Executive Compensation Limits

General

The current form of Treasury’s Stock Purchase Agreement requires that a participant arrange things so that its compensation policies comply with section 111(b) of EESA “as implemented by guidance or regulation issued and in effect on the closing date” of any stock purchase by Treasury.  To date, Treasury has issued two “Interim Final” Rules covering this topic and has proposed further rules, and Congress has adopted the Economic Recovery Act adding still more rules (“ERA Rules”).  This memo outlines those rules.

The ERA Rules are in some places vague and unclear, and we will have to await interpretative rules by the Treasury.

The rules always apply to the CEO, CFO and the three most highly compensated officers other than the CEO and CFO.  These persons are called Senior Executive Officers (“SEOs”).  To determine who are the three other most highly compensated executive officers you first must determine which officers are executive officers; generally, those persons will be the officers in charge of principal divisions or functions in your organization.  To determine each person’s compensation for purposes of the rules, you look to the last completed fiscal year and add the officer’s salary and bonus, the value of stock and option awards and other compensation using the methods in Item 402 of Regulation S-K of the SEC.  In addition, certain of the ERA Rules also apply to other employees of the Company, as will be indicated below.

The compensation standards apply only while Treasury holds any debt or equity acquired by Treasury.  So, it is not necessary to permanently modify your compensation programs.  In addition, the ERA Rules allow a Company to immediately pay back any money it got from Treasury if it doesn’t like the new rules.

Current Rules

Golden Parachute Payments.  This is a misnomer, because the rules actually apply to any termination of the executive.  Generally, the Treasury rules prohibit any severance payments to an SEO that exceed three times the “base amount” as that term is defined in the tax law, generally to mean the executive’s average annual compensation for the preceding 5 years.  A severance payment of 2.99 times the base amount would not violate the rules.  In addition, however, the ERA Rules seem to apply to any severance payment regardless of amount and extend the prohibition to SEOs and the next 5 most highly compensated employees.

Deductibility of Compensation.  The rules limit the tax deductibility of compensation to any SEO for a taxable year to $500,000.

Risk Review.  The Board of Directors of an institution or its compensation committee must within 90 days of Treasury’s stock purchase review the SEO’s incentive compensation arrangements to ensure that the arrangements “do not encourage SEOs to take unnecessary and excessive risks that threaten the value” of the institution.  A similar review must be made annually.  If the reviews uncover any features that encourage an SEO to take such risks, those features should be “appropriately” limited.

Clawbacks.  Any compensation payments to an SEO and, under the ERA Rules, any of the next 20 most highly compensated employees based on materially inaccurate financial statements or performance criteria must be returned to the employer. 

Bonus.  The ERA Rules establish that a Company can’t pay a bonus except in restricted stock of not more than 1/3 of salary that doesn’t fully vest while Treasury holds preferred stock to (i) its most highly compensated employee, (ii) if the Company got between $25 million and $250 million, the 5 most highly compensated employees, and, if the Company got between $250 million and $500 million, the SEOs and the next 10 most highly compensated employees.

Luxury Expenses.  The ERA Rules require that a company establish a policy regarding “excessive or luxury” expenditures.

Shareholder Vote.  The ERA Rules state that any “proxy or consent” for a Company shareholder meeting must permit a non-binding shareholder vote to approve the compensation of executives.  This will apply to all public companies.  It is not clear whether it will apply to private companies that solicit proxies.

Renegotiation of Past Compensation.  A particularly troublesome provision of the ERA Rules allows Treasury to review all past compensation of SEOs and the next 20 most highly compensated employees to determine if the compensation was “inconsistent with …TARP or were otherwise contrary to the public interest,” and authorizes Treasury to “seek to negotiate” for “appropriate reimbursement” to the U.S.

Certificates.  The Board or compensation committee must certify that it has made the reviews described under Risk Review above.  Public companies must include the certification in its Compensation Discussion and Analysis.  Private companies must give the certificate to its primary regulatory agency.

In addition, within 120 days of the closing of any preferred stock purchase by the Treasury, the institution’s CEO must certify to Treasury’s TARP Chief Compliance Officer that the Board or compensation committee has made its required review.  In addition, the CEO must give the Chief Compliance Officer a certificate within 135 days of the end of each fiscal year that (i) the Board or compensation committee has made and certified its required review and (ii) each provision of the executive compensation limits has been complied with.  The institution must preserve “appropriate” documentation and records to substantiate each certification for six years after the certification, in an easily accessible place for the first two of those six years.