As part of passing the American Recovery and Reinvestment Act of 2009 ("ARRA"), commonly known as the Stimulus Act, Congress substantially tightened the restrictions on executive compensation which apply to financial institutions receiving capital infusions from the U.S. Treasury Department. The new restrictions apply prospectively to institutions receiving new infusions of capital under the Treasury's revamped Capital Access Program ("CAP"), as well as retrospectively to institutions which received investments under the Treasury's Troubled Asset Relief Program ("TARP"). The new restrictions have seriously affected compensation programs at financial institutions while Treasury investments in them remain outstanding, prompting many such institutions to consider early repayment of their Treasury investments. The new restrictions also signal Congress' intent to impose new restrictions on executive compensation across the board, not just within the financial sector.
Background of Restrictions
The traditional consensus which applied to compensation practices at private sector companies was that executive compensation decisions were the sole responsibility of the board of directors of the company at issue. Under this view, the board's fiduciary duty to shareholders and the discipline of the stock markets provided appropriate restraints against irresponsible compensation decisions. Financial institutions were free to award large compensation packages to their executives, so long as their regulatory capital ratios were maintained within prescribed guidelines.
With the passage of Section 162(m) of the Internal Revenue Code (the "Tax Code") in the mid-1990s, this hands-off public policy approach was modified slightly to allow public companies to deduct for tax purposes compensation expense in excess of $1 million per executive so long as the excess met the conditions for "performance-based compensation" under the related tax regulations. For example, a shareholder-approved stock option plan typically qualifies as a vehicle for paying "performance-based compensation." These conditions in practice have not been difficult for companies to comply with, so they have not served to limit executive compensation in an overall sense.
A more serious challenge to executive compensation practices at public companies, including financial institutions and non-financial companies, has been posed by the increasing disclosure requirements applied by the U.S. Securities and Exchange Commission to proxy materials used by public companies to solicit votes for the election of directors at annual meetings. Public companies are currently required to disclose in exhaustive detail all items of compensation paid to the chief executive officer, the chief financial officer and the three next most highly-compensated executives (the "Named Executive Officers") in the annual proxy statement. Such companies are also required to discuss at length the basis for and rationale behind compensation decisions for the Named Executive Officers in a "Compensation Discussion and Analysis" section of the proxy statement. Although shareholders are not entitled to vote on executive compensation as such, they are free to withhold votes for incumbent directors if they believe that the described compensation is inappropriate. In practice, shareholder voting recommendation services such as Risk Metrics (formerly known as Institutional Shareholder Services) have used the threat of a recommendation to withhold votes in favor of incumbent directors, to force public companies to stay within their published guidelines for reasonable compensation of executive officers. The result has been a proxy solicitation system which has exerted some real restraint on executive compensation at public companies.
Effect of the Current Economic Crisis
The consensus that executive compensation decisions are the responsibility of the private sector, has broken down during the economic crisis of 2008-2009. Hundreds of financial institutions lined-up for federal funds to restore depleted capital, and many large institutions argued that they needed huge infusions of taxpayer money or they would fail and cause widespread damage to the economy. As a result of these events, congressmen and taxpayers in the fall of 2008 began asking pointed questions about why institutions which received billions in taxpayer funds were continuing to pay executives large sums of discretionary pay. Depending on the point of view of the person describing the payments, they have been variously called "bonuses," "retention payments," or "incentive compensation."
In one prominent case, the management of the brokerage firm Merrill Lynch distributed a bonus pool of $3.6 billion to approximately 700 key employees, shortly prior to its merger with Bank of America. The payments followed the loss by Merrill Lynch of $27 billion during fiscal year 2008 and its federally-arranged and -supported takeover by Bank of America. Merrill Lynch management defended the payments as an expected part of compensation for key employees and a necessary step to retain those employees. Critics such as the New York State Attorney General, Andrew Cuomo, however, pointed out the incongruity of such large payments after a disastrous financial performance by Merrill Lynch in 2008 and asserted that such payments are not necessary to retain employees in a recessionary time. This and other similar cases, in the context of troubled economic times, have produced a political groundswell of criticism of the status quo regarding executive compensation.
Compensation Restrictions
Responding to this criticism and the perception that the compensation restrictions that were earlier imposed under the Emergency Economic Stabilization Act of 2008 were inadequate, Congress held several hearings regarding executive compensation at financial institutions. When the ARRA was passed on February 16, 2009, the law contained several significant new restrictions on executive compensation by financial institutions benefiting from the TARP and the CAP, the most important of which were:
- If the financial institution has received greater than $300 million of Treasury support, then the per-executive limit which applies to the Named Executive Officers or the equivalent officers, if the institution is a non-public company ("Senior Executive Officers"), on the tax deductibility of compensation under Section 162(m)(5) is $500,000, with no exception for performance-based compensation. Without the benefit of this deduction, the after-tax cost to affected financial institutions of compensation above $500,000 has become heavy, thereby tending to set a practical ceiling at that figure.
- The financial institution must make arrangements with its Senior Executive Officers and the 20 next most highly-compensated employees to recover any bonus, retention award or incentive compensation that is based on statements of earnings, revenues, gains or other criteria that are later found to be materially inaccurate. Given the prevalence during the last several years of restatements of financial statements due to faulty or fraudulent accounting, this measure was considered necessary to prevent executives from keeping misgotten gains. Under general legal principles, it is difficult to claw-back pay from executives, so Congress felt it necessary to facilitate this type of legal action.
- The financial institution is prohibited from making any severance payment at all to the Senior Executive Officers and the next five most highly-compensated employees. Under the generally-applicable Section 280G of the Tax Code, companies are restricted from paying severance greater than three times an employee's average annual base pay. Under previous rules adopted by the Treasury under the Emergency Economic Stabilization Act of 2008, such financial institutions were able to make severance payments, as long as they did not exceed three times the employee's average annual base pay. Under the new rules, the Treasury considered the prospect of severance paid to executives for taxpayer-funded financial institutions to be inappropriate.
- The financial institution is prohibited from making any bonus, retention award or incentive compensation to various different levels of executives, depending on the level of federal assistance to the institution, except (i) where the award does not vest in full during the time when the Treasury investment remains outstanding, (ii) where the value of the award does not exceed 1/3 of the total annual compensation of the employee receiving the award, and (iii) the award meets other criteria established by the Treasury Department. In the context of an industry where incentive compensation has historically played a very large role, this restriction is clearly very painful for executives of financial institutions.
- Certain financial institutions which receive exceptional assistance will have their compensation structures and payments to Senior Executive Officers and other highly-paid employees subject to review and approval by a new Special Master for TARP Executive Compensation. The Special Master is charged with evaluating compensation structures and payments to ensure that they do not encourage the taking of unnecessary or excessive risks, and considering the competitive needs of the financial institution, the appropriate allocation of compensation between short-term and long-term vehicles, whether performance-based compensation is appropriately tailored, and whether an employee's compensation reflects his or her value to the financial institution.
- The financial institution is required to establish a board compensation committee that is comprised entirely of independent directors. The compensation committee is required to review and discuss each compensation plan to eliminate features that could encourage executives to manipulate earnings to boost their compensation. The compensation committee is also required to ensure that the compensation plans which apply to the Senior Executice Officers do not encourage taking of unnecessary or excessive risks. Most financial institutions are public companies and, as such, are already subject to exchange listing rules which require the board to have a compensation committee made up of independent directors, so this provision elevates to the form of law an existing practical requirement.
- The board of directors of the financial institution must adopt a company policy regarding excessive or luxury expenditures on such items as entertainment, office renovations, aviation services and other events that are not reasonable business expenditures. Published horror stories about expensive office renovations and junkets gave rise to this rule.
- The financial institution must, for any annual meeting held during the period of time in which a Treasury investment remains outstanding, conduct a separate shareholder vote to approve the compensation of executives described in the proxy statement. Although the vote is to be non-binding on management, it is inevitable that a negative vote on executive compensation will be seen as a powerful rebuke to the board of directors of the financial institution. It is thought that the prospect of even a non-binding no-vote on executive compensation will exert a powerful influence on board compensation decisions.
With the passage of these restrictions, many banks have come to view their investments by the Treasury as onerous. While many institutions viewed the wave of investments under the TARP program as highly favorable, the new restrictions changed their assessment of the benefits and burdens of carrying a Treasury investment. A number of banks have already returned their invested funds to the Treasury. The leading investment banking firm Goldman Sachs, which received $10 billion from the Treasury, announced that it is exploring ways to repay the investment after returning to short-term profitability.
A Preview of Things to Come?
It is tempting to view these executive compensation restrictions as a reaction to a few glaring abuses during a period of temporary economic hardship. However, to view these rules as a passing phenomenon would be to seriously underestimate the current political situation. At present, several congressmen are said to be drafting legislation with general applicability restricting executive compensation. In particular, Rep. Barney Frank, the powerful chairman of the House Financial Services Committee, has been quoted as saying, "We plan to put laws into effect, no question. We have to address this ‘heads-I-win, tails-I-break-even' issue." While many proposals are likely being floated and the outcome of the congressional debates is difficult to predict, it is not difficult to imagine the following restrictions being enacted as part of legislation affecting all public companies:
- A requirement that public companies annually conduct a non-binding shareholder vote on the compensation of their Named Executive Officers - the so-called "say on pay" vote. This practice has been advocated by shareholder groups since before the current financial crisis, as a way of allowing shareholders to provide meaningful feedback on the overall level of executive compensation or to express outrage over particularly large individual pay packages. A number of public companies have voluntarily instituted such votes, as a way of demonstrating good corporate governance practices. Although the conduct of shareholder meetings has traditionally been regarded as a matter of state law, a departure from that tradition in this instance, particularly if the vote on compensation is non-binding, has been defended as a measure designed to enhance the functioning of the private sector, rather than a heavy-handed substantive rule.
- Further limits may be placed on the deductibility for tax purposes of executive compensation payments under Section 162(m) of the Tax Code. The current set of conditions for the performance-based compensation exception to the $1 million general cap are widely considered toothless, and it is not difficult to imagine that Congress will tinker with these conditions to make them more restrictive. Whether any new restrictions would focus on the process of setting pay packages or the outcome of such processes, is difficult to foresee.
- The applicable period of time in which payouts under incentive awards are determined and paid is likely to be the subject of rules. One common theme voiced by critics of executive pay, particularly in the financial sector, is that the current practice of making yearly incentive award payouts tends to promote risky executive behavior because it rewards executives for positive short-term results but fails to penalize executives when such positive short-term results are reversed or prove to have been illusory. Making the amounts payable to executives subject to several years' business risk, it is asserted, more closely aligns the interests of the executives and the shareholders, who are (or should be) invested in a particular stock for the long-term. Until the 1980's, many financial institutions were owned by private partnerships and the partnership's capital was at-risk if bad decisions were made. However, with almost all financial institutions now owned in whole or in large part by public investors, executives are less focused on protecting the firm's capital.
- It is logical that legal provisions allowing the claw-back of executive pay which was based on financial results which later turn out to be inaccurate, will be enhanced. These types of provisions are designed to avoid the unseemly situation where an executive who is considered either the author or a beneficiary of a financial misstatement ends up keeping unearned incentive compensation, just because no legal tools exist to recover the payouts.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
|
