Congress passes $700 billion financial relief package, which includes substantial new limitations on executive compensation paid by financial institutions that sell troubled assets to the Federal government.

The terms of the Emergency Economic Stabilization Act, approved by Congress this afternoon (October 3, 2008), imposes new limitations on the amount and type of compensation that may be paid by distressed financial institutions to its senior executives. The Act applies only to those financial institutions that sell troubled assets to the Federal government under the terms of the Act. The nature and extent of the executive compensation restrictions largely depend on whether the government acquires the troubled assets from the financial institution through an auction purchase or through a direct purchase not involving an auction process.

Direct Purchases

A Financial Institution (defined below) must adopt the following executive compensation standards if the government purchases any Troubled Assets (defined below) from the institution without any bidding or auction process and receives a meaningful equity or debt position in the Financial Institution:

  • Incentive Pay. The compensation payable by a Financial Institution to its Senior Executives (defined below) must not incentivize its Senior Executives “to take unnecessary and excessive risks that threaten the value of the financial institution.”
  • Clawbacks. The Financial Institution must provide for recovery of incentive compensation paid to its Senior Executives based on earnings, gains or other criteria that are later proven to be materially inaccurate.
  • Golden Parachute Payments. The Financial Institution may not pay any Golden Parachute Payments (defined below) to its Senior Executives.

These executive compensation standards must remain in effect until the government no longer holds any debt or equity position in the Financial Institution.

Auction Purchases

The following restrictions will apply to any Financial Institution (a “Covered Institution”) that sells more than $300 million in Troubled Assets to the Federal government if at least one such sale occurs through an auction or bidding process. For purposes of applying these restrictions, a Covered Institution and its affiliates are treated as a single institution.

  • Golden Parachute Payments.
    • No Golden Parachute Payments Permitted Under New Contracts. A Covered Institution may not enter into any new employment agreement providing for any Golden Parachute Payments. Employment agreements in effect before the Financial Institution becomes a Covered Institution are not affected by this restriction.
    • Excise Tax and Loss of Tax Deduction Imposed on Golden Parachute Payments. If a Senior Executive of a Covered Institution receives Golden Parachute Payments, the Senior Executive’s severance payments in excess of his or her average taxable compensation during the preceding five years is non-deductible by the institution and subject to a 20 percent excise tax payable by the Senior Executive.

These restrictions are effective for the period beginning on the date the institution becomes a Covered Institution and ending on the date the government’s authority to purchase Troubled Assets expires. The government’s authority to purchase Troubled Assets generally expires December 31, 2009, but the Secretary of the Treasury may extend that authority to as late as the second anniversary of the date the Act is enacted.

  • Loss of Tax Deduction for Compensation in Excess of $500,000. Compensation (including deferred compensation) in excess of $500,000 that is earned in a year by a Senior Executive of a Covered Institution is non-deductible by the Covered Institution.

This deduction limitation applies to compensation earned in any taxable year beginning with the taxable year in which the institution becomes a Covered Institution and ending with the taxable year in which the government’s authority to purchase Troubled Assets expires, without regard to when such compensation is actually paid to the Senior Executive. Thus, deferred payments of excess amounts earned while the $500,000 cap is in effect will remain non-deductible even if the payment is not made until years after the government’s authority to purchase Troubled Assets has expired.

Definitions

Financial Institution: Financial Institution means any bank, savings association, credit union, security broker or dealer or insurance company established or regulated, and having significant operations, in the United States (excluding foreign central banks or any institution owned by a foreign government).

Golden Parachute Payments: A Senior Executive will be treated as receiving (or being entitled to receive) Golden Parachute Payments under the Act if the Senior Executive receives (or is entitled to receive) severance payments due to his or her involuntary severance from employment or in connection with the Covered Institution’s bankruptcy, liquidation or receivership if the present value of the severance payments paid or payable to the Senior Executive equals or exceeds three times the average annual taxable compensation the Senior Executive received during the five-year period preceding his severance from employment.

Senior Executive: The executive compensation restrictions applicable to auction purchases (as described above) apply to any person who was a CEO or CFO of the Financial Institution at any time during the taxable year or one of the three other highest-paid executive officers whose compensation is reportable under the SEC’s executive compensation disclosure requirements (or, their counterparts in any privately-held institution). The restrictions applicable to direct purchases (as described above) apply only to the five highest paid executive officers of the Financial Institution. Note that it is possible for an executive officer to be subject to one set of executive compensation restrictions but not the other set. For instance, if a Financial Institution sells Troubled Assets in both auction purchases and direct purchases, it is possible that the institution’s CFO may not be one of the five highest-paid officers. Should that be the case, the auction sale restrictions would apply to the CFO, but the direct sale restrictions would not.

Troubled Assets: Troubled Assets are only residential or commercial mortgages and securities, or other financial instruments related to the mortgages. Under certain circumstances, however, troubled assets may include other financial instruments.