Earlier today, October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into law. EESA generally provides the US Department of the Treasury (“Treasury”) with sweeping authority to purchase up to $700 billion of unsound financial assets held by banks and other financial firms that played a part in disrupting the global credit and other financial markets.
Under the Troubled Asset Recovery Program (the “TARP”) created by EESA, Treasury is authorized to buy certain troubled mortgage-related instruments from affected institutions at the lowest possible price through an auction. Where no bidding or market prices are available, Treasury may purchase the troubled assets directly from a financial firm that, in turn, provides the government with an equity stake in the selling institution. Treasury’s authority may extend in various circumstances to the assets of tax-qualified retirement plans and certain other similar arrangements. Treasury’s purchasing authority terminates on December 31, 2009, unless extended by Congress to a date not later than October 3, 2010.
A number of EESA provisions intended to rein in executive compensation of firms participating in the TARP were identified by key members of Congress as critical to garnering support for the law’s enactment. Also included is an unrelated provision that may particularly affect the compensation arrangements of certain investment funds using offshore entities.
Summary of Executive Pay Limitations
EESA places limits on executive pay for certain financial firms that sell troubled assets to Treasury. Various executive pay restrictions may apply to a financial firm and its top five executives officers, depending on the dollar amount of troubled assets sold to Treasury and the method of such sales.
If a financial firm sells more than $300 million of troubled assets to Treasury exclusively through one or more auctions, the following constraints will apply to the top five executives and the firm:
- The firm will lose a deduction for pay above $500,000 for any applicable tax year; and
- EESA’s “golden parachute” provisions will (i) impose a 20% excise tax on certain severance payment received by covered executives while the firm forfeits a deduction for such payments; and (ii) any new employment contract entered into between the firm and any of its top five executives must not provide for golden parachutes payable in connection with the executive’s involuntary termination or the firm’s financial instability.
If a financial firm either sells troubled assets to Treasury through (i) direct sales only (without regard to any dollar amount) or (ii) a combination of direct sales and auction sales that are in the aggregate less than $300 million, then the following constraints will apply to the top five executives and the firm:
- The firm must eliminate any incentives that encourage such executives to take unnecessary and excessive risks that threaten the value of the financial institution;
- The firm must recoup any incentive compensation that was paid to such executives based on financial reports that are later proven to be materially inaccurate; and
- Such executives are prohibited from receiving golden parachutes payable in connection with their involuntary termination or the firm’s financial instability.
If a financial firm sells more than $300 million of troubled assets to the Treasury through a combination of auctions and direct sales, then all of the restrictions discussed above shall apply. As discussed below, the new golden parachute tax provisions may effectively be moot in this situation.
If a financial firm sells $300 million or less of troubled assets to the Treasury exclusively through one or more auction purchases, then no executive compensation restrictions will apply.
The following table illustrates these provisions.
Existing $1 Million Deduction Cap. Section 162(m) of the Internal Revenue Code of 1986 (the “Code”) generally imposes a $1 million cap on the deductibility of compensation paid to certain executive officers by a public corporation, unless an exception applies. One important exception is for qualified “performance-based compensation.” The deduction limitation generally does not apply to deferred compensation that is paid after the executive has ceased to be covered by Section 162(m).
New $500,000 Deduction Cap. Under EESA, the Section 162(m) deduction limit is reduced to $500,000 for affected financial firms, whether publicly or privately held, or incorporated or unincorporated, that sell over $300 million of troubled assets to Treasury through one or more auctions (or a combination of auctions and direct sales). The existing exceptions from Section 162(m), including the exception for qualified performance-based compensation, will not apply under the new rules. The limit applies to a taxable year in which the $300 million threshold is first exceeded and any subsequent taxable year in which Treasury is authorized to purchase troubled assets (“applicable taxable years”). Generally, all corporations in the same controlled group are treated as a single financial firm for purposes of determining whether an executive’s compensation received from any members of the controlled group exceeds the $500,000 deduction limit, and whether the troubled asset sales to Treasury exceed the $300 million threshold.
Persons Covered. The reduced cap on deductions is limited to “covered executives.” A covered executive is any individual who serves as the CEO or CFO at any time during the portion of the taxable year that includes Treasury’s authorized purchase period. The deductibility cap also applies to any executive who (i) is one of the three highest compensated officers (other than the CEO or CFO) determined on the basis of the executive compensation disclosure rules applicable to reporting companies (without regard to whether those rules actually apply to the financial firm), and (ii) is employed during any portion of the taxable year that includes the authorized purchase period. In a departure from existing law, a covered executive will maintain this status for all subsequent taxable years for purposes of the special rule discussed below regarding deferred compensation.
Special Rule for Deferred Compensation. A special rule applies to compensation related to services performed by a covered executive during an applicable taxable year, which becomes deductible in a later taxable year, as in the case of nonqualified deferred compensation. Under this rule, any unused portion of the $500,000 limit for the applicable taxable year is carried forward until the year in which the compensation is otherwise deductible, and applied to the compensation. The following examples are based on those given in EESA’s legislative history:
Example 1: Illustrates deferred compensation earned in an applicable taxable year and paid in a later taxable year. Assume a covered executive is paid $400,000 in cash salary by an applicable employer in 2008 (an applicable taxable year) and the covered executive earns $250,000 in nonqualified deferred compensation payable in 2015. The full $400,000 in cash salary is deductible under the $500,000 limit in 2008. In 2015, the employer’s deduction with respect to the $250,000 will be limited to $100,000, which represents the unused portion of the $500,000 limit from 2008. (while being denied a deduction for the remaining $150,000 of nonqualified deferred compensation earned in 2008).
Example 2: Illustrates deferred compensation earned in one applicable taxable year and paid in another applicable taxable year. Assume the same facts as Example 1, except that the nonqualified deferred compensation is deferred until 2009 (also an applicable taxable year) and the covered executive is paid $500,000 in cash salary in 2009. As in the example above, the employer’s deduction for the $250,000 of nonqualified deferred compensation paid in 2009 (related to services performed in 2008) would be limited to $100,000. The entire $500,000 of cash salary earned in 2009 would also be deductible. In 2009, the employer may deduct $600,000 (while being denied a deduction for the remaining $150,000 of nonqualified deferred compensation earned in 2008).
Example 3: Illustrates deferred compensation earned in a taxable year and paid in an applicable taxable year. Assume the same facts as Example 1, except that the covered executive also receives in 2008 a payment of $300,000 in nonqualified deferred compensation that was attributable to services performed in 2006. Only the $400,000 cash salary paid in 2008 will be subject to the new $500,000 limit. Accordingly, the employer may deduct $700,000 in 2008 (consisting of $300,000 of nonqualified deferred compensation earned in 2006 that is not subject to the limit and $400,000 of base salary earned in 2008). In addition, the deduction of $100,000 may be carried forward to a future year and applied to the nonqualified deferred compensation attributable to services performed in 2008.
It remains to be seen whether the deduction limitation will result in controls on executive compensation, or a loss in tax deductions which could ultimately have the effect of hurting the financial firm and its shareholders. Experience with existing Section 162(m) illustrates that either alternative is possible in any particular case. It also remains to be seen whether any of the new rules will eventually be extended by Congress under Section 162(m) generally.
Section 280G of the Code generally provides for punitive excise taxes on executives and losses of deductions for employers in the case of certain excess “parachute payments” contingent on a change in control. For the first time, this existing golden parachute regime has been expanded in its application outside the realm of a corporate change in control.
Tax Provisions. EESA modifies Section 280G to impose limits on severance payments made to the covered executives of a financial institution on account of such executives’ involuntary termination or the firm’s bankruptcy filing, liquidation or receivership during an applicable taxable year. For this purpose, the terms “covered executive” and “applicable taxable year” have the same meaning as under the modifications to Section 162(m) of the Code (described above).
In situations where Treasury purchases more than $300 million of troubled assets through auction purchases from a financial firm, the excess parachute payment, as determined under Section 280G for these purposes, are nondeductible by such firm. In addition, an excise tax is imposed on the recipient of any excess parachute payment equal to 20% of the amount of such payment. These tax consequences apply to parachute payments triggered by an applicable termination of employment during Treasury’s authorized purchasing period. It is not immediately clear how terminations for so-called “good reason” and other similar constructive terminations will be treated under EESA.
We note that, in a case where more than $300 million in troubled assets are sold under the TARP through a combination of auctions and direct purchases, the 20% excise tax and loss of deduction for excess parachute payments may effectively be moot. This result arises because it is possible that the prohibitions (discussed below) on making any golden parachute payments, in the case of direct purchases under the TARP, may ultimately operate to prohibit excess parachute payments altogether.
Yet again, it is unclear whether these provisions will act to rein in executive pay or will result in additional costs for affected financial firms and their shareholders. As there might be constitutional or other infirmities to unilaterally imposing restrictions on an executive which are inconsistent with the firm’s contractual obligations, firms that are considering participating in the TARP may wish to (i) review their existing contractual obligations for any provisions which could be inconsistent with EESA’s requirements and (ii) exercise care regarding the establishment of any new contractual arrangement which could run afoul of EESA.
Prohibited Golden Parachute Payments. If Treasury acquires troubled assets through direct purchases from a financial firm and obtains an equity position in such firm, then Treasury is to impose standards which prohibit the financial firm from making any golden parachute payments to its covered executives. This restriction is applicable during the period Treasury holds an ownership interest in the financial firm.
In situations where Treasury purchases more than $300 million of troubled assets through auction purchases from a financial firm, EESA also prohibits covered financial firms from entering into new employment contracts with any covered executive which provide for parachute payments.
Notably, the statute does not define golden parachute payments, and it remains to be seen how broadly Treasury will interpret the scope of which such payments are prohibited under EESA. In addition, under EESA, Treasury is to provide further guidance regarding the interplay of a severance payment that is treated as a golden parachute under both the existing “change in control” and the new “severance” regimes of Section 280G.
Limitations on Incentive Pay
In situations where Treasury purchases troubled assets from a financial firm through direct purchases, such firm must eliminate any incentives that encourage its top five executive officers to take “unnecessary and excessive risks” that threaten the value of the financial institution. This restriction applies during the period Treasury holds an equity position in the financial firm.
The provision is intended to prevent financial firms from taking irresponsible risks that may fail while the government has a stake in the firm. However, EESA does not define the phrase “unnecessary and excessive risk.”
If Treasury purchases troubled assets directly from a financial firm, any bonus or incentive awards paid to the top five executives that were based on materially inaccurate financial reports must be returned to the firm. This restriction, apparently modeled on a similar clawback provision under the Sarbanes-Oxley Act of 2002, applies during the period Treasury holds any equity position in the financial firm.
Nonqualified Deferred Compensation
One of the non-TARP provisions included in EESA would tax certain offshore deferred compensation arrangements. Under existing law, Section 457 of the Code limits deferred compensation paid by certain tax-exempt entities. New Section 457A limits deferred compensation paid by certain offshore tax-indifferent entities. Section 457A may particularly impact a number of investment funds using offshore entities. We note that there may be a number of technical and other issues under the new provision. See generally New York State Bar Assoc. Tax Section, Report on Proposed Carried Interest and Fee Deferral Legislation, pp. 100-113 (Sept. 24, 2008), 2008 TNT 87-42.
Affected institutions will want to review employment agreements and incentive compensation plans to identify any agreements or provisions that may be affected by EESA. Others in the market may be well-advised to become familiar with EESA, as Congress may well look to the new law as guidance for adopting more broadly applicable changes that shape the executive compensation landscape. White & Case stands ready to assist your company in its efforts to comply with these new rules.