Despite numerous reports yesterday that the final version of HR 1, the American Recovery and Reinvestment Act of 2009 (ARRA), would not contain new TARP executive compensation limits, the conference agreement – which has now passed the House and is on the way to the Senate – does indeed impose new restrictions on any institution that has received or will receive TARP funds. It appears that these new executive compensation measures were included in the bill at the insistence of Senate Banking Committee Chairman Christopher Dodd (D-CT), reflecting broader Congressional displeasure over Wall Street compensation practices and Treasury's somewhat less stringent executive compensation rules announced last week.

TARP recipients that no longer find the deal attractive will be permitted to repay the assistance without regard to whether the financial institution has obtained replacement Tier 1 capital and without regard for any waiting period, but must first consult with the appropriate banking regulators before returning funds. This “free out” is helpful for TARP recipients that now find the terms of the deal unacceptable; of course, it is not really free, as companies who received funds have incurred transactions costs and some funds have already been expended. Also repayment of Treasury's investment will require approval from an institution's primary regulator, which cannot be assured.

The provision re-writes Section 111 of the Emergency Economic Stabilization Act (EESA), which was the original basis of the TARP standards. These new standards will apply regardless of the particular assistance program. Treasury also has the authority to impose additional restrictions.

Following is a summary of the standards that apply to all TARP participants under the ARRA. For purposes of the new limits, “senior executive officer” (SEO) is defined in a similar manner as previously, and means the top 5 most highly paid officers as required to be disclosed for proxy purposes (and non-public company counterparts). Also, the $500,000 limit on deductibility of SEO compensation continues to apply.

  • Prohibition on bonus, retention awards and incentive compensation. TARP participants may not pay or accrue any bonus, retention award, or incentive compensation during the period in which any obligation arising from TARP financial assistance remains outstanding, except that this prohibition does not apply to a payment of long-term restricted stock by the TARP participant, provided that the award:
    • does not fully vest during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding,
    • has a value that is not greater than one-third of the total amount of annual compensation of the employee receiving the stock; and
    • is subject to such other terms and conditions as the Secretary of the Treasury determines to be in the public interest.

The number of persons to whom this prohibition applies depends on the amount of financial assistance the TARP participant has received. If the amount of the financial assistance received is:

  • less than $25 million, the prohibition applies only to the participant's most highly compensated employee;
  • $25 million or greater but less than $250 million, it applies to at least the five most highly-compensated employees (or such higher number as the Secretary of the Treasury determines to be in the public interest with respect to the TARP participant);
  • $250 million or greater but less than $500 million, it applies to the SEOs and at least the 10 next most highly-compensated employees (or such higher number as the Secretary of the Treasury determines to be in the public interest with respect to the TARP participant);
  • $500 million or more, it applies to the SEOs and at least the 20 next most highly-compensated employees (or such higher number as the Secretary of the Treasury determines to be in the public interest with respect to the TARP participant).

This prohibition does not apply to any bonus payment required to be paid pursuant to any written employment agreement executed on or before February 11, 2009, as such valid employment contracts are determined by the Secretary of the Treasury.

It is important to note that these limitations apply to institutions' most highly compensated "employees," not just executive officers. Since traders and other non-executive-officer employees often earn bonuses that can far exceed amounts paid to executive officers, these new restrictions may lead to an unanticipated exodus of talented employees to institutions that have not received government assistance.

  • Prohibition on golden parachute payments. TARP participants may not make any golden parachute payment to an SEO or any of the next five most highly compensated employees during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding. A "golden parachute payment" is defined to mean "any payment to a senior executive officer for departure from a company for any reason except for payments for services performed or benefits accrued.” Unlike the rule that applied under the Capital Purchase Program (CPP) guidance, this restriction applies to any severance payments, not those payable only due to involuntary termination. In addition, the “three times base compensation” safe harbor under the CPP rule no longer appears to apply.
  • Prohibition on risky compensation. TARP recipients must prohibit compensation that provides incentives for SEOs to take unnecessary and excessive risks that threaten the value of the institution during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding.
  • Claw back. TARP participants must provide for the return of any bonus, retention award, or incentive compensation paid to an SEO and any of the next 20 most highly compensated employees based on statements of earnings, revenues, gains, or other criteria that are later found to be materially inaccurate.
  • No incentive to manipulate earnings. A TARP participant may not have any compensation plan that would encourage manipulation of the reported earnings of the TARP participant to enhance the compensation of any of its employees.

In addition to these restrictions, the following requirements also apply:

  • The CEO and CFO must certify that the institution has complied the TARP requirements.
  • The institution must establish a board compensation committee, comprised entirely of independent directors, to review employee compensation plans. This committee is to meet at least semi-annually. In the case of TARP participants that are not publicly-traded and which have received less than $25 million in financial assistance, this review and evaluation may be performed by the participant's board of directors.
  • The Board must adopt a company-wide policy regarding "excessive" or "luxury" expenditures, addressing such items as entertainment or events, office and facility renovations, aviation and other transportation services, and other activities or events that are not reasonable expenditures for staff development, reasonable performance incentives, or other similar measures conducted in the normal course of the participant's business operations.
  • The institution must permit a non-binding shareholder “say on pay” resolution. The SEC is required to promulgate rules to implement this requirement within one year of the date of enactment.

In addition to the general retroactive effective date, Treasury is directed to review the bonuses, retention awards, and other compensation of the SEOs and the next 20 most highly compensated employees of any TARP participant that received financial assistance before the date of enactment of the ARRA to determine whether any such payments were inconsistent with the purposes of the ARRA, TARP or were otherwise contrary to the public interest. If the Secretary determines that any of these payments were not appropriate, he is to seek to negotiate with the TARP participant and the affected employee for appropriate reimbursements to the Federal government.

Where do we go from here?

In terms of TARP recipients, after the bill clears the Senate, President Obama is expected to sign the bill on President’s Day. Treasury guidance on the new standards hopefully will be forthcoming soon. Much of the guidance Treasury issued as interim final regulations under EESA will need to be revised. Treasury may have a head start to the extent that some of the new requirements are consistent with the standards President Obama and the Treasury had previously announced.

There will be more to come, however, in the overall realm of executive compensation. It remains to be seen how much of the TARP provisions will carry over into general rules for all companies.