Financial and Economic Crisis - Law Firms Jack And The Beanstalk: Taking The Ax To Executive Compensation - 3 Mar 2009

Stephen T. Lindo and Jason R. Ertel

Willkie Farr & Gallagher LLP

After 25 years of largely counterproductive efforts to restrain
executive compensation by imposing excise taxes on golden parachutes,
limiting deductions for incentive compensation that did not meet
rudimentary performance standards, and confining deferred compensation
to a regulatory straightjacket, Congress has run out of patience.
Outright prohibitions on offending pay practices are beginning to
replace tax disincentives as the preferred method of attacking the
disparity between top executive and average worker pay.

The
last-minute compensation provisions of the American Recovery and
Reinvestment Act of 2009 (ARRA or, in the case of the incentive
compensation limitations, perhaps it will come to be known as ERRA)
represent a frustrated, broad-brush, and in some respects,
ill-conceived response to incentive compensation that continued to
reward executives as the financial industry imploded. For covered
employees at the more than 400 institutions that have taken federal
assistance to date under the Troubled Asset Relief Program (TARP), ARRA
creates startling new pay limitations that continue to apply until the
assistance is paid back.

Applying ARRA's compensation
rules may prove to be a challenge: The statute includes few
definitions, provides no delayed effective dates, and gives the
Secretary of the Treasury broad latitude to promulgate whatever
regulatory standards are thought to be appropriate, regardless of what
the statute says. The rules are effective immediately and may in some
cases have retroactive effect. Covered institutions will need to figure
out who is a covered employee, set pay levels, restrict departure
payments, and file proxy statements before regulations are issued.

Incentive/Bonus Limits

No more retention or incentive compensation awards may be paid or
accrued for covered employees unless they are paid in the form of
restricted stock that represents no more than one third of total annual
pay. Restricted stock awards may not fully vest during the period in
which any obligation arising from financial assistance provided under
TARP remains outstanding. No more annual cash bonuses may be paid or
accrued unless they are required by a written employment contract
signed before February 12, 2009.

The "no accrual" rule
would seem to rule out attempts to avoid the limits by deferring the
payment of incentive compensation for current services into a future
payment year. While there is no limit on the amount of
non-incentive-based compensation that can be paid, such payments will
continue to be subject to the $500,000 deduction limit of Internal
Revenue Code Section 162(m)(5) if the recipient is a "senior executive
officer."

The new rules should do an excellent job of
preventing underperformers from being overcompensated. They will also
likely insure that top performers are undercompensated, because all
covered employees will generally be paid without regard to individual
performance. In a world where institutions will continue to need new
equity to rebuild capital, restricted stock may take a long time to
deliver value. Given these constraints, recruiting and retaining top
performers will present a difficult challenge at a time when top people
are most needed.

No Severance Rule

The definition of "golden parachute payment" has been expanded so that
no severance payments can be paid to a covered employee on departure
for any reason, unless the payments are "for services performed or
benefits accrued." This definition may leave some wiggle room. For
example, payments of previously accrued supplemental pension benefits
and previously earned deferred compensation would seem to be unaffected
by the "no severance" rule and could still be paid on termination
assuming a timely and proper payment election.

Who Is A Covered Employee?

This is an elastic concept. Most of the rules apply to "senior
executive officers" of both public and private companies that have
received TARP assistance (SEOs). SEOs are the top five most highly paid
executives of a public company whose compensation is required to be
disclosed under the securities laws, and their non-public company
counterparts. The "no severance" rule is fixed - it applies to SEOs and
the next five most highly compensated employees. The scope of the
incentive/bonus limits depends on the amount of TARP assistance
received. If assistance is less than $25 million, only the most highly
compensated employee is covered. If assistance is at least $500
million, all SEOs and at least the next 20 most highly compensated
employees are covered. The number of covered employees scales down for
intermediate levels of assistance, but in the case of all institutions
receiving at least $25 million in assistance, the number of covered
employees can be increased if the Secretary of the Treasury determines
that to be in the public interest.

When Are SEO Determinations Made?

ARRA does not address this question, but early guidance would logically
track the guidance issued under the Emergency Economic Stabilization
Act of 2008 (EESA), since the definitions of SEO are largely the same
in both statutes.¹ Under this approach, SEO status
for the current fiscal year would be based on compensation received
with respect to the prior fiscal year. Thus 2009 covered employee
status may be dependent on calculation and payment of 2008 bonuses.

This
rule is perplexingly circular. For securities laws purposes, a bonus
paid in one year for a prior year is generally considered compensation
for the prior year. Where the 2008 bonus might otherwise create covered
employee status, ARRA may prevent the payment of that bonus in 2009. In
that case, the executive's compensation might no longer be subject to
disclosure under the securities laws, or total compensation could drop
below the threshold for SEO status. In any event, covered employee
status is tested annually, and the operation of ARRA pay limits in one
year may depress compensation to the point that there could be a number
of new players in the set of covered employees for the following year.

Another
pressing question, both for the covered institution and for the
potential covered employee considering whether to accept employment, is
how to deal with pre-existing and ongoing bilateral contractual
commitments entered into with an employee who could potentially become
a covered employee in a later year. This will be especially problematic
if the covered executive has deferred compensation that is otherwise
required to be paid in a year in which ARRA prohibits the payment from
being made. Employment contracts and other compensation plans may need
to include standard, boilerplate TARP override payment limitations.

Expansion Of EESA Compensation Standards

EESA established two separate sets of compensation limits. One applied
to recipients in which the Treasury acquired a "meaningful" equity or
debt position by means of direct purchases of troubled assets. The
other applied to recipients in which the Treasury acquired more than
$300 million of troubled assets through auction purchases alone or
through a combination of auction purchases and direct purchases.

For
purposes of applying its compensation standards, ARRA does away with
the distinction between direct purchases and auction purchases. ARRA
also eliminates the threshold level of TARP assistance that must have
been provided before its standards apply. If an institution has
received, or will receive, $1 of TARP assistance, it will become
subject to ARRA's restrictions on compensation. These standards will
continue to apply for as long as any obligation arising from financial
assistance provided under TARP remains outstanding. ARRA clarifies that
this period does not include any period during which the Treasury holds
only warrants to purchase common stock of the TARP recipient.

In
addition to the incentive/bonus limits and the "no severance" rule
discussed above, ARRA expands upon EESA's direct purchase standards by
requiring the Secretary of the Treasury to establish and apply the
following standards to all TARP recipients: