Executive Compensation Restrictions Under the American Recovery and Reinvestment Act of 2009

On February 17, 2009, President Barack H. Obama signed into law the American Recovery and Reinvestment Act of 2009 (ARRA). Among other things, the ARRA amended the executive compensation provisions of the Emergency Economic Stabilization Act of 2008 (EESA), which established requirements applicable to participants in the Troubled Assets Relief Program (TARP). The amendments effected by the ARRA maintained the definition of “senior executive officer” to include the top five most highly paid executives of a publicly traded company (and non-publicly traded company counterparts) whose compensation is required to be disclosed in public company proxy statements under the Securities Exchange Act of 1934, but also expanded the scope of some of the executive compensation restrictions to apply to additional employees beyond these senior executive officers (SEOs), depending upon the amount of funds invested in the financial institution by the U.S. Department of the Treasury (Treasury).

The requirements of the amended provisions generally fall into the following categories:

• The Secretary of the Treasury (Secretary) must require companies that have received or that will receive financial assistance under TARP (TARP recipients) to meet appropriate standards for executive compensation and corporate governance, including specifically the following:
  
  
  • Limits on compensation that exclude incentives for SEOs to take “unnecessary” and “excessive” risks that threaten the value of the TARP recipient
  • Maintenance of a clawback policy
  • A prohibition on any “golden parachute payments” to SEOs or any of the next five most highly compensated employees
  • A prohibition on bonuses, retention awards, or incentive compensation, other than restricted stock not to exceed one-third of annual total compensation, to certain executives
  • A prohibition on compensation plans that would encourage manipulation of reported earnings
  • Appointment of a compensation committee composed of independent directors
• Tax non-deductibility of annual compensation in excess of $500,000 for the chief executive officer (CEO), chief financial officer (CFO), and three other most highly compensated officers of certain TARP recipients
• The CEO and CFO of each TARP recipient must certify compliance with the executive compensation provisions
• The board of directors of each TARP recipient must adopt a policy concerning “excessive or luxury expenditures”
• Each TARP recipient “shall permit” an advisory shareholder vote on executive compensation

Each of these requirements is described in greater detail below. These requirements apply during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding (other than if the Treasury only holds warrants to purchase common stock of the TARP recipient).

Excluding Incentives to Take Unnecessary and Excessive Risks
The requirement to limit compensation to exclude incentives for SEOs to take unnecessary and excessive risks that threaten the value of the TARP recipient is substantially unchanged from the pre-amendment version of the EESA. The text of the ARRA amendments, like the pre-amendment version of the EESA, does not provide detail on the content of this requirement. If, however, the Treasury’s regulations implementing this requirement are consistent with its Capital Purchase Program regulations under the pre-amendment version of the EESA, they will require the compensation committee of a TARP recipient to meet with the TARP recipient’s senior risk officers, identify the features in the TARP recipient’s incentive compensation arrangements for SEOs that could lead SEOs to take unnecessary and excessive risks that threaten the value of the TARP recipient, and limit any such features.

Expanded Clawback Policy
The amended provisions will require TARP recipients to provide for recovery of any bonus, retention award, or incentive compensation paid to an SEO or any of the next 20 most highly compensated employees of the TARP recipient based on statements of earnings, revenues, gains, or other criteria that are later found to be materially inaccurate. The amendments broaden the earlier version of the clawback requirement to include retention awards and to apply to 20 additional employees.

Golden Parachute Payments
The ARRA amendments will require a general prohibition on any golden parachute payments to an SEO or any of the next five most highly compensated employees of the TARP recipient. Golden parachute payments are defined by the amended provisions as “any payment for departure from a company for any reason, except for payments for services performed or benefits accrued.” This definition differs from any of the definitions of golden parachute payments under the pre-amendment version of the EESA, and the amendments have extended application of the prohibition beyond the SEOs to the next five most highly compensated employees.

Prohibition on Bonuses Other Than Limited Restricted Stock Awards
TARP recipients will be prohibited from paying or accruing any bonus, retention award, or other incentive compensation, except in the form of “long-term” restricted stock that (i) does not exceed one-third of the total annual compensation of the employee, (ii) does not “fully vest” while the TARP aid is outstanding, and (iii) is subject to other terms and conditions imposed by the Secretary. This prohibition, which was not included in the pre-amendment version of the EESA, does not apply to bonus payments required under written employment contracts executed prior to February 12, 2009 if determined to be valid by the Secretary or the Secretary’s designee. Treasury regulations will need to clarify the meaning of “long-term” restricted stock, the prohibition against any restricted stock “fully vesting” until the Treasury’s investment is repaid, and whether other forms of equity compensation will qualify as restricted stock.

The number of employees subject to the bonus prohibition depends on the amount of TARP funds received by the TARP recipient:

• Where the TARP aid received is less than $25 million, the prohibition applies only to the most highly compensated employee of the TARP recipients
• For TARP recipients receiving at least $25 million and less than $250 million, the prohibition applies to at least the five most highly compensated employees
• For TARP recipients receiving at least $250 million and less than $500 million, the prohibition applies to the SEOs and at least the next 10 most highly compensated employees
• For TARP recipients receiving $500 million or more, the prohibition applies to the SEOs and at least the next 20 most highly compensated employees

For those companies receiving $25 million or more of TARP aid, the specified number of highly compensated employees affected is a minimum and may be increased for any specific TARP recipient by the Secretary, if the Secretary determines the increase to be in the public interest. Treasury regulations will need to define how to identify the most highly compensated employees, whether they also need to be officers, and whether any types of employees or compensation (i.e., commissions) will be excluded from the determination.

Manipulation of Reported Earnings
The ARRA amendment’s prohibition on compensation plans that would encourage manipulation of reported earnings does not resemble any of the requirements of the pre-amendment version of the EESA, and the ARRA amendments do not provide any additional guidance on what types of compensation plans are prohibited. How this requirement is substantively different from the limitation on compensation plans that encourage unnecessary and excessive risk is unclear, as is the necessity for this prohibition in light of the clawback requirements. Accordingly, regulatory guidance will likely be needed to determine what further compensation plan changes, if any, are required under this provision.

Independent Compensation Committee
The amended provisions require TARP recipients to establish a compensation committee composed entirely of independent directors “for the purpose of reviewing employee compensation plans.” The committee must meet at least semi-annually to discuss and evaluate employee compensation plans in light of an assessment of any risk posed to the TARP recipient from such plans. For certain non-public TARP recipients, the board of directors, rather than a compensation committee, will be required to carry out the specified duties.

$500,000 Tax Deduction Cap
TARP recipients will be subject to the limitations of Internal Revenue Code Section 162(m)(5) on the deductibility of compensation paid to the CEO, CFO, and three other most highly compensated officers “as applicable.” Section 162(m)(5), recently enacted by the EESA, imposes a $500,000 cap on tax-deductible compensation for financial institutions that sell more than $300 million of assets through their participation in the TARP auction purchase program. Treasury regulations are needed to clarify further the application of Section 162(m)(5) to other TARP recipients.

Certification Requirement
The CEO and the CFO of each TARP recipient will be required to provide a written certification that their company is in compliance with the new executive compensation requirements. The certification must be provided to the Secretary if the TARP recipient is not publicly traded. If the TARP recipient is publicly traded, the TARP recipient must provide the certification to the U.S. Securities and Exchange Commission (SEC) with its annual securities filings.

Luxury Expenditures
The amended provisions will require the boards of directors of TARP recipients to have in place company-wide policies regarding excessive or luxury expenditures. The excessive or luxury expenditures that must be subject to this policy will be identified by the Secretary. These may include excessive expenditures on entertainment or events, office and facility renovations, aviation or other transportation services, and other activities or events that are determined not to be reasonable expenditures for staff development, reasonable performance incentives, or other similar measures conducted in the normal course of the business operations of the TARP recipient.

“Say on Pay”
Under the amended version of the EESA, TARP recipients must permit a separate, non-binding shareholder vote to approve the compensation of executives as disclosed under the compensation disclosure rules of the SEC in any proxy statement for an annual shareholders’ meeting. Whether this is a self-initiating requirement or one that must be initiated by a shareholder of the TARP recipient is unclear. Also unclear is whether this requirement applies to the current 2009 proxy season or only after the SEC issues applicable regulations (as it would appear from the text of the ARRA).

Retroactive Review of Prior Payments
The ARRA amendments also will require the Secretary to review retroactively the bonuses, retention awards, and other compensation paid to the SEOs and the 20 most highly compensated employees of all companies that received TARP aid prior to the enactment of ARRA. If the Secretary determines that any such payments were inconsistent with the purposes of the amendments to the EESA or TARP or if the payments were otherwise contrary to the public interest, the Secretary must negotiate with the TARP recipient and employee for reimbursement to the federal government (not the TARP recipient) of such compensation or bonuses.

Conclusion
Although the ARRA’s executive compensation-related amendments do not include the strictest limits that were previously proposed (e.g., limiting TARP recipient executives’ compensation to the compensation of the president of the United States), the additional restrictions could still disadvantage TARP recipients in their attempts to attract and/or retain experienced executive-level talent. Even as experienced leadership and direction is the highest priority for most TARP recipients, these amendments could make executives vulnerable to poaching by entities not subject to similar restrictions. The elimination of bonuses, incentive compensation, and retention awards, other than limited restricted stock grants, only serves to diminish greatly the “pay-for-performance” emphasis that has been so important over the past several years to corporate governance pundits and institutional shareholders. The ultimate impact of these restrictions remains to be seen, but any such competitive disadvantage and decoupling of pay-for-performance could harm the leadership and performance of TARP recipients even as they seek to return to financial stability.

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