United States: Stimulus Package Imposes Stringent Limits On Executive Compensation For TARP Participants

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (the "Act"), Title VII of which imposes new and more stringent limits on executive compensation for participants in the United Stated Department of Treasury ("Treasury") Troubled Assets Relief Program ("TARP") under the Emergency Economic Stabilization Act of 2008 (the "EESA"). These new restrictions apply retroactively and prospectively, to existing and new participants in the TARP Capital Purchase Program, for so long as the TARP participant retains any obligation arising from the financial assistance it received under TARP (the "Restricted Period"). Once the TARP participant has redeemed its preferred stock from Treasury, the restrictions go away — importantly, the restrictions do not apply during any period for which the federal government only holds warrants to purchase common stock of a TARP participant. In addition, Title VII of the Act permits TARP participants, with the approval of the Secretary of the Treasury (the "Secretary") and the applicable federal bank regulatory agency, to redeem its preferred stock at any time, notwithstanding the original restrictions on redemption set forth in the EESA.

Title VII of the Act replaces the original Section 111 of the EESA, entitled Executive Compensation and Corporate Governance, with a new Section 111 that, among other things:

Title VII of the Act does not affect the non-deductibility of compensation in excess of $500,000, and the new 26 U.S.C. § 162(m)(5), which was added to the Internal Revenue Code as part of the EESA to implement this deduction limitation, remains in effect.

The new restrictions in Title VII of the Act follow closely on the heels of updated guidance on TARP executive compensation matters issued by Treasury on February 4, 2009. (For further discussion of Treasury's guidance issued on February 4, 2009, which applies to financial institutions receiving assistance on and after February 4, 2009, click here.) To the extent of any inconsistencies in the recently issued Treasury guidance and previously-issued regulations concerning executive compensation matters, the provisions of Title VII will control. Treasury is required to adopt standards for the implementation of many components of Title VII, which should shed additional light on the application of these stringent new restrictions — as is usually the case, the devil will be in the details, and we will continue to monitor Treasury's implementation of these standards. For a copy of Title VII of the Act, click here.

The executive compensation restrictions set forth in Section 111 of the EESA, as amended by the Act, apply principally to a TARP participant's senior executive officers ("SEOs"), which includes those individuals who are the top five most highly paid executives of a public company, whose compensation is required to be disclosed pursuant to the Securities Exchange Act of 1934 (and related regulations), and the employee counterparts of companies the shares of which are not traded on the public markets. The amended Section 111 expands the applicability of certain of the TARP executive compensation provisions to the next 20 most highly-compensated employees in addition to the SEOs.

Under 31 C.F.R. Part 30 as presently in effect, the top five employees automatically includes the chief executive officer, the chief financial officer and the next three most highly-compensated employees of the TARP participant's controlled group of companies (which may include employees of the holding company, the financial institution and their subsidiaries). For TARP participants with securities registered with the Securities and Exchange Commission ("SEC"), the three most highly-compensated executive officers are determined according to the requirements in Item 402 of Regulation S-K (17 C.F.R. § 229.402). Privately held TARP participants must follow Item 402 in determining their highest compensated employees. At this time, we do not expect that Treasury will alter its current guidance concerning the determination of a TARP participant's most highly-compensated employees, but changes in this guidance certainly are possible.

New Standards for Executive Compensation and Corporate Governance

Under Title VII, the Secretary must require each TARP participant to "meet appropriate standards for executive compensation and corporate governance," which standards must include the following:

• Incentives must not encourage a TARP participant's SEOs to take unnecessary and excessive risks that threaten the value of the participant (same as original Section 111 of the EESA). In addition, no TARP participant may have any compensation plan that would encourage manipulation of the reported earnings of the recipient to enhance the compensation of any of its employees.

• Clawback provisions apply to any bonus or incentive compensation paid to an SEO or to any of the TARP participant's next 20 most highly-compensated employees based on statements of earnings, gains, or other performance metric criteria that are later proven to be materially inaccurate.

• Golden parachute payment restrictions will apply to the SEOs and the TARP participant's next 5 most highly-compensated employees. Title VII significantly broadens the definition of "golden parachute payment" so that the term now includes any severance payment to a covered employee, not just payments in excess of three times the employee's base salary, except that payments for services performed or benefits accrued are excluded from the new definition.

• Except for grants of restricted stock, as discussed below, a TARP participant may not pay or accrue any bonus, retention award or incentive compensation during the Restricted Period to the employees identified in the following table (or such higher number of employees as the Secretary may determine is in the public interest with respect to a particular participant). This restriction shall not prohibit any bonus payment required to be paid pursuant to a written contract executed on or before February 11, 2009. The Secretary has the right to determine whether an employment contract is valid.

TARP participants may grant long-term restricted stock to their covered highly-compensated employees provided that the stock (i) does not fully vest during the Restricted Period, (ii) has a value in an amount that is not greater than 1/3 of the total amount of annual compensation of the employee recipient, and (iii) is subject to other terms and conditions prescribed by the Secretary. Title VII does not provide any guidance on the treatment of existing long-term restricted stock grants that vest during the Restricted Period.

• Each TARP participant must establish a compensation committee of the board of directors, comprised entirely of independent directors, that meets at least semi-annually to discuss and evaluate employee compensation plans and assess any risk posed to the TARP participant from such plans. Compensation committee duties for TARP participants who receive $25 million or less can be carried out by the participant's full board of directors.

• The CEO and CFO of publicly-traded TARP participants must provide to the SEC written certifications of the participant's compliance with the TARP executive compensation restrictions, and privately-held participants must deliver such certifications to Treasury. The required certifications likely will be consistent with the certification requirements set forth in 31 C.F.R. Part 30.

Review of Prior Payments to Executives

For each TARP participant, the Secretary is required to (a) review bonuses, retention awards and other compensation paid to their SEOs and the next 20 most highly-compensated employees before the Title VII effective date (February 17, 2009), and (b) determine whether any such payments were excessive or inconsistent with the purposes of TARP or Title VII or otherwise contrary to the public interest. In the event of such a determination, the Secretary must negotiate with the TARP participant and the employee for appropriate reimbursements of the applicable payment, but Title VII does not specifically grant any enforcement powers to the Secretary.

Limits on Luxury Expenditures

The board of directors of each TARP participant must establish and maintain a company-wide policy concerning excessive or luxury expenditures, including expenditures on entertainment or events, office and facility renovations, aviation or other transportation services, or other activities or events that are not reasonable expenditures for conferences, staff development, reasonable performance incentives, or other similar measures conducted in the participant's normal course of business operations. The Secretary is required to identify what constitutes excessive or luxury expenditures.

Annual Shareholder Approval of Executive Compensation

The shareholders of each TARP participant must be permitted to vote (at least annually) to approve executive compensation, and proxy materials concerning such shareholder meetings must include SEC-type compensation disclosures, tables, discussion and analysis and related materials. Any such shareholder vote is non-binding on the TARP participant's board of directors, and it may not be construed as overruling a decision by the participant's directors or to create or imply any additional fiduciary duty by the directors. Such a vote also shall not restrict or limit the ability of the participant's shareholders to make proposals for inclusion in shareholder meeting proxy materials related to executive compensation matters. The Secretary is required to issue final rules concerning shareholder voting matters within one year from the enactment of the Act.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.