The newly enacted Emergency Economic Stabilization Act of 2008 (“EESA”) imposes significant new tax and non-tax limitations on compensation arrangements for senior executives at banks and thrifts that participate in the Treasury Department’s Troubled Asset Relief Program (“TARP”). These limitations vary depending on the nature of the assistance sought by, or extended to, the institution. It should be emphasized that the rules for executive compensation have not changed for institutions that do not participate in the various EESA or related Treasury programs. While existing regulatory limitations on compensation that apply to troubled institutions or constraints based on other safety and soundness concerns remain in place, the new rules apply only if the institution elects assistance under an EESA program or takes advantage of Treasury’s Capital Purchase Program. 

The following provides a brief guide as to how these limitations apply under the various Treasury programs. We caution, however, that the analysis below is subject to change based on further guidance issued by Treasury over the coming days and weeks as the fast moving evolution of the assistance program continues.

Scope of the Restrictions

The tax and non-tax limitations will generally affect an institution’s Chief Executive Officer, Chief Financial Officer and the next three most highly compensated officers (“covered officer(s)”). The rules cover both public and private institutions. The determination of the three most highly compensated officers is made according to the requirements of federal securities regulations governing disclosure of executive compensation.

Troubled Asset Auction Program

Non-Tax Restrictions

Under EESA, financial institutions that sell more than $300 million in troubled assets to the government in Treasury’s forthcoming reverse auction program may not, for the duration of the program, enter into new contracts with covered officers that provide for golden parachute payments. Golden parachute payments are defined as payments in the nature of compensation made as a result of severance from employment to the extent such payments equal or exceed an amount equal to three times the executive’s “base amount” – i.e., three times the average of the executive’s taxable compensation over the five completed taxable years preceding the executive’s termination of employment.

Severance payments covered by this restriction are payments received by a covered officer by reason of an involuntary termination of the executive by the employer or in connection with a bankruptcy, liquidation, or receivership of the employer. Involuntary termination includes voluntary termination for good reason due to a material negative change in the executive’s employment relationship and voluntary termination where the facts and circumstances indicate that the employer would have terminated the executive had the executive not voluntarily terminated.

There is no requirement for institutions that participate in the reverse auction program to modify existing employment contracts to eliminate golden parachute payments, although the tax consequences of such payments may motivate participating institutions to do so. It is important to note that a contract that is renewed is treated as entered into on the date of the renewal and that if a contract is materially modified, it is treated as a new contract entered into as of the date of the material modification.

Tax Restrictions

EESA made two major changes to the tax treatment of executive compensation. One change relates to Internal Revenue Code §162(m), which limits the deductibility of compensation paid to certain corporate executives. The other change is to §280G and §4999, which provide that a corporate executive’s “excess parachute payments” are not deductible and impose an excise tax on the executive for those amounts. The tax changes imposed by EESA are applicable to auction program participants that sell more than $300 million in troubled assets to the Treasury. These changes apply for the tax years that include any portion of the period that the TARP program is in place. Under EESA, the authority of Treasury to administer TARP expires on December 31, 2009, but may be extended to October 3, 2010.

As a result of the change to §162(m), covered institutions may not deduct in excess of $500,000 in compensation paid to a covered officer. This limit works differently than the existing $1 million limit on the deductibility of certain executive compensation, as there is no exception for performance-based compensation.

The legislation has also extended the golden parachute rules under §280G that apply in a change-in-control context to cover severance payments received by a covered officer by reason of an involuntary termination of the executive by the employer or in connection with a bankruptcy, liquidation, or receivership of the employer. If the severance payments equal or exceed three times the covered officer’s base amount, then (i) the institution cannot deduct any amount of the payment in excess of the executive’s base amount and (ii) the covered officer is subject to an additional 20% excise tax on the excess payment.

Capital Purchase Program

Institutions that receive an infusion of equity capital under the Capital Purchase Program announced by Treasury on October 14th will be subject to the executive compensation and corporate governance standards specified in EESA. These standards include: (a) limits on compensation that exclude incentives for covered officers of financial institutions to take unnecessary and excessive risks that threaten the value of the financial institution; (b) required recovery of any bonus or incentive compensation paid to a covered officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate; (c) prohibition on the financial institution from making any golden parachute payment to any covered officer during the period that the Treasury holds an equity or debt position as it applies to participants in the TARP auction program; and (d) agreement to not claim a federal income tax deduction for executive compensation that would not be deductible under §162(m) as it applies to participants in the TARP auction program. These standards apply while the Treasury holds an equity or debt position in the financial institution.

In order to comply with the requirement to exclude incentives to take unnecessary and excessive risks, a financial institution must comply with the following rules: (1) within 90 days after the purchase under the Capital Purchase Program, the financial institution’s compensation committee, or a committee acting in a similar capacity, must review the covered officers’ incentive compensation arrangements with the institution’s senior risk officers, or other personnel acting in a similar capacity, to ensure that the covered officers’ incentive compensation arrangements do not encourage those officers to take unnecessary and excessive risks that threaten the value of the financial institution; (2) thereafter, the compensation committee must meet at least annually with senior risk officers to discuss and review the relationship between the financial institution’s risk management policies and practices and the covered officers’ incentive compensation arrangements; and (3) the compensation committee must certify that it has completed the reviews of the incentive compensation arrangements required under (1) and (2) above. Public companies must include the certification with the Compensation Discussion and Analysis required by federal securities regulations. Other companies must file the certification with their primary regulator.

The clawback requirement under EESA goes further than the similar requirement that currently exists under the Sarbanes-Oxley Act in that it applies to the three most highly compensated executive officers in addition to the principal executive officer and the principal financial officer; applies to both public and private financial institutions; is not exclusively triggered by an accounting restatement; does not limit the recovery period; and covers not only material inaccuracies relating to financial reporting but also material inaccuracies relating to other performance metrics used to award bonuses and incentive compensation.

Treatment of Existing Employment Contracts and Compensation Arrangements

As a condition to the closing of the sale of preferred shares to Treasury under the Capital Purchase Program, a participating financial institutions must modify or terminate all benefit plans, arrangements and agreements to the extent necessary to be in compliance with the EESA’s executive compensation and corporate governance requirements. Specifically, employment agreements should be modified to limit any severance payment so that no golden parachute payments are made. Change in control agreements may also need to be revised to prevent golden parachute payments. Many employment and change in control agreements already impose a similar limit on severance payments made in the context of a change in control. In addition, employment agreements and other compensation arrangements should be modified to specify that any incentive compensation based on materially inaccurate financial statements or other performance metrics will be subject to recovery by the institution.

As an additional condition to closing, the participating institution and its covered officers must grant Treasury a waiver from any claims that they may have as a result of the issuance of any regulations that modify the terms of any benefit plan, agreement or arrangement to eliminate any terms that would not be in compliance with the executive compensation and corporate governance standards of EESA.

As discussed above, financial institutions that sell over $300 million of troubled assets in the reverse auction procedure will not be required to amend existing employment contracts, but any new, renewed or modified agreements must prohibit golden parachute payments. 

Institutions That Receive Direct Assistance

The harshest restrictions will apply to failing institutions that receive financial assistance from the Treasury in the form of a direct acquisition of troubled assets outside of the auction program. These institutions will be subject to the same standards that apply to participants in the Capital Purchase Program, with one significant difference. In situations where Treasury provides assistance under the systemically significant failing institutions program, the golden parachute restriction is defined more strictly to prohibit any payments to departing covered officers.