Golden Parachutes and the Intersection of the Emergency Economic Stabilization Act of 2008 and Section 409A of the Internal Revenue Code

Article

Corporate & Finance Alert

December 23, 2008

One of the most important executive compensation provisions of the Emergency Economic Stabilization Act of 2008 is the prohibition on golden parachute payments. The United States Treasury Department recently issued guidance on this prohibition. This article will discuss the guidance and how the prohibition intersects with the final regulations under Section 409A of the Internal Revenue Code dealing with nonqualified deferred compensation arrangements.

Under the Capital Purchase Program (“CPP”), the Treasury will purchase a financial institution’s preferred stock. The CPP requires participating institutions to limit severance payments to senior executive officers to less than three times the executive’s average taxable compensation for the five years prior to the year in which termination of employment occurs. The limitation applies to participating institutions for as long as the Treasury holds any equity or debt of the institution.

The limitation applies to severance payments contingent on the senior executive officer’s involuntary termination of employment regardless of whether a change in control occurs, or termination of employment on the participating institution’s bankruptcy, liquidation, or receivership. Involuntary termination means an involuntary termination of employment by the institution, the executive’s resignation due to the institution’s decision not to renew the executive’s employment agreement, and the executive’s resignation for good reason due to a material negative change in the employment relationship.

Under the Troubled Asset Auction Program (“TAAP”), the Treasury will hold auctions in which it will offer to purchase troubled mortgage-related assets from financial institutions. If Treasury purchases assets from an institution of greater than $300 million in one or more auctions, or a combination of auctions and direct sales, the institution must not enter into a new employment agreement with a senior executive officer that contains a golden parachute. The prohibition applies until the expiration of the Treasury’s authority under the Emergency Economic Stabilization Act of 2008. This authority expires on December 31, 2009, but upon request of the Treasury Secretary, Congress can extend it to October 3, 2010. The definition of golden parachute is the same as that under the CPP.

Institutions participating in the CPP and TAAP will implement the prohibition on golden parachutes by capping a senior executive officer’s severance payments to less than three times the executive’s average taxable compensation for the five years prior to the year in which termination of employment occurs. If the severance payments exceed the cap, the employment agreement will reduce the severance payments to below the cap. This reduction requires the parties to determine which payments will be reduced, and the order of the payments to be reduced.

The order of the reduction of severance payments must not run afoul of Section 409A of the Internal Revenue Code. Section 409A and the final regulations issued thereunder establish dizzyingly complex rules for nonqualified plans of deferred compensation on the timing of initial deferral elections, the timing of subsequent deferral elections, the timing and forms of distribution, and the prohibition on the acceleration of the timing of payments. In addition, the final regulations prohibit payments that act as the substitute for a payment of deferred compensation when the substitution results in an acceleration of the payment of deferred compensation.

Severance payments are a form of nonqualified deferred compensation under the final Section 409A regulations. The final Section 409A regulations classify severance payments as those exempt from Section 409A, and those subject to Section 409A. When an employment agreement reduces one type of severance payment to satisfy the cap imposed by the prohibition on golden parachutes, and preserves other severance payments, the IRS can take the position that this reduction and preservation are an impermissible subsequent deferral election, or an impermissible substitution in violation of Section 409A. A Section 409A violation results in recognition of income when a right to payment becomes vested, rather than when the payment is made, a twenty percent tax in addition to regular income tax, and additional interest on the late payment of tax commencing on the date of vesting. One approach for addressing the potential Section 409A violation is for the employment agreement to provide for a nondiscretionary order of reduction of specified types of severance payments. For example, the employment agreement can provide for a reduction of the following types of severance payments in the following order:

  1. Reduction of cash payments that are exempt from Section 409A;
  2. Cancellation of acceleration of vesting of equity compensation awards that are exempt from Section 409A;
  3. Reduction of welfare benefits that are exempt from Section 409A;
  4. Reduction of cash payments that are subject to Section 409A;
  5. Cancellation of acceleration of vesting of equity compensation awards that are subject to Section 409A; and
  6. Reduction of welfare benefits that are subject to Section 409A.

Should you have any questions regarding your own situation, please contact Steven H. Sholk of our Corporate Department.