Treasury Issues Executive Compensation Guidance For TARP Recipients

On June 10, the United States Treasury issued an interim final rule that provides welcome guidance to recipients of financial assistance under the Troubled Assets Relief Program (TARP) regarding the broadened executive compensation restrictions and stricter corporate governance standards imposed by the American Recovery and Relief Act of 2009 (ARRA).

Background

The interim final rule, published in the Federal Register on June 15, furnishes detailed guidance for TARP recipients to aid them in determining and meeting their compliance obligations under Section 111 of the Emergency Economic Stabilization Act of 2009 (EESA)—the provision establishing executive pay restrictions for TARP recipients. ARRA, signed into law on February 17 of this year, amended Section 111 of EESA to strengthen those restrictions and impose heightened corporate governance standards. Prior to the enactment of ARRA, TARP recipients were subject to Section 111 as originally adopted and the regulations promulgated by Treasury in October 2008.

In amending Section 111 of EESA, ARRA provided little in the way of specifics; instead, it directed the secretary of the Treasury to adopt implementing regulations. The rule attempts to provide those specifics by providing effective dates, definitions, actions required for compliance and examples illustrating the application of the rule.

Covered Entities

The rule applies to "TARP recipients," which it defines to mean any entity that has received financial assistance under TARP, as well as any entity with which it would be aggregated under Internal Revenue Code Section 414(b) or (c) and the regulations under those sections, but applying a 50 percent rather than 80 percent ownership threshold and disregarding the rules for brother-sister controlled groups and combined groups. This definition covers, for instance, participants in the Capital Purchase Program (CPP) that sold preferred stock and issued warrants to Treasury in return for TARP funds.

Any entity that has not directly engaged in a financial transaction with Treasury as a counterparty, however, including entities receiving loans under the Federal Reserve Term Asset-Backed Securities Loan Facility (TALF) program, will not be considered to have received "financial assistance" and will not be subject to the rule. Also excluded are recipients of funds under mortgage modification programs funded by TARP.

An investment fund formed under the Public-Private Investment Program (PPIP) would be a TARP recipient under the rule, and compliance with the rule could be triggered for asset managers of or private investors in such a fund if their interest (determined under the above aggregation rules) reached 50 percent.

The TARP recipient will no longer be subject to the rule once it repays the financial assistance, even if Treasury continues to hold warrants to purchase common stock of the TARP recipient after such repayment.

Executive Compensation Restrictions

ARRA amended Section 111 of EESA to require the Treasury secretary to adopt specific executive compensation restrictions and corporate governance standards for TARP recipients, which had to include:

• Limits on compensation incentives for senior executive officers (SEOs) to take unnecessary and excessive risks that threaten the value of the TARP recipient
• The ability for the TARP recipient to recover any bonus, retention award or incentive compensation paid to an SEO or any of the 20 next most highly compensated employees based on materially inaccurate statements of earnings or other performance metrics
• A broad prohibition on bonus payments (with certain exceptions) to an SEO or any of next five most highly compensated employees
• A broad prohibition on golden parachute payments, defined as any payment made to an SEO for his or her departure (excluding unpaid amounts for services or accrued benefits)

The rule now adopts these restrictions and standards—in some cases expanding their application beyond what the statute required—and specifies actions required for compliance.

Bonus Payments

A significant portion of the rule is devoted to furnishing much-needed detail regarding the prohibition on bonus payments brought about by ARRA.

Bonus limited Employees. The specific employees to whom the prohibition applies ("bonus limited employees") depends upon the level of assistance received by the TARP recipient. At lower levels of assistance, the rule looks to the TARP recipient's most highly compensated employee(s). "Most highly compensated employees," for purposes of the rule, are identified by reference to total compensation for the prior fiscal year, determined in accordance with Item 402 of Regulation S-K under the federal securities laws. Persons can fall in and out of the restrictions, then, based on changes in compensation. Note that a TARP recipient's most highly compensated employees will not necessarily be its SEOs—the persons who would be the TARP recipient's "named executive officers" under Item 402(a)(3) of Regulation S-K, which are not identified strictly by compensation.

The amended statute provided a specific exclusion to the bonus prohibition for bonuses paid pursuant to an employment agreement entered into on or before February 11, 2009. The rule now clarifies that the requirement is satisfied if the person had a "legally binding right" to the payment on February 11, with "legally binding right" determined in a manner consistent with Internal Revenue Code Section 409A. This should mean, then, that if a bonus limited employee became eligible on January 1, 2009, to receive a performance award at the end of the three-year period ending December 31, 2011, that award should not fall within the scope of prohibited bonus payments. If, however, the award could be reduced unilaterally or eliminated in the discretion of the employer after the bonus limited employee had performed the services creating the right to the award, the bonus limited employee would not be deemed to have acquired a legally binding right to that payment, and would be subject to the prohibition.

Covered Payments. The rule defines bonus, retention awards and incentive compensation and offers other guidance to help guide TARP recipients determine what is and what is not swept up in the broad prohibition.

• Nonqualified deferred compensation, such as a contribution to a SERP or similar arrangement, may constitute a bonus.
• Bonuses do not include "commission compensation," defined in detail in the rule. This exclusion is significant for the many TARP recipients having employees who sell life insurance and financial products or offer broker-dealer, investment management or investment advisory services, and who generally receive commission-based compensation.
• "Incentive compensation" includes a stock option or stock plan, regardless of whether the awards are subject to performance-based vesting.
• Retention awards do not include amounts accrued under a nonqualified deferred compensation plan to the extent the amounts are accrued in the normal course of the employee's service at the TARP recipient and not accrued by reason of a material enhancement of such benefits.
• Payment to an employee in a subsequent year may be recharacterized as an impermissible bonus if paid in a year when the employee is not covered by the bonus limitation, but related to the period when the employee was a bonus limited employee, and is designated as some other form of payment, such as a salary increase or a stock option grant.
• Without running afoul of the prohibition on bonus payments, a TARP recipient may pay salary or other permissible payment in the form of stock, but such stock must be subject to transferability restriction and cannot be subject to a substantial risk of forfeiture or any requirement of future services.

Bonus Accruals. The rule addresses some of the complex issues that arise with respect to accrued bonuses—in which a person acquires a right to a bonus payment as a result of services performed over a period of time, including multiyear periods. Given that persons can fall in and out of the rule from year to year, and that a right to a bonus payment can be attributed to services performed before the affected employee's employer became a TARP recipient, these issues can be expected to arise with relative frequency.

As a general matter, the rule provides that bonus payments paid or accrued prior to June 15, 2009, the date on which the rule was published in the Federal Register, will not be subject to the enhanced restrictions imposed by ARRA. Also, the bonus payment limitation does not apply to bonus payments paid or accrued by TARP recipients or their employees before the first date of the TARP period (defined as the period starting when the TARP recipient receives any financial assistance and ending on the last date on which any obligation arising from financial assistance remains outstanding, but without regard to warrants held by Treasury). Where a bonus or incentive award was accrued or relates to a period that starts before the TARP period and ends after the TARP period has commenced, the bonus payment won't be treated as having been accrued after the TARP period, so long as that bonus is reduced to reflect at least the portion of the service period that occurs after the first date of the TARP period. If the employee is a bonus limited employee at the time the bonus becomes payable, however, the bonus still may not be paid until bonus payments to that employee are permitted.

Similar treatment will apply with respect to bonuses accrued over a period, some portion during which the employee was a bonus limited employee and some portion during which the employee was not. Under these facts, the bonus that is paid after the employee is no longer a bonus limited employee must be reduced to reflect only the period when the employee was not subject to the bonus limitation.

409A Issues. Responding to concerns expressed that the nonpayment, or delay in payment, of a bonus, incentive compensation or retention award would give rise to a violation of Internal Revenue Code Section 409A, the preamble to the rule indicates that no violation of Section 409A will occur, and a payment that otherwise would have been a short-term deferral under Internal Revenue Code Section 409A regulations will not be treated as a payment of deferred compensation if the payment is made promptly following the first date upon which the payment could be made without violating the terms of the TARP recipient's agreement with Treasury.

Long-term Restricted Stock. Although it prohibits bonus payments to certain employees, Section 111 of EESA as amended by ARRA does permit the grant of "long-term restricted stock," subject to certain limitations: the long-term restricted stock cannot fully vest while any obligation arising from financial assistance provided to the TARP recipient remains outstanding, and must be restricted in value to no more the one-third of the bonus limited employee's compensation for the fiscal year.

The rule provides guidance on how to calculate compensation and the value of the long-term restricted stock for purposes of the above limitation. Equity-based compensation granted in fiscal years ending after June 15, 2009, will be included in the calculation only in the year in which it is granted at its total fair market value on the grant date. Similarly, the value of the restricted stock will be included in the calculation in the year in which it is granted at its total fair market value on the grant date.

To provide flexibility for those smaller TARP recipients that are closely held community banks, the rule defines long-term restricted stock to include restricted stock units, payable either in cash or restricted stock, as long as the value of the payment is equal to the value of the underlying stock.

The rule subjects the long-term restricted stock to certain requirements and limitations not contained in ARRA. These include a minimum two-year service requirement after the date of the grant of the long-term restricted stock. The rule also restricts the transferability of the stock, even where the shares have vested, until the TARP recipient has made financial assistance repayment. In general, the rule allows a 25 percent portion of the total long-term restricted stock to become transferable as 25 percent of total financial assistance is repaid. An exception is carved out for the transfer of shares as necessary for the payment of taxes arising upon vesting, where the employee did not make an election under Internal Revenue Code Section 83. The rule does not address the transferability of vested shares upon the employee's death.

Although the rule does not expressly say so, the service requirement and transferability restrictions appear to be Treasury's method for implementing the requirement in ARRA that long-term restricted stock not fully vest during the TARP period. TARP recipients who issued restricted shares after February 11 may now to have to amend agreements governing those shares to include those restrictions. In theory, this could present an issue for any TARP recipient who failed to reserve the contractual right to amend those agreements as required for ongoing compliance with TARP restrictions.

Ban On Golden Parachutes

ARRA amended Section 111 of EESA to prohibit the payment of golden parachutes, now expansively defined to include any payment made on account of the employee's departure, and removing the exception formerly available for payments that do not exceed three times the employee's base pay as defined in Internal Revenue Code Section 280G. The prohibition applies to an SEO or any of the next five most highly compensated employees of the TARP recipient. Although ARRA confined the definition of golden parachute payment to severance payments, the rule expands the definition to include payments made on account of a change in control, determined in accordance with Internal Revenue Code Section 280G regulations.

The rule clarifies two critical points regarding golden parachute payments. First, the departing executive is deemed to have received all of his or her severance on the date of the executive's departure. Therefore, a TARP recipient cannot avoid the prohibition by delaying payment until after the TARP period has expired. Second, amounts paid by a TARP recipient prior to June 15 of this year will not fall under ARRA's more expansive prohibition on golden parachutes. This means, then, that an executive who departed before June 15 can be paid severance if, at the time he or she departed, such payments were permissible either because the employer was not yet a TARP recipient or because payments were permissible under the TARP regulations in effect at that time.

It is not hard to imagine that disputes may arise in cases where the employee is contractually entitled to a payment under an agreement that pre-dates his or her employer's participation in TARP, and his or her agreement was not required to be modified to comply with Section 111 of EESA at the time the TARP recipient entered into its agreement with Treasury because the employee was not then an SEO. There is no grandfathering for arrangements entered into before the TARP period began, except for amounts that were paid before June 15, 2009.

Ensuring Compensation Avoids "Unnecessary Risk"

The rule now imposes on the TARP recipient's compensation committee a duty every six months—in contrast to the annual requirement that formerly applied—to discuss, evaluate and review with senior risk officers the SEO and employee compensation plans and the risks those plans pose to the TARP recipient. The compensation committee must identify and make reasonable efforts to limit risk features to ensure that its plans do not encourage an SEO to take an unnecessary or excessive risk, do not unnecessarily expose the TARP recipient to risk, and do not include features that would encourage earnings manipulation or other behavior focused on short-term results rather than long-term value creation.

Clawback

The rule adopts the standard provided in amended Section 111 of EESA requiring TARP recipients to provide for the recovery or "clawback" of any bonus payment paid to an SEO or one of the next 20 most highly compensated employees during the TARP period if payments were based on materially inaccurate financial statements or other materially inaccurate performance metric criteria. The rule clarifies that the clawback must apply to amounts to which the employee acquired a legally binding right during the TARP period—and thus presumably would exclude bonus amounts paid during the TARP period pursuant to arrangements entered into before the TARP period, so long as those arrangements gave the employee a legally binding right to the payment. The rule also requires the TARP recipient to exercise its clawback rights unless it would be unreasonable to do so—for instance, if the costs of recovery exceeded the bonus payment.

Excessive Or Luxury Expenditures Policy

As amended by ARRA, Section 111 of EESA requires a TARP recipient's board of directors to have a company-wide policy with respect to excessive or luxury expenditures as identified by the secretary. The rule now fleshes out general requirements for such a policy.

A written excessive or luxury expenditures policy must be adopted by the TARP recipient's board of directors; filed both with Treasury and the institution's primary federal regulator (such as the Federal Reserve or Office of Thrift Supervision); and posted on the TARP recipient's Web site (if it maintains one)—all within 90 days after the later of the date of the TARP recipient's agreement with Treasury or June 15, 2009.

The policy must do all of the following:

• Address certain categories of expenses identified in the statute, including entertainment or events, office and facility renovations, aviation or other transportation services, and similar items, activities and events
• Identify the types and categories of prohibited expenses or expenses requiring prior approval
• Adopt reasonable approval procedures for expenses requiring prior approval
• Require certification by the principal executive officer and principal financial officer that prior approval was properly obtained for any expenditure for which prior approval by any SEO or similar executive officers or the board of directors was required
• Mandate prompt internal reporting of any policy violation
• Mandate accountability for adherence to the policy

Although the rule provides general content requirements for such policies, it deliberately declines to provide specifics. It instead leaves that responsibility to the TARP recipient's board of directors, much in the way that federal securities regulations furnished a general framework rather than specific detail for the code of ethics required to be adopted by public companies under Sarbanes-Oxley.

Say On Pay

The rule reiterates the requirement contained in Section 111 of EESA requiring TARP recipients to permit in a proxy or consent or authorization for an annual or other shareholder meeting a separate nonbinding shareholder vote to approve executive compensation arrangements as required to be disclosed pursuant to the federal securities laws, including compensation discussion and analysis, the compensation tables and related materials.

Additional Standards

Pursuant to its general authority to publish executive compensation and corporate governance standards, the Treasury secretary included in the rule additional standards that were not specifically required by ARRA.

Approval Of Compensation Arrangements For TARP Recipients Receiving Exceptional Assistance

TARP recipients receiving exceptional assistance (defined as financial assistance under the Programs for Systemically Failing Institutions, the Targeted Investment Program, the Automotive Industry Financing Program or a similar program designated as such by the Treasury secretary) must submit for approval to the newly created Office of the Special Master for TARP Executive Compensation their compensation payments and structures for SEOs, bonus limited employees, all other executive officers and 100 most highly compensated employees. Approval is not required with respect to any executive who is not an SEO or a bonus limited employee whose compensation is limited to $500,000 (excluding long-term restricted stock).

Annual Disclosures Of Perquisites And Use Of Compensation Consultants

The rule requires TARP recipients to disclose annually to Treasury and to their primary federal regulator:

• Any perquisites whose total value exceeds $25,000 for any bonus limited employee; the TARP recipient must also provide a justification for offering those perquisites. (Public companies are already subject to perquisite disclosure requirements under the Securities Exchange Act of 1934.)
• Whether the TARP recipient has engaged a compensation consultant and all types of services that the compensation consultant has provided in the last three years, including benchmarking and other comparisons employed to identify the percentile of compensation

Such disclosures must be provided within 120 days of the end of the fiscal year, if during any part of the fiscal year the TARP recipient had any obligation arising from financial assistance under TARP still outstanding (excluding warrants held by Treasury).

Ban On Tax Gross-Ups

The rule prohibits tax gross-ups or other reimbursements relating to severance payments, perquisites or other form of compensation for payment of taxes to SEOs and the next 20 most highly compensated employees. This prohibition does not apply to tax-equalization arrangements for employees assigned abroad who may be subject to tax in their country of residence as well as in the United States.

Compliance Reporting Regime

The rule requires the TARP recipient to provide periodic certifications and disclosures with respect to the executive compensation restrictions and corporate governance standards of the rule.

Compensation Committee

The TARP recipient's compensation committee must certify that it has met every six months to review with the senior risk officers the SEO compensation plans and has made reasonable efforts to ensure that those plans do not encourage SEOs to take unnecessary and excessive risk, to limit any necessary risk these plans pose to the TARP recipient, and to eliminate features that would encourage the manipulation of reported earnings. Each fiscal year it also must provide a narrative description of each SEO compensation plan and explain how that plan meets the required standard for risk and earnings manipulation limitation described above. The certification and narrative description must be furnished in the compensation committee report of the TARP recipient, if the TARP recipient is subject to that federal securities disclosure obligation, and must otherwise be furnished to the TARP recipient's primary regulatory agency and to Treasury.

Principal Executive Officer And Principal Financial Officer

The TARP recipient's principal executive officer and principal financial officer must certify that the TARP recipient has complied with the requirements of the rule. The rule provides model forms for those certifications.

Certifications must be made after the TARP recipient's first fiscal year during which it had an outstanding obligation under TARP, and each other fiscal year thereafter during any part of which the TARP recipient has an outstanding obligation. The principal executive officer and principal financial officer certifications must be filed as Exhibit 99.1 to the TARP recipient's Form 10-K if it has publicly-held securities, or otherwise to its primary federal regulator.

Compensation Committee Requirement

A TARP recipient that does not have a compensation committee of its board of directors at the time it enters into an agreement under TARP with Treasury will be required to establish one within 90 days after the closing date of that agreement. There is an exception for TARP recipients that have no securities registered under the Securities Exchange Act of 1934 and receive $25 million or less in TARP assistance. These recipients are instead permitted to delegate the duties of the compensation committee under the rule to the board of directors.

Special Master

The rule provides for the establishment of the new Office of the Special Master by the Treasury secretary. The Treasury secretary has the power to appoint and remove the special master, whose authority is limited to oversight of the executive compensation and corporate governance standards.

The rule assigns the special master the following duties, authority and responsibilities:

• To interpret and determine the application of Section 111 of EESA and its regulations and guidance to specific facts and circumstances
• To review and administer Section 111(f) of EESA, which directs the Treasury secretary to review prior bonuses, retention awards and other compensation paid by TARP recipients before February 17, 2009, and to negotiate with the TARP recipient and subject employee for appropriate reimbursement to the federal government of such amounts identified as inconsistent with the purpose of EESA or TARP or otherwise contrary to the public interest
• To approve compensation paid by TARP recipients receiving exceptional financial assistance, which approval is now required by the rule
• To provide opinions as requested or otherwise as appropriate regarding payments to or compensation structures for employees of TARP recipients
• To perform other duties requested by the Treasury secretary related to executive compensation issues associated with EESA or TARP as may be delegated to the special master. This includes specifically the interpretation or application of contractual provision between the federal government and the TARP recipient with respect to the TARP recipient's compensation.

Rule Comment Period

Treasury has asked for comments on the topics covered by rule, and it is reasonable to expect the rule, when issued in final form, to include additions or other modifications made in response to those comments. The period for submitting comments ends August 14 (60 days after the rule was published in the Federal Register). The possibility of revisions to the rule notwithstanding, TARP recipients will have to start now the process of reviewing and, as required, amending their compensation arrangements consistent with the new rule, and their compensation committees and board of directors likewise will have to familiarize themselves with and prepare to meet their new obligations under the rule.

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.