On Friday, October 3, 2008, the President signed into law the Emergency Economic Stabilization Act of 2008 (“EESA”). Commonly referred to as the “bailout” legislation, this law gives authority to the U.S. Department of the Treasury (“Treasury”) to establish the Troubled Asset Relief Program (“TARP”). Through the TARP, Treasury is authorized to purchase from financial institutions up to $700 billion of residential or commercial mortgages, and any mortgage-related securities, obligations or other instruments that were originated or issued on or before March 14, 2008 (these mortgages and related securities are generally referred to in EESA as “troubled assets”). The TARP provides two methods by which Treasury may purchase troubled assets. When there are no bids for a troubled asset or when there is no market for a particular asset, Treasury can purchase the troubled asset directly from the financial institution so long as it also receives a “meaningful” equity position in the financial institution. When meaningful bids or a market exists for a troubled asset, Treasury can purchase the troubled asset at the lowest auction price.

In response to concerns that the bailout could enrich the executives of the financial institutions that take advantage of the TARP, EESA includes several provisions that are designed to rein in the compensation practices of participating financial institutions as they relate to their senior executives, and to limit the tax deductions under Sections 162(m) and 280G of the Internal Revenue Code of 1986, as amended (“Code”), that participating institutions can receive for compensating their executives. As discussed below, the application of these compensation provisions will depend on how the sales to Treasury are made and the value of the troubled assets that are sold. These provisions apply equally to public and private companies.

Executive Compensation Limitations

Direct Sales

If a financial institution sells any assets directly to Treasury and Treasury receives “a meaningful equity or debt position in the financial institution,” the financial institution must meet “appropriate standards for executive compensation and corporate governance” for as long as Treasury holds the equity or debt position. These appropriate standards include:

  • Limits on the incentive compensation arrangements that would encourage senior executives to take “unnecessary and excessive risks that threaten the value of the financial institution” 
  • A provision for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer as a result of financial reports that are later proved to be “materially inaccurate” 
  • A prohibition on golden parachute payments to senior executive officers during the time that Treasury holds the equity or debt position

Auction Sales

If a financial institution sells more than $300 million of troubled assets to Treasury through any combination of TARP auctions and direct purchases, the financial institution will be prohibited from entering into any new employment agreement with a senior executive officer that provides a golden parachute payable in the event of an involuntary termination, bankruptcy filing, insolvency or receivership. This prohibition would continue for as long as the TARP remains in effect. Currently, the TARP is effective through December 31, 2009, but it is subject to extension through October 3, 2010.

For purposes of these rules, the term “senior executive officer” is defined to mean the top five most highly paid executive officers of a public company whose compensation is required to be disclosed pursuant to the requirements of the Securities Exchange Act of 1934, as amended. A private company would apply these same principals when determining which of its senior executive officers are covered by EESA.

Amendments to the Tax Code

$500,000 Limitation under Section 162(m)

Section 162(m) of the Code imposes a $1 million limit on the deductibility of compensation paid to certain executive officers of public corporations. Under EESA, the $1 million cap is reduced to $500,000 for any financial institution, corporate or otherwise, that sells more than $300 million of troubled assets to Treasury through any combination or auctions or direct purchases. In addition, the exception for qualified performance-based compensation (e.g., equity and incentive-based compensation pursuant to shareholder approved plans) will not apply, and the income from such items will count toward the $500,000 limitation. This reduced limitation would remain in effect as long the TARP remains in effect.

Taxation of EESA Golden Parachute Payments

Sections 280G and 4999 of the Code provide for a deduction limit and 20 percent excise tax that are applicable to excess parachute payments after a change in control. EESA extends the deduction limit and 20 percent excise tax to payments received by a covered executive at a participating financial institution by reason of an involuntary termination by the financial institution, bankruptcy filing, insolvency or receivership of the financial institution without regard to whether a change of control occurs (“EESA Golden Parachute Payments”). These amendments to Section 280G specifically provide that the amount treated as an EESA Golden Parachute Payment cannot be reduced by amounts that are considered reasonable compensation as allowable in the change-in-control context. The amendments to Sections 280G and 4999 apply to any financial institution that sells more than $300 million of troubled assets to Treasury through any combination or auctions or direct purchases, and remain applicable as long as the TARP remains in effect.

These amended tax provisions apply only to “covered executives.” The term “covered executives” is defined to mean a company’s chief executive officer, chief financial officer and its three other most highly compensated officers as determined using the disclosure requirements of the Securities Exchange Act of 1934.

Open Issues and Implications

Future Regulations

EESA does not define many terms, including “involuntary termination,” “golden parachute,” “meaningful equity or debt position,” “appropriate standards for executive compensation and corporate governance,” and “unnecessary and excessive risks.” However, Congress provided the Secretary of Treasury broad authority to issue regulations to “carry out the purposes” of the tax provisions of EESA and to presumably answer many of the open questions raised by these new provisions, including the undefined essential terms and phrases. Moreover, Section 111 of EESA only states that the executive compensation limitations must include the items set forth in the statute, but does not limit Treasury from imposing other limitations or restrictions. It is unclear whether the limitations set forth in the statute will be the only executive compensation rules issued under EESA.

Impact on Executives

There is widespread concern that participating financial institutions that have to amend their compensation programs to comply with EESA will be less attractive employers and may lose executives or have difficulty attracting executive talent. In addition, these restrictions may have a wider impact on the industry in general to the extent other non-participating financial institutions adopt similar policies.

Review Compensation Issues Now

It is unclear whether a financial institution will be required to amend its compensation agreements to comply with EESA before the institution can participate in the TARP, or whether these prohibitions will apply retroactively to agreements that are currently in place. Financial institutions that are considering participation in the TARP must look at their compensation arrangements immediately, including severance and other deferred compensation, gross-up payments, and incentive compensation to evaluate the impact of the changes to Sections 162(m) and Sections 280G of the Code on the financial institution and its executives. If an institution determines that its employment agreements require amendment, it will take time for counsel to prepare amended agreements and for the institution to receive any necessary Compensation Committee approvals. It is important to note that the amended tax provisions in EESA do not have a customary transition period.

Don’t Forget About Form 8-K and Proxy Statement Disclosure

For public companies, the material amendment of executive compensation arrangements may be reportable on Form 8-K within four business days after the amendment’s execution. In addition, amendments to employment agreements, changes to compensation programs, and the revised applicability of Sections 162(m) and 280G of the Code will require disclosure in the upcoming proxy statement both in the narrative and in the tables, particularly in the potential payments upon termination or change-in-control table.

These Executive Compensation Restrictions Could be a Model for Future Legislation

There has been growing support for federal legislation that would limit executive compensation or reduce incentives (like tax deductibility) applicable to all executive compensation. It is possible that the limitations and restrictions set forth in EESA could be used as a model for comprehensive executive compensation reform legislation.