative products, declared: “A credit default swap . . . is an insurance contract, but [the industry has] been very careful not to call it that because if it were insurance, it would be regulated.” New York State went even further. New York State Insurance Commissioner Eric Dinallo testified before a House Committee investigating credit derivatives: “the insurance regulator for New York is a relevant authority on credit default swaps,” because “[w]e believe . . . [they are] insurance.” Although New York has delayed its regulatory plans pending a federal review of credit derivative regulation, the question of whether credit derivatives are insurance remains an open and much bandied about one that needs to be analyzed.

In a forthcoming paper in the Connecticut Insurance Law Journal (available as a University of Chicago Law & Economics, Olin Working Paper here) I argue that it makes little or no sense to regulate credit derivatives as or like “insurance,” regardless of whether they are used as to reduce risk for one party. The instinct to call credit derivatives “insurance” is sensible enough – the lender buying credit protection looks much like an insured and the party selling credit protection looks much like an insurer, at least where the protection seller is in privity with holders of notes of indebtedness. The analogy is obvious: in a plain-vanilla credit default swap, the bank making an original loan pays a premium to a third party that in turn agrees to make the bank whole in the event of a future liability, that is, a default on the underlying loan or bond. This transaction resembles a typical insurance contract, where the insured pays a premium to a third party (an insurance company) in return for a promise to make the insured whole in the event of a loss.

But observing that something resembles or provides insurance against loss is not enough to warrant regulating it as “insurance.” Many contracts that are not called insurance or regulated as insurance imbed some component of insurance or risk sharing. For instance, when a farmer enters into a contract that allows the farmer to sell wheat at a fixed price in the future – a forward contract called a put option – the farmer is in effect insuring against a drop in the price of wheat. On the other side of this transaction, there may be a baker who enters into a forward contract that allows the baker to insure against an increase in the price of wheat. Both parties are buying price insurance from each other, likely with a middleman, known as a market maker, standing between and reducing the counterparty risk in the transaction. But these contracts, and all similar hedging contracts entered into by regular consumers and sophisticated financial entities, are not regulated as insurance contracts. The point can be made more bluntly: it would be fanciful to argue that every contract in which a party could be said to reducing its risk and another party was willing to take on some of that risk is or should be called insurance. If this were the case, state insurance regulators would be involved in regulating hedge funds, commodities, options, swaps, and countless other contracts entered into by consumers and firms. In fact, every contract assigns, shares, and apportions some sort of risk. No one seriously advocates this scope for insurance regulation. Simply providing some risk sharing is not enough to be regulated by state insurance commissioners.

The reason insurance regulation does not extend to every contract that involves some element of insuring risk has to do with the purpose of insurance regulation, as opposed to other types of regulation. There are broadly two justifications for a special law of insurance: first, the peculiar governance problems associated with insurance firms; and second, worries about unsophisticated consumers being duped by complicated and essential products. My Working Paper shows that neither of these justifications obtains or makes sense for the regulation of credit derivatives.

Governance problems arise because insurance companies have an inverted production cycle and do not generally have concentrated creditors like non-insurance firms. This means that two crucial constraints on the potential misinvestment of resources are missing: the feedback to the firm provided by product and other markets is missing given the fact that the insurance company produces its product (that is, payment of claims) many years after the consumers pay for it; and when things go badly for the insurance company, there is no concentrated interest to keep the firm from adopting an excessively risky strategy (from the perspective of creditors (that is, policy holders).

Insurance law is designed to prevent the risk that insurers competing for policyholders, but unconstrained by normal forces, will charge too little for their products. This happens because of the continuous nature of insurance company inflows and outflows, coupled with a delinkage between the time of pricing a risk and the time of paying out the loss from the risk. In other words, insurance can look a bit like a Ponzi scheme, where new creditors of the firm are paying off the liabilities to old creditors. And, just as in a Ponzi scheme, when things go badly for the firm (that is, when actuarial estimates of liability turn out to be wrong), there is a natural tendency to offer new investors an attractive return to increase cash flows to pay for higher-than-estimated outflows.

The second part of the governance problem – the lack of concentrated creditors – exacerbates this problem, since there is no sophisticated entity with bargaining power that can keep the firm from adopting a shareholder-friendly, go-to-Vegas strategy in the event liability estimates in the first period were erroneous. Without these governance constraints, initial misestimates and mistakes can fester and lead to large losses. My Working Paper shows how the counterparties in credit derivative contracts do not have this continuous investment problem or these governance problems, unless, of course, they are insurance companies, and how insurance regulation would be futile in any event.

Consumer problems arise because the consumers of insurance company products are average individuals without the expertise or sophisticated judgment to assess what they are buying in insurance products. The consumer-centric element of insurance regulation consists of three commonly recited justifications: to make sure insurers don’t charge too much; to regulate the substance and terms of policies; and to regulate service and coverage issues. Unlike the average consumer of insurance, the average participant in credit derivative markets is large, sophisticated, and capable of bearing losses. There is simply no basis for transferring the paternalistic impulses of insurance to this market.

Performance Sensitive Debt and CEOs’ Equity Incentives

This post comes to us from Alexei Tchistyi of the University of California Berkeley, David Yermack of New York University, and Hayong Yun of the University of Notre Dame.

In our paper, Negative Hedging: Performance Sensitive Debt and CEOs’ Equity Incentives, which was recently accepted for publication in the Journal of Financial and Quantitative Analysis, we examine whether performance sensitive debt (PSD) contracts enable executives to transfer value to themselves at the expense of shareholders. In particular, our paper tests whether the existence and strength of PSD contract terms are related to managers’ incentives from ownership and compensation.

Performance pricing in commercial debt contracts links the borrower’s interest payments to a measure of financial performance, such as its current credit rating or balance sheet ratios. A typical performance sensitive debt (PSD) contract charges lower interest rates in times of good performance and higher interest during poor performance. As a result, PSD contracts redistribute the gains to equity holders across certain future states, increasing returns to equity when the firm performs very well, while reducing them when performance lies in a middle range.

For our empirical tests, we merge a large sample of commercial bank debt contracts with data about the equity ownership of the borrowing firms’ CEOs. For each CEO in our sample, we calculate the delta, or sensitivity of stock and option values to changes in stock price, as well as the vega, or sensitivity of option values to changes in stock volatility. Using a sample of 4,451 loan contracts (1,236 PSD and 3,215 straight debt) negotiated by 1,359U.S. companies from 1994 to 2002, we find that firms whose CEOs exhibit high deltas from their stock and option holdings tend to have flatter performance pricing schedules; one standard deviation increase from the mean in delta corresponds to a 39% decrease in the slope of the performance pricing schedule. Conversely, we find that CEOs with high vegas from option inventories tend to have steeper performance pricing schedules: after controlling for heterogeneity in borrowers’ characteristics and loan characteristics, a one standard deviation increase from the mean of log (1+vega) corresponds to a 17% increase in the performance pricing schedule’s slope.

We examine the relationship between CEOs’ incentives and the PSD slope more closely in two different ways. We look at the “interest-increasing” and “interest-decreasing” segments of the PSD slope, those that lie at credit ratings just below and just above the firm’s rating at the time of contracting. We find a stronger relationship between CEOs’ delta incentives and the interest-increasing slope, implying that CEOs with high ownership are more concerned with avoiding expected costs of financial distress than with reaping the benefits of high rewards for performance improvements. We also examine the convexity, rather than the slope, of the PSD pricing schedule, and we find that both local and overall convexity are positively associated with CEOs’ vega incentives and negatively related to their delta incentives.

The full paper is available for download here.

M&A Practitioner Panel Discusses Delaware Takeover Cases

Editor’s Note: This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Recently, in the Mergers & Acquisitions course at Harvard Law School, several preeminent mergers and acquisitions practitioners and academics discussed questions regarding Delaware case law: Was the Time-Warner decision (Paramount Communications, Inc. v. Time Inc., 571 A.2d 1140 (Del. 1990)) Correctly Decided? Was the QVC Decision (Paramount Communications, Inc. v. QVC Network Inc., 637 A.2d 34 (Del. 1994)) Consistent With Time-Warner? And is the QVC Decision Sound In Corporate Finance Terms?

The panel consisted of Isaac Corré, Senior Managing Director of Eton Capital Management L.P.; Reinier Kraakman, Ezra Ripley Thayer Professor of Law at Harvard Law School; James Morphy, a partner and prominent mergers and acquisitions lawyer at Sullivan & Cromwell LLP; and Ted Mirvis, a partner and prominent litigator at Wachtell, Lipton, Rosen & Katz who represented parties involved in these cases. Messrs. Morphy and Mirvis are both member of the advisory board of the Harvard Law School Program on Corporate Governance. Moderating the discussion was Vice Chancellor Leo Strine, Jr.

The video of the panel is available here. (video no longer available)

Study Highlights Recent Trends in M&A Deal Terms


The Mergers & Acquisitions Committee of the American Bar Association’s Business Law Section recently released the 2009 Strategic Buyer/Public Target M&A Deal Points Study. I am the Co-Chair of the Committee’s M&A Market Trends Subcommittee and the Project Chair of the working group that compiled the Study.

The Study examines key deal points in acquisitions of publicly traded companies by strategic buyers announced in 2008. It also compares the data from the 2008 deals to the data from the Subcommittee’s prior studies of public company acquisitions, which cover deals announced in 2005, 2006 and 2007.

The 2009 Study also tested new deal points in the 2008 deals, including operating covenant provisions, reverse termination fees in strategic deals, and provisions providing the target the express right to pursue damages on behalf of the target’s stockholders (so called “ConEd” language). Interestingly, only 17% of the deals in the data set included ConEd language.

In addition to myself, Keith Flaum, Vice Chair of the Mergers & Acquisitions Committee and former Chair of the M&A Market Trends Subcommittee, and Rick Climan, former Chair of the Mergers & Acquisitions Committee, acted as Special Advisors for the 2009 Study. My Co-Chair of the M&A Market Trends Subcommittee, Jessica Pearlman, and more than 20 M&A lawyers from major firms across North America, assisted in the preparation of the Study. Their names are listed in the Study.

M&A Break Fees: US Litigation vs. UK Regulation

In a recent working paper, M&A Break Fees: US Litigation vs. UK Regulation, I consider differences in M&A break fees between the UK and US systems. Despite generally similar economies and political systems, the UK and US restrict M&A break fees very differently. The UK, in essence, regulates them; the US governs them through litigation. The contrast may be able to teach us something about trade-offs between litigation and regulation as modes of governance, including how laws change under each regime over time.

Analysis of data on 1,136 bids in 1989-2008 and 61 fee disputes show: (1) the UK caps fees at a low level with a simple ex ante rule based not on regulatory expertise but on an arbitrarily chosen percentage of bid value, which nonetheless has the virtues of clarity and lower litigation costs, and enhances competition conditional on an initial bid, and (2) US courts evaluate fees ex post with a complex and vague standard, allowing for greater variation and higher average fees, reducing bid competition and increasing bid completion rates, and possibly increasing M&A overall, at the cost of legal uncertainty and litigation (although less than might be expected), in part because courts resist articulating clear rules. Laws in each nation exhibit inertia; are protected by entrenched interest groups (institutional investors in the UK, lawyers in the US); and co-exist with the opposite approach (litigation in the UK, regulation in the US), even
within the domain of M&A law. Subject to strong limits on external validity, the case study suggests that interest groups may be the most important factors shaping the initial choice between regulation and litigation, even for otherwise similar nations in a similar context, and that a combination of interest groups formed in response to a given choice, as well as lawmaker incentives, may preserve those choices even after the conditions giving rise to the initial choice have passed away.

The Changing Market Reaction to Reported Earnings

This post comes to us from Edmund Keung, Zhi-Xing Lin and Michael Shih of the National University of Singapore.


In our paper, Does the Stock Market See a Zero or Small Positive Earnings Surprise as a Red Flag?, which was recently accepted for publication in the Journal of Accounting Research, we investigate the stock market reaction to specific levels of reported earnings. Akerlof’s classic analysis of a market with information asymmetry suggests that if potential buyers cannot distinguish good used cars from bad ones, the prices they will pay for all used cars are lower than what good used cars are worth. In our setting, this analysis suggests an increasing incidence of firms managing earnings and/or analyst expectations will induce investors to discount not only the shares of firms that are confirmed manipulators, but also those of firms that are mere “suspects.” To the extent that some of the suspects are actually innocent, lower valuations for the suspect firms would represent a cost jointly borne by all firms for the “numbers game” that not all of them play.

We investigate whether firms incur the aforementioned cost in two stages. We first document a rising trend in the number of firms meeting or narrowly beating analyst earnings forecasts relative to the number of firms narrowly missing the forecasts in the period 1992-2006. This would suggest to investors a rising prevalence of firms playing the numbers game, given empirical results indicating manipulators prefer to meet or narrowly beat analyst earnings forecasts rather than to beat them by a large margin. The impression of a rising number of “lemons” (manipulators) is likely to increase investors’ skepticism toward firms that “make the numbers,” especially those that meet or narrowly beat analyst earnings forecasts, resulting in zero or small positive earnings surprises.

We test this in the second stage of our investigation. We compare the coefficient in the regression of abnormal stock returns around the earnings announcement on earnings surprise across ranges of earnings surprises. The coefficient is referred to in prior studies as the earnings response coefficient (ERC). We find the ERC is significantly lower for earnings surprises in the range [0, 1¢] than for those in adjacent ranges ([-1¢, 0) and (1¢, 2¢]) for firm-quarters in 2002-2006, but not for those in either the period 1992-1996 or 1997-2001. These results suggest investors’ skepticism toward zero and small positive earnings surprises is a fairly recent event, and its development over time was induced by the rising tide of firms playing the numbers game. Our results are robust to the inclusion of controls. Our results are unchanged after controlling for the sign of estimated discretionary accruals and the trajectory of analyst forecasts before the earnings announcement.

We also find evidence that investors’ skepticism toward zero and small positive earnings surprises is justified. The relation of future earnings surprise with current earnings surprise is more negative for current earnings surprises in [0, 1¢] than for those in any other range throughout the period 1992-2006. It appears that analysts became aware of the problem earlier than investors. We compare the coefficient in the regression of analysts’ revision of next-quarter earnings forecast on earnings surprise across ranges of earnings surprises. We term this coefficient the analyst earnings response coefficient (AERC). The AERC is lower for earnings surprises in [0, 1¢] than for those in any other range throughout the period 1992-2006. There is also evidence that investors and analysts are skeptical about firms that narrowly avoid quarterly losses or quarterly earnings declines throughout the same period.

The full paper is available for download here.

Microsoft Adopts Triennial “Say on Pay” Policy

This post is based on a Wachtell, Lipton, Rosen & Katz client memorandum by Jeremy L. Goldstein and Christina Cheng.

Microsoft’s Board of Directors recently became the first U.S. company to adopt a “say on pay” policy that will enable its shareholders to cast a non-binding, advisory vote every three years on compensation programs for the company’s senior executive officers. The first vote will occur at the company’s annual shareholders’ meeting on November 19. The United Brotherhood of Carpenters, which had previously submitted a similar triennial shareholder proposal to Microsoft, has since withdrawn its proposal. Many will closely watch this development to see if other companies will follow suit or if Microsoft’s actions will reinvigorate the triennial “say on pay” movement in Congress. The House of Representatives considered but ultimately rejected the triennial approach in the “say on pay” bill it passed in August.

We continue to believe that “say on pay” votes constrain the ability of compensation committees to exercise their business judgment with respect to nuanced personnel and compensation decisions that are often driven by sensitive information. We also believe that such advisory votes represent a transfer of basic responsibility of corporate management from directors to shareholders and would subject compensation decisions to the whims of shareholders no matter how inconsistent their views may be with long-term corporate performance.

If, as some have suggested, “say on pay” is inevitable, Microsoft’s triennial policy may nonetheless be a preferable alternative to the annual shareholder advisory vote. A triennial vote would help align “say on pay” with the goal of avoiding short-termism in corporate governance and executive pay arrangements. Most fundamentally, a triennial approach would permit shareholders, directors and managers to evaluate the effects of a company’s pay program on long-term performance and would be less likely to subject a company’s compensation plans to the whims of hedge funds and other constituencies seeking to apply pressures unrelated to long-term corporate performance. In addition, the triennial approach would allow shareholders to engage in more thoughtful analysis and voting by providing more time between votes and by causing fewer votes among public companies in any given year. Further, the three-year period between each vote would correlate more closely to the business cycle of many companies, and would provide management with the time necessary to implement improvements and changes to address concerns reflected by a negative vote.

With the Senate set to consider a “say on pay” bill in the coming months, Microsoft’s adoption of the triennial approach may provide momentum towards a more moderate stance in the “say on pay” debate.

Reducing Incentives for Risk-Taking

(Editor’s Note: This post is based on a piece by Lucian Bebchuk and Holger Spamann published today on the New York Times’ Dealbook and available here. The piece builds on their joint paper “Regulating Bankers’ Pay.”)

It is now widely accepted that compensation structures in financial firms should be designed to avoid excessive incentives for risk-taking and that doing so requires tying executive compensation to long-term results and preventing cashing out of large amounts of compensation on the basis of short-term results.

What long-term “results” are we talking about though? We propose that risk-taking incentives could be improved by tying executives’ pay not only to the long-term payoffs of shareholders but also to those of preferred shareholders, bondholders and taxpayers insuring depositors.

In examining how executive compensation can affect risk-taking in financial firms, attention has focused on distortions that can arise from the ability of executives to cash out large amounts of compensation before the long-term consequences of risk-taking are realized. The importance of eliminating such distortions, which was first highlighted in a book, Pay without Performance, that one of us published with Jesse Fried five years ago, has become widely accepted in the aftermath of the financial crisis.

But there is another type of potential distortions that should be recognized. Bank executives’ payoffs have been insulated from the consequences that losses could impose on parties other than shareholders. This source of distortions is separate and distinct from the short-termism problem; and it would remain even if executives’ payoffs were fully aligned with those of long-term shareholders.

Equity-based awards, coupled with the capital structure of banks, tie executives’ compensation to a highly levered bet on the value of banks’ assets. Bank executives expect to share in any gains that might flow to common shareholders, but they are insulated from losses that the realization of risks could impose on preferred shareholders, bondholders, depositors or the government as a guarantor of deposits. This gives executives incentives to give insufficient weight to the possibility of large losses and therefore provides them with incentives to take excessive risks.

How could pay arrangements be redesigned to address this distortion? To the extent that executive pay is tied to the value of specified securities, such pay could be tied to a broader basket of securities, not only common shares. Rather than tying executive pay to a specified percentage of the value of the common shares of the bank holding company, compensation could be tied to a specified percentage of the aggregate value of the common shares, the preferred shares and all the outstanding bonds issued by either the bank holding company or the bank. Because such a compensation structure would expose executives to a broader fraction of the negative consequences of risks taken, it will reduce their incentives to take excessive risks.

Indeed, even the above structure would not lead bank executives to internalize fully the adverse consequences that risk-taking might have for the interests of the government as guarantor of deposits. To do so, it would be necessary to broaden further the set of positions to whose aggregate value executive payoffs are tied. One could consider, for example, schemes in which executive payoffs are tied not to a given percentage of the aggregate value of the bank’s common shares, preferred shares and bonds at a specified point in time, but rather to this aggregate value minus any payments made by the government to the bank’s depositors, as well as other payments made by the government in support of the bank, during the period ending at the specified time.

Alternatively, one could consider tying executive payoffs to the aggregate value of the bank’s common shares, preferred shares, and bonds at the specified time minus the expected value of future government payments as proxied by the product of (i) the implied probability of default inferred from the price of credit default swaps at the specified time, and (ii) the value of the bank’s deposits at that time.

Even if such schemes are not used, however, tying executive pay to the aggregate value of common shares, preferred shares and bonds will already produce a significant improvement in incentives compared with existing arrangements.

Similarly, to the extent that executives receive bonus compensation that is tied to specified accounting measures, it could instead be tied to broader measures. For example, the bonus compensation of some bank executives has been based on accounting measures that are of interest primarily to common shareholders, such as return on equity or earning per common share. It would be worthwhile to consider basing bonus compensation instead on broader measures such as earnings before any payments made to bondholders.

Recognizing this problem highlights the limits of corporate governance reforms for fixing the design eliminating excessive risk-taking incentives in banks. Concerns about excessive risk-taking have led legislators and regulators, both in the United States and abroad, to adopt or propose various corporate governance measures, such as say-on-pay votes, aimed at improving pay-setting processes and better aligning pay arrangements with the interest of banks’ shareholders.

Although such measures can discourage some inefficient risk-taking that is undesirable from bank shareholders’ perspectives, they cannot be relied on to eliminate the incentives for excessive risk-taking that arise from moral hazard: The common shareholders in financial firms do not have an incentive to induce executives to take into account the losses that risks can impose on preferred shareholders, bondholders, depositors, taxpayers underwriting governmental guarantees of deposits and the economy. This moral hazard problem is at the heart of the extensive body of banking regulations that we have. Consequently, regulatory encouragement or even intervention may be needed to eliminate all excessive risk-taking incentives.

Be that as it may, any attempt to eliminate excessive incentives for risk-taking requires a full understanding of the sources of such incentives. Such understanding requires focusing not only on the length of executives’ horizons but also on the definition of long-term results to which executives’ interests should be tied.

Questions TARP Employees are Asking Today

This post comes to us from Michael J. Katzke and Lisa M. Brubach of the Bachelder Law Offices.

On June 10, the Treasury Department issued an interim final rule (the “IFR”), effective June 15, providing guidance on the executive compensation standards applicable to companies participating in the Troubled Assets Relief Program (TARP). The IFR superceded all prior Treasury guidance with respect to the provisions of the Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009. The analysis—which is not intended to be an exhaustive examination of the IFR—addresses a few of the more common questions we are being asked by employees of TARP companies as they are faced with significant restrictions on compensation.

(1) If I am “covered” (i.e., subject to pay restrictions) under TARP in 2009, will I continue to be covered in 2010?

Although the number of covered employees varies based upon the compensation provision (and, in the case of bonus payments, the amount of TARP assistance received by the employer), covered employees generally include the company’s senior executive officers (SEOs) as set forth in the company’s annual proxy, plus a specified number of the company’s most highly compensated employees based upon the prior year’s annual compensation. Therefore, the list of covered employees could change from year to year, creating both confusion and opportunity as compensation varies.

Accordingly, the Treasury has invited comments on how to keep companies from intentionally cycling employees in and out of covered status each year to allow them periods of freedom from TARP’s compensation restrictions. We note that, given that covered status is based on the prior year’s compensation and on proxy statement status, new hires appear not to be treated as covered employees in the year in which they are hired, and may be able to receive a sign-on bonus without it being subject to TARP restrictions, if such bonus is properly structured.

(2) I have been told there is no base salary cap, but the only incentive payment I can receive is in restricted stock or restricted stock units. If this is the case, what is the best vesting schedule my employer can offer under the IFR?

While the base salary cap has indeed been lifted, the limits imposed on incentive pay are significant. Certain covered employees (depending upon the amount of TARP assistance received by the employer) may receive bonus pay only in the form of long-term restricted stock or restricted stock units (RSUs), the value of which may not exceed one-third of the employee’s annual compensation.

Any such award must be forfeited if the employee does not remain with the company for at least two years from the date of the grant (unless his departure is due to disability or death, or a change-incontrol event occurs). Importantly, there are no exceptions for termination without cause or constructive termination.

In addition, the award may only become transferable or payable in 25% increments when the TARP recipient repays 25 percent of TARP funds (subject to sales permitted to pay taxes upon vesting). This provision would, however, permit full vesting after two years (subject to transfer/payment restrictions) even if the employee were to terminate employment before TARP is repaid.

(3) I have an employment agreement that provides for a guaranteed bonus. Can I receive it if my employer is under TARP?

Yes, but only if the agreement was in effect as of February 11, 2009 and created a legally binding right to the bonus. This grandfathering provision applies to retention awards and other incentive compensation provided under an employment agreement as well. A bonus that depends on the satisfaction of performance criteria would not create a legally binding right and thus would not be payable under the IFR.

(4) If I am dismissed from my job, could I receive severance pay provided under my company’s severance plan or my employment or separation agreement?

During the TARP period, severance pay to SEOs and the next five most highly compensated employees is prohibited, even if such pay is provided for by a binding employment agreement or company severance plan in effect as of February 11, 2009. Severance is considered to have been paid at the time of departure, so if a termination of employment occurs during the TARP period it is not permissible to simply delay payment until after the period has ended.

Note, however, that severance payments made in connection with a departure that preceded the employer’s TARP period are not prohibited even if the employer remains under TARP. Also, the IFR does not appear to prohibit entering into an agreement with a covered employee during the TARP period providing for severance to be paid in the event that the employee departs employment after the TARP period has ended or if he is otherwise no longer a covered employee under TARP.

(5) My company is in merger negotiations. Could I be eligible for severance or excise tax gross-up pay following the merger?

The nature of the merger would govern eligibility. If a TARP company is acquired by a non-TARP company, the employees of the merged entity will not generally be subject to TARP rules (there may need to be some clarification in the final rule on whether the form of acquisition could impact continuation of TARP requirements); note that excise and other tax gross-ups may need to be negotiated with the acquirer. If however, two TARP companies merge or a TARP company acquires a non-TARP company, TARP rules prohibiting severance and gross-ups would continue to apply.

The above list represents just a few of the questions TARP employees are asking. As employers begin to interpret and apply the IFR and the final regulations are issued, many more questions will likely arise.

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