In response to the national financial crisis in the fall of 2008, Congress on October 3, 2008 hurriedly passed the Emergency Economic Stabilization Act of 2008, Pub. Law No. 110-343 ("EESA"). The twin centerpieces of the EESA are the Troubled Assets Relief Program ("TARP"), under which the Secretary of the Treasury (the "Treasury") is authorized to purchase troubled assets from a broad range of financial institutions, and the Capital Purchase Program ("CPP"), under which the Treasury is authorized to invest in selected financial institutions in the form of senior preferred stock and warrants, to augment their capital. Almost as soon as EESA was passed, the original concept of the Treasury purchasing troubled assets from financial institutions was discarded and the program was oriented primarily toward preferred stock investments in those financial institutions under the CPP. In the first tranche of $350 billion authorized under EESA, over 200 financial institutions were chosen for investments prior to December 31, 2008. The second tranche of $350 billion originally envisioned in EESA is currently awaiting authorization by Congress, and which institutions might be chosen for investments by the incoming Obama Administration is unclear. It is also unclear whether the concept of the Treasury purchasing troubled assets from financial institutions envisioned in the TARP will be resurrected and will be operated in tandem with the preferred stock investments used in the CPP. Some financial institutions not in dire need of capital may be deterred from participating in these programs due to the requirement that they submit to substantial new limits and controls on the compensation they pay to their key executive officers.
Background of Compensation Rules and Controls
The new compensation limits and controls for participating financial institutions enacted with EESA come at a time of increasing public and regulatory concern with executive compensation. As reported in the media, many troubled financial institutions involved in the crisis have continued paying executives large bonuses and other incentive compensation and have paid large severance packages to departing executives.[1] During the deliberations in Congress over the passage of EESA, many senators and congressmen indicated that limits on executive compensation were, because of political considerations, an essential part of the legislation.[2]
Most of the new compensation rules included in EESA operate through several existing levers on executive compensation under the Internal Revenue Code of 1986, as amended (the "Tax Code"), and the federal securities laws. Certain of the new rules, however, represent relatively new levers designed to influence executive compensation. Some of the existing levers are:
- For many years, Section 280G of the Tax Code has limited the deductibility for tax purposes of executive compensation which is triggered by a change of control of a company to three times the executive's base compensation. The Section 280G limits are known as the "golden parachute" rules. Without the benefit of deductibility, any compensation payable by a company is effectively much more expensive to the company.
- Since the mid-1990s, Section 162(m) of the Tax Code has limited the deductibility of compensation to certain key executive officers of a public company to $1 million, except for "performance-based compensation" meeting various requirements. Since most public companies feel a need to pay their chief executive officer, and often other executive officers, greater than $1 million annually, they typically structure their compensation plans to comply with the performance-based rules of Section 162(m).
- In 2006, the U.S. Securities and Exchange Commission (the "SEC") promulgated a comprehensive set of new disclosure requirements around executive compensation. Among other things, the new rules require management and the board of directors to discuss at length all items of compensation awarded to executives, and the metrics and rationale used in making compensation awards, in a new "Compensation Discussion and Analysis" section in the company's proxy materials. The stated goal of these new rules was to encourage transparency around compensation decisions and amounts. The unstated premise of this approach was that companies which are forced to discuss compensation decisions in greater detail, are less likely to award large compensation packages.
Coverage of the New Rules
Shortly after the passage of EESA by the Congress and its signature by the President, Treasury promulgated a set of interim final rules under EESA interpreting various aspects of that law.[3] The Internal Revenue Service also issued a notice explaining its interpretation of the tax-related provisions of EESA.[4] The new limits and controls on executive compensation enacted with EESA apply to financial institutions regardless of whether they are public companies registered under the Securities Exchange Act of 1934 (the "Exchange Act"), or whether they are private companies or partnerships. The affected executives are the same as those singled-out for disclosure under the SEC's proxy rules under Regulation S-K, Item 402: the chief executive officer, the chief financial officer, and the three next most highly-compensated executive officers of the company (the "covered executives"). The rules apply for so long as the Treasury holds debt or equity in the participating financial institution.
Corporate Governance Provisions
The provisions of EESA and the accompanying regulations and interpretations include three substantive corporate governance rules:
- Executive compensation programs must be designed not to create incentives for covered executives to take unnecessary and excessive risks that threaten the value of the participating financial institution. Under the Treasury's regulations, the financial institution's board compensation committee must identify the features of the covered executives' compensation arrangements which could lead them to take unnecessary and excessive risks, to discuss these features with the institution's senior risk officers, and ensure that the covered executives are not actually encouraged to take such risks. Similar discussions and determinations by the compensation committee must happen on an annual basis. Financial institutions which are subject to SEC reporting requirements must provide such a certification as part of the Compensation Discussion and Analysis section of the proxy statement, while institutions which are not subject to SEC reporting must provide a similar certification to their primary regulatory agency, for example, the FDIC.
- The participating financial institution must retain the right to recover any bonus or incentive compensation paid to a covered executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate. Unlike the similar Sarbanes-Oxley clawback requirements, this new requirement does not apply only to cases where financial statements are restated. This new clawback rule can be triggered if any metric used in calculating compensation proves to have been materially inaccurate. Presumably, financial institutions subject to this requirement will need to amend their compensation plans and employment agreements to allow for the recovery of compensation under these circumstances.
- The particpating financial institution from which the Treasury has purchased greater than $300 million of debt and/or equity securities through auction purchases, is prohibited from making any "golden parachute payment" to its executive officers while the Treasury continues to hold any debt or equity in the financial institution. As with the existing Section 280G prohibition, an amount of compensation greater than three times the applicable base amount is considered a golden parachute payment. However, the payments prohibited by this new rule include not just amounts payable upon a change of control, but also amounts payable upon an involuntary termination of employment of the executive or the bankruptcy or insolvency of the financial institution.
Limitations on Compensation
The provisions of EESA also include several important limitations on the deductibility of the compensation paid to a participating financial institution's covered executive officers. These limits only apply if the Treasury has purchased or invested in debt or equity securities from a participating financial institution for a price exceeding $300 million. The limitations are as follows:
- The limit for deductible non-incentive compensation is $500,000, lowered from $1 million for all other public companies.
- The performance-based compensation exclusion from the above limitation will not apply to such financial institutions. Thus, the deductibility of any compensation amount of the kind regularly paid to covered executive officers will be limited to the $500,000 ceiling amount. Since few major financial institutions will want to limit compensation for their top executive officers to $500,000, this rule will substantially raise the after-tax cost of executive compensation for participating financial institutions and will therefore discourage large compensation packages.
Wider Application of New Rules?
Given the reformist mood in Washington, it is entirely possible that additional proposals will be put forward in the new Congress to address executive compensation. Since EESA uses several common levers to approach issues of executive compensation, Congress might also choose to use some of these levers to deal with executive compensation in the corporate community at large. For example, it would represent a modest extension to the existing Compensation Discussion and Analysis disclosure rules, to require the compensation committee of a public company to evaluate and discuss risk management issues raised by the compensation of their leading executive officers. Although billed as a corporate governance measure, such a measure might well exert a restraining influence on executive compensation in practice. Similarly, it is not difficult to imagine additional conditions and limitations being placed on the deductibility of executive compensation, in the same vein as the modifications to Sections 280G and 162(m) of the Tax Code which EESA imposes on certain participating financial institutions. Because deductibility substantially affects the after-tax cost to companies of paying executive compensation, any such modification is also likely in practice to restrain executive compensation.
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.
See "A.I.G. to Help Cuomo Recover Millions in Executive Pay," New York Times, Oct. 16, 2008.
See "Bailout Plan Wins Approval; Democrats Vow Tighter Rules," New York Times, Oct. 3, 2008.
31 CFR Part 30.
Notice 2008-94.
|
