The Treasury Department has begun to provide clarity on its expanding focus from providing liquidity under its Troubled Assets Relief Program (TARP) to actual investments of equity into capital deficient banks through its capital purchase program. Using authority granted in the recently enacted Emergency Economic Stabilization Act (EESA), the Treasury has commenced its capital purchase program with committed investments in large, high profile financial institutions such as Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co., Bank of New York Mellon, and State Street Corp. This program, expected to reach $250 billion of equity investments in thousands of banks, is designed to eliminate some of the stigma of participating in the program.

The strategy of the Treasury, along with the Federal Reserve Board and the other U.S. bank regulatory agencies, is likely to continue to change. Indeed, Federal Reserve Chairman Ben Bernanke stated in a letter published earlier this week in The Wall Street Journal, “Our strategy will continue to evolve and be refined, and we will adapt to new developments and the inevitable setbacks.”

The capital purchase program is intended to strengthen financial institutions and to be a catalyst for resumed lending. Financial institutions participating in the program will be subject to corporate governance and executive compensation restrictions, which, as described in interim regulations under EESA (at 31 C.F.R. Part 30), will result in the overhaul their existing executive compensation arrangements and require implementation of a new incentive compensation monitoring processes.

Key features of the capital purchase program are as follows: 

  • Qualified Financial Institutions:

Any U.S. savings association, bank, bank or financial holding company, or savings and loan holding company which engages only in activities permitted for financial holding companies under Section 4(k) of the Bank Holding Company Act. 

  • Eligibility:

The Treasury Department will determine eligibility and allocation for investments in consultation with the appropriate Federal banking agency

  • Amount:

Minimum purchase is 1 percent of the institution’s risk weighted assets; maximum purchase is the lesser of $25 billion or 3 percent of risk-weighted assets; Treasury will fund by year-end 2008.

  • Security:

Non-voting senior preferred stock, with a 5 percent annual dividend that rises to 9 percent after five years.

  • The preferred stock is callable at par after three years, and redeemable prior to that with the proceeds of the issuance of specified classes of stock. 
  • Restrictions on common stock dividend increases and on share repurchases. 
  • Treasury is entitled to transfer the preferred stock, with issuing institutions required to file a shelf registration covering the preferred stock. 
  • Warrants:

Treasury will receive warrants to purchase non-voting common stock with a market price (based on the 20 trading-day trailing average) on the date of the Treasury purchase equal to 15 percent of the amount of the preferred stock. The warrants are exercisable for 10 years, but will be reduced by 50 percent if the institution is able, by December 31, 2009, to sell common or preferred stock generating proceeds equal to at least 100 percent of the issue price of the preferred stock paid by Treasury.

Of critical interest to many institutions are the executive compensation provisions for institutions participating in the capital purchase program: 

  • For the period of time that the Treasury maintains its equity or debt interest:
  • The institution’s incentive pay criteria cannot be based on measures that would encourage senior executive officers to take unnecessary and excessive risks tending to undermine the value of the institution; 
  • The institution cannot pay its senior executive officers any golden parachute severance; and 
  • The institution must agree to forgo a deduction on any senior executive officer compensation that would be nondeductible under Section 162(m) as amended by EESA. 
  • The institution must impose a “claw-back” provision to recover any bonus or incentive compensation paid to a senior executive officer based on earnings or other criteria later determined to be materially inaccurate.

The new restrictions cover the institution’s “Senior Executive Officers” (or SEOs), who are the Chief Executive Officer (CEO), the Chief Financial Officer (CFO), and each of the three most highly compensation officers of the institution (other than the CEO and the CFO).

Compensation Committee Action.

The moment the financial institution chooses to participate in the capital purchase program, its compensation committee will have a full agenda. At private

institutions the acting body must be a committee acting in a capacity similar to the compensation committee of a public company. The committee will have to audit incentive arrangements for prohibited risks, eliminate those risks and certify the results upon completion of the review. Indeed, the SEO incentive compensation audit will have to be completed no more than 90 days after purchases by the Treasury under the capital purchase program. The committee also will have to add to SEO employment contracts and arrangements the claw-back provision relating to improperly paid incentive compensation and a provision capping severance at the amount permitted under the golden parachute rules (described below). Given these rules, it undoubtedly is sound practice for compensation committees of financial institutions to undertake the process of reviewing their SEO pay arrangements for compliance with the requirements of the capital purchase program as a matter of due course, whether or not participation in the program currently is contemplated. The review process will highlight any tension between the needs of the financial institution and the contractual rights of the executives under their employment arrangements.

Golden Parachute Restriction.

The prohibition against paying any golden parachute during the period in which the Treasury maintains its equity or debt interest means that a participating financial institution can not pay severance in excess of three times the base amount under tax code section 280G. Institutions organized as corporations would have encountered these rules in connection with mergers and acquisitions activity, where 280G has long been applied to make change in control severance payments nondeductible. Under EESA’s capital purchase program, there is a blanket prohibition against such excess payments. The base amount for determining whether severance would equal or exceed the golden parachute limit is the individual’s average compensation over the five preceding taxable years. Essentially, this will be the average of base pay, plus bonus and compensation from option exercises and the vesting of restricted stock, less deferred compensation amounts, for the five preceding taxable years.

SEO employment contracts should be reviewed closely and tallies undertaken to determine whether current arrangements would exceed the golden parachute cap for payments on account of an ordinary severance, i.e., an involuntary termination of employment or constructive termination for good reason (without regard to a change in control). Overall severance amounts promised under existing contracts easily could exceed the golden parachute cap. Although it rarely is the case that basic severance will be determined by a three times multiple of base pay plus annual incentive, it is not uncommon for basic severance to be supplemented by additional severance constituting a pro rata bonus for the year in which termination occurs, accelerated vesting of options and the extension of the option exercise period, accelerated vesting in other equity compensation previously awarded (such as performance-based and time-vested restricted stock or stock units), and employer-paid continuation health coverage. When these are valued and added to the basic severance, the currently promised severance amount easily could exceed the golden parachute cap. A cut back would be the institution’s only option. Executives are likely to want to know the magnitude of any such potential cut back, now, for potential future planning (such as option exercises).

Many executive contracts currently have golden parachute tax gross-up provisions, and with respect to benefits that vest, are enhanced or paid based just on the change in control (i.e., singletrigger benefits), those gross-ups still can be applied. A double-trigger, such as change in control severance, seemingly would require the elimination of the gross-up and imposition of a cap. This may encourage a move from a double-trigger severance to a single-trigger payment in lieu of severance.

Incentive Pay Criteria Audit.

In undertaking an incentive pay criteria audit to ensure that the performance criteria do not encourage unnecessary and excessive risk taking, the compensation committee is required to review the criteria with the institution’s senior risk officers. In addition, after limiting problematic provisions, eliminating offensive provisions and certifying the audit, the institution, if publicly traded, is required to include the certification in its Compensation Discussion and Analysis (CD&A) in its proxy, and, if a private institution, must file the certification with its primary regulatory agency. Currently, there is no requirement that the audit itself be described in the proxy or in any other public document, or that the institution make public the changes prompted by the audit. However, for those public companies participating in the capital purchase program, investors may draw conclusions from the description provided by in next year’s CD&A regarding changes in its incentive compensation practices. After becoming a participant in the program, this audit must be undertaken annually.

An institution engaging in an audit would be well advised to enlist the services of a compensation consultant to review its incentive pay criteria. Even fairly routine criteria such as total shareholder return might be viewed as potentially encouraging unnecessary risk. Companies that base incentives on year over year increases in total shareholder return could be seen as focusing the efforts of its senior executive officers on increases in the companies stock price. Stock price increase by any means necessary could result in unnecessary and excessive risk.

Claw-back.

The claw-back requirement, that the company recover amounts paid based on materially inaccurate criteria, should come as no surprise. This kind of provision has been gaining traction among publicly traded companies, and one could argue that prior to the explicit inclusion of a claw-back in certain employment contracts recovery would have been the required remedy in any event where a company has mistakenly paid incentive compensation. Nevertheless, the rule has now been articulated and codified in a more expansive manner than under section 304 of Sarbanes-Oxley. Unlike the Sarbanes-Oxley restriction, there is no limit on the recovery period and, unlike the Sarbanes-Oxley provision, this claw-back applies to private financial institutions as well as public ones, and to all SEOs (not just the Chief Executive Officer and the Chief Financial Officer). The EESA claw-back only relates to amounts paid during the period Treasury holds an equity or debt positions in the financial institution.

Amended Section 162(m).

Bank of America, Wells Fargo, Bank of New York Mellon, and Citigroup, just to name a few financial institutions, will be impacted by the new Section 162(m) rules. Under section 162(m)(5), applicable compensation payable to a covered executive at a financial institution in excess of $500,000 is nondeductible to the employer. Base salary alone from

2007 for the named executive officers of the listed banks exceeded $500,000. New section 162(m)(5) takes into account all compensation attributable to services performed during a taxable year. Furthermore, in a stunning departure from the rules as they existed prior to EESA, under section 162(m)(5) deferred compensation received after the individual ceases to be a covered executive counts towards the limit as does performance-based compensation, such as employer stock options granted with an exercise price of fair market value under a shareholder approved plan. If current pay practices continue, large swatches of SEO compensation are likely to become nondeductible to the employer. It remains to be seen whether the new section 162(m)(5) results in smaller compensation generally for financial institution executives, and, if not that, smaller incentive compensation, i.e., bonuses and grants of options and other equity compensation that would vest or otherwise be based on the performance of services during the period Treasury holds its interest in institutions under the capital purchase program.

An institution should review its top five (5) executives’ compensation packages to determine whether the executives’ compensation will exceed $500,000 (both now and in the future). Such a review will be necessary even if the institution has never needed to perform such a review previously under Code Section 162(m) because it was neither public nor a corporation. The new limitation applicable to these financial institutions under section 162(m) covers both publicly traded and private institutions, and even non-corporate entities such as partnerships and trusts. Particular attention should be paid in such a review to items such as deferred compensation (for the year in which a deduction would otherwise be permitted), commissions, stock options, SARs, and other performance based compensation that normally would not be included for purposes of Code Section 162(m).

After completing a review and determining whether or not a financial institution will lose compensation deductions with respect to executive remuneration and deferred executive remuneration for its top five executives, an institution should assess whether such lost deductions will have a significant value to the institution. For example, the lost deductions may be relatively small in the context of the institution’s overall tax liabilities or the institution may have more deductions than it can effectively apply in the near term. Some institutions may find little to no practical financial harm to the loss of the deductions.

Mergers and Acquisitions.

If an unrelated institution (not itself a participant in any TARP program) purchases a capital purchase plan institution, the buyer will not become subject to the executive compensation restrictions. Executives at the target company cease to be covered by the SEO executive compensation restrictions as of the first anniversary of the transaction close.