Economic “Stimulus” Legislation to Impose New Executive Compensation Restrictions - 16 Feb 2009

(Editor’s Note: The post is based on a client memorandum prepared by attorneys at Sullivan & Cromwell LLP.)

The final version of the American Recovery and Reinvestment Act of
2009, which was passed by the House on February 13 and was expected to
be passed by the Senate later that night, includes extensive new
restrictions on the compensation arrangements of financial institutions
participating in the Troubled Asset Relief Program (“TARP”). The new
legislation, which the President is expected to sign into law shortly,
rewrites Section 111 of the Emergency Economic Stabilization Act of
2008 (“EESA”) (1) and directs the Treasury Department to establish
standards and promulgate implementing regulations.

TREASURY TO ESTABLISH NEW STANDARDS

The new standards will codify many of the executive compensation
guidelines for TARP recipients announced by the Treasury Department on
February 4, 2009, impose additional restrictions and apply to all
existing and future TARP recipients. It is not clear whether the
standards will be immediately effective or will only be effective after
regulations are issued.

Under the legislation, the standards are required to include the
restrictions and other provisions summarized below, which include a
variety of terms the meaning and scope of which have not been made
clear.

• Financial Institutions Affected. The restrictions
apply to all entities that have received or will receive financial
assistance under the TARP during the period the TARP recipient has an
obligation outstanding that arises from TARP financial assistance.
However, the restrictions cease to apply if the Federal Government only
holds warrants to purchase common stock of the TARP recipient.

• Employees Affected. Many of the restrictions
extend beyond the TARP recipient’s CEO, CFO and three next most
highly-compensated executive officers (the “senior executive officers”)
and apply to other highly-compensated employees as well. It does not
appear that other highlycompensated employees need to be officers of
the TARP recipient, nor do any provisions specify how to identify such
highly-compensated employees (for example, whether based on current or
prior year compensation, whether a potential highly-compensated
employee could drop off the prohibited group because of the bonus limit
and how compensation would be defined for this purpose.

• Prohibition on Bonuses, Retention Awards, and Other Incentive Compensation.
During the TARP restricted period, a TARP recipient may not pay (or
accrue) any “bonus, retention award or incentive compensation” to a
group of employees that depends on the amount of TARP assistance the
financial institution has received. The restricted group ranges from
the most highly-compensated employee for institutions with less than
$25 million of TARP assistance to the five senior executive officers
and at least the next 20 most highly paid employees for institutions
with more than $500 million of TARP assistance.

The prohibition does not apply to (1) any bonus required to be paid
pursuant to written employment contracts executed on or before February
11, 2009 (“as such valid employment contracts are determined by”
Treasury) or (2) payment of “long-term” restricted stock that has a
value not exceeding 1/3 of the employee’s total annual compensation,
that does not fully vest during the TARP period, and that is subject to
such other terms and conditions as Treasury determines are in the
public interest. The legislation does not make clear how the term
“fully vests” is to be interpreted and whether other forms of equity
compensation and long-term incentives could qualify for the restricted
stock exception. This prohibition also does not appear to apply to
salary.

• Prohibition on Golden Parachutes. No golden
parachute payments may be made to the five senior executive officers or
the next five most highly-compensated employees during the TARP
restricted period. Unlike the current regulations that apply to
companies in the TARP Capital Purchase Program, “golden parachute” is
broadly defined to include “any payment. . . for departure from a
company for any reason, except for payments for services performed or
benefits accrued”.

• Expanded Clawback. An expanded clawback applies
to any bonus, retention award or incentive compensation paid to the
five senior executive officers or 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 Incentives that Encourage Unnecessary and Excessive Risks.
Compensation may not include incentives for the five senior executive
officers to take unnecessary and excessive risks that threaten the
value of such recipient.

• Prohibition on Compensation Plans that Would Encourage Manipulation of Earnings. Compensation plans may not encourage the manipulation of reported earnings to enhance compensation.

• Independent Board Compensation Committee Review.
Each TARP recipient must establish a Board Compensation Committee
comprised entirely of independent directors to review its compensation
plans. This Board Compensation Committee must meet at least
semiannually to assess any risks posed to the TARP recipient by its
employee compensation plans. In private companies that receive or have
received TARP assistance not exceeding $25 million, the board of
directors will handle the duties of the Board Compensation Committee.

OTHER NEW RESTRICTIONS AND PROVISIONS

In addition to requiring Treasury to establish new standards as
described above, the legislation includes the following restrictions
and other provisions:

• Early Repayment Explicitly Permitted. TARP
recipients are permitted (subject to Treasury’s consultation with the
appropriate Federal banking agency, if any) to repay any assistance
previously received without regard to any waiting periods and without
regard to whether the financial institution has replaced the funds with
funds from any other source. Upon repayment of assistance, Treasury is
to liquidate warrants associated with the assistance at the current
market price and the financial institution will no longer be subject to
any of the TARP compensation restrictions.

• Retroactive Review of 2008 and Early 2009 Bonuses.
Treasury must retroactively review bonuses, retention awards and other
compensation paid to the senior executive officers and the next 20 most
highly-compensated employees of each TARP recipient before the date of
enactment of the new legislation. The review is to determine whether
such compensation is inconsistent with the purposes of the new
legislation or the TARP or is otherwise contrary to the public interest
and, if so, Treasury must seek reimbursement from the TARP recipient
and individual employee with respect to such compensation or bonuses.

• Annual Say on Pay Vote. At each annual or other
meeting of shareholders during the TARP period, TARP recipients must
allow a separate nonbinding “say on pay” shareholder vote to approve
executives’ compensation. The legislation requires the SEC to issue any
final rules and regulations required by the “say on pay” provision
within one year after enactment. It is not clear if this requirement
will apply to upcoming annual proxies or only after regulations have
been issued.

• Policy on Luxury Expenditures. Boards of
directors of TARP recipients must adopt companywide policies on
excessive or luxury expenditures (as identified by Treasury), including
excessive spending on transportation (including aviation) services,
entertainment, office and facility renovations, and other events or
activities that are not “reasonable expenditures for staff development,
reasonable performance incentives, or other similar measures conducted
in the normal course” of the TARP recipient’s business operations.

• Required Certification by CEO and CFO. The CEO
and CFO of each TARP recipient must provide written certification of
compliance with Section 111 of EESA. Public companies will provide the
certification to the SEC together with their annual filings, and
private companies will provide the certification to Treasury.

• $500,000 Tax Deduction Cap. The legislation
provides that, during the TARP period, each TARP recipient will be
subject to the provisions of section 162(m)(5) of the Internal Revenue
Code, “as applicable”. Section 162(m)(5), recently enacted by EESA,
imposes a $500,000 cap on deductible compensation for financial
institutions that sell more than $300 million of assets through their
participation in the TARP auction purchase program.(2)

* * *

ENDNOTES

(1) For more information about the Emergency Economic Stabilization Act
of 2008 and its executive compensation standards, please see our
memoranda entitled “Emergency Economic Stabilization Act” and
“Financial Bailout Legislation Restricts Executive Compensation”, both
dated October 7, 2008; “Treasury Implements New Executive Compensation
Standards” dated October 21, 2008; and “Strict New Executive
Compensation Standards Under TARP” dated February 5, 2009.

(2) For more information about this provision, see our memorandum
entitled “Financial Bailout Legislation Restricts Executive
Compensation”, dated October 7, 2008, pages 6-7.