Update to Executive Compensation Rules Under the EESA

Article

Corporate & Finance Alert

October 28, 2008

By: Steven H. SholkLawrence Cohen

On October 14, 2008, the U.S. Treasury Department issued Notices 2008-94, 2008-TAAP, and 2008-PSSFI, and Interim Final Rule 31 CFR Part 30 to provide guidance on the executive compensation rules that apply to financial institutions that participate in the Treasury’s programs under the Emergency Economic Stabilization Act of 2008 (the “EESA”). Understanding this guidance is important not only for the participating financial institutions and their senior executive officers, but also for the companies that do business with them.

Background.  An institution that participates in the Troubled Asset Auction Program (“TAAP”), Capital Purchase Program (“CPP”), and Programs for Systemically Significant Failing Institutions (“PSSFI”), must satisfy the executive compensation rules established by the Treasury Department. These rules apply to the chief executive officer, chief financial officer, and the next three most highly compensated senior executive officers. In addition, institutions that sell more than $300 million of troubled assets to the Treasury under the Troubled Assets Relief Program (“TARP”) by auction, or a combination of auction and direct purchase, are subject to the EESA amendments to Code Sections 162(m) and 280G. The amendments to Section 162(m) limit the deductibility of compensation of senior executive officers to $500,000 per applicable taxable year.

The amendments to Section 280G expand the definition of parachute payments to include payments made on account of an “applicable severance from employment,” which is an involuntary termination, or a severance in connection with any bankruptcy filing, insolvency, or receivership. Once a senior executive officer’s parachute payments equal or exceed three times the officer’s average annual compensation for the five years prior to the year of severance (the “base amount”), the parachute payments above the base amount are not deductible by the institution under Section 280G, and are subject to a nondeductible 20% excise tax on the officer under Section 4999.

If the TARP program in which the institution participates prohibits golden parachute payments, the amendments to Section 280G do not have any practical effect because the institution cannot not make any golden parachute payments that trigger the deduction disallowance and the nondeductible 20% excise tax.

Under the TAAP, a financial institution that sells more than $300 million of troubled assets to the Treasury by auction or a combination of auction and direct purchase cannot enter into a new employment contract that provides golden parachute payments to a senior executive officer on account of that officer’s applicable severance from employment. An applicable severance from employment is an involuntary termination, or a severance in connection with the institution’s bankruptcy filing, insolvency, or receivership. Golden parachute payments are payments whose present value equals or exceeds three times the senior executive officer’s base amount.

A new employment contract means any material compensatory contract, including a contract that is renewed. In addition, if a contract is materially modified, it is treated as a new contract. A contract is materially modified if it is amended to increase the amount of compensation, to accelerate the date on which vesting occurs, or to accelerate payment.

The prohibition on new employment contracts with golden parachutes applies for the TARP authorities period from October 3, 2008 to December 31, 2009, or, if extended, from October 3, 2008 to the date so extended but not later than October 3, 2010 (the “TARP Authorities Period”), and without regard to whether Treasury ceases to hold an equity or debt position in the institution.

The CPP is designed to provide equity capital under standardized terms directly to financial institutions to strengthen their capital structures and support lending. A participating institution is subject to the executive compensation rules as long as Treasury holds an equity or debt position acquired under the CPP.

Under the CPP, within ninety days after a purchase, the institution’s compensation committee must review senior executive officer incentive compensation arrangements with the institution’s senior risk officers to ensure that the arrangements do not encourage the officers to take unnecessary and excessive risks that threaten the institution’s value. Thereafter, the compensation committee must meet at least annually with senior risk officers to discuss and review the relationship between the institution’s risk management policies and the incentive compensation arrangements.

Finally, the compensation committee must certify that it completed the reviews. Publicly traded institutions should provide this certification in the Compensation Discussion and Analysis in the annual proxy required under Item 402(b) of Regulation S-K under the federal securities laws. Private institutions should file the certification with its primary regulatory agency.

The CPP also imposes a clawback requirement on any bonus and incentive compensation paid to a senior executive officer based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria. This clawback requirement is broader than the requirement of Section 304 of the Sarbanes-Oxley Act of 2002 for the CEO and CFO to forfeit any bonus, incentive-based compensation, or equity-based compensation received and any profits from sales of the company’s securities during the twelve months following a materially noncompliant financial report.

The requirement under the CPP applies to the three most highly compensated executive officers in addition to the CEO and CFO; applies to both public and private institutions; is not exclusively triggered by an accounting restatement; does not limit the recovery period; and covers not only material inaccuracies related to financial reporting, but also material inaccuracies related to other performance metrics used to award bonuses and incentive compensation.

In addition, participating institutions in the CPP must prohibit golden parachute payments to a senior executive officer as long as Treasury holds an equity or debt position acquired under the CPP. Golden parachute has the same definition as under the TAAP. Finally, participating institutions must agree that no deduction will be claimed for remuneration that would not be deductible if Section 162(m)(5) applied to the institution.

The PSSFI programs provide direct assistance to certain failing firms on terms negotiated on a case-by-case basis. The same executive compensation rules under the CPP apply to institutions that participate in the PSSFI, but with a more stringent golden parachute rule. The prohibition on golden parachute arrangements prohibits any payments to a senior executive officer made on account of an applicable severance from employment. There is no requirement that the aggregate present value of the payments equal or exceed three times the senior executive officer’s base amount. These rules apply as long as Treasury holds an equity or debt position acquired under the PSSFI.

Modified Deduction Limit for Covered Executives.  Section 302 of the EESA amends Code Section 162(m), by adding new subparagraph (5). It also amends Code Section 280G by adding new paragraph (e).

Section 162(m) generally limits to $1 million per year the deduction for compensation paid or accrued for a “covered employee”1 of a publicly traded corporation with a class of securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”). The $1 million limit is reduced by “excess parachute payments,” as defined in Section 280G, that are not deductible by the corporation.

Prior to the EESA, five categories of compensation were excluded from the deduction limit: (1) commission-based remuneration; (2) performance-based compensation that met outside director and shareholder approvals; (3) payments to tax-qualified retirement plans (including salary reduction contributions); (4) amounts excludable from the employee’s gross income; and (5) remuneration payable under a written binding contract effective on February 17, 1993 and not materially modified thereafter.

New Section 162(m)(5) reduces the deduction limit to $500,000 for “executive remuneration” and “deferred deduction executive remuneration,” attributable to services performed by covered executives for an applicable employer during an applicable taxable year. An “applicable employer” is any financial institution, whether publicly traded or privately held, from which the Treasury acquires over $300 million of troubled assets by auction or a combination of auction and direct purchase, but not a financial institution from which the Treasury makes only direct purchases.

When the Treasury makes only direct purchases of troubled assets, the $1 million deduction limit continues to apply. Notice 2008-94 also points out that, in the case of noncorporate entities, if the selling institution (e.g., a limited partnership) does not have employees, then its managing entity (e.g., the general partner) is the “applicable employer.” Further, the exceptions for commission-based remuneration, performance-based compensation, and certain written binding contracts do not apply to the Section 162(m)(5) limitation.

Taxable Year.  Section 162(m)(5) applies to an applicable employer only if during a taxable year of the employer that includes any portion of the TARP Authorities Period, the aggregate amount of the troubled assets acquired from the employer in that taxable year by auction or a combination of auction and direct purchase, when added to the amount acquired under TARP for all preceding taxable years, exceeds $300 million. Once the $300 million threshold is met, Section 162(m)(5) applies to that taxable year and to all subsequent taxable years that include any portion of the TARP Authorities Period.

Covered Executives.  The guidance under Notice 2008-94 modifies the definition of “covered employee” by applying the limitation to the “covered executives,” who are the employer’s senior executive officers. The senior executive officers are (1) the chief executive officer and the chief financial officer of the applicable employer during the taxable year that includes any portion of the TARP Authorities Period, and (2) the three highest compensated officers other than the CEO or CFO, taking into account only employees employed during the taxable year that includes any portion of the TARP Authorities Period.

Corporations that are subject to the Exchange Act determine the three highest paid officers on the basis of the shareholder disclosure rules under the Exchange Act, but unlike the Exchange Act disclosure rules, which determine these officers by reference to total compensation for the last completed fiscal year, the measurement period of Section 162(m)(5) for an applicable taxable year is that taxable year. For private employers and noncorporate entities, similar rules apply.

If an employee is a senior executive officer for an applicable employer for an applicable taxable year, that status continues for all subsequent applicable taxable years, including any subsequent taxable year under the rule for “deferred deduction executive remuneration.”2

Change of Control Transactions.  For acquisitions, mergers, or reorganizations, if a target financial institution that sold troubled assets is acquired by an unrelated entity, the troubled assets sold by the target prior to the acquisition are not aggregated with assets sold by acquirer prior to or after the acquisition.

In determining whether the acquirer is an applicable employer, troubled assets of the acquired institution sold by its new controlled group must be aggregated with any assets sold by the acquirer, whether before or after the acquisition. If the target already qualified as an applicable employer when it was acquired, (1) the acquirer will not become an applicable employer solely as a result of purchasing the target, and (2) a covered executive of the target will continue to be a covered executive during the TARP Authorities Period if he or she is employed by the controlled group of which the target is a member, regardless of whether the acquirer is an applicable employer and regardless of whether the covered executive of the target is a covered executive of the acquirer. However, if, after an acquisition, the target’s controlled group terminates a covered executive, no new executive of the target will be a covered executive solely because of such termination, unless that executive is a covered executive of the acquirer.

Definition of Executive Remuneration.  For purposes of the Section 162(m)(5) limitation, “executive remuneration” means applicable employee remuneration, as defined under Section 162(m)(4), but excludes commission-based remuneration, performance-based compensation, and compensation under certain existing binding contracts. Applicable employee remuneration is based on the year in which the remuneration is deductible, regardless of whether the remuneration is paid in that year or is includible in the employee’s income in that year.

Deferred Deduction Executive Remuneration.  For services performed during any applicable taxable year, no deduction is allowed to the extent that the amount of the deferred remuneration exceeds $500,000, minus the sum of the executive remuneration for that applicable taxable year, and plus the portion of the deferred deduction executive remuneration for such services taken into account in a preceding taxable year.

The unused portion, if any, of the $500,000 limit for the applicable taxable year that has not been taken into account is carried forward until the year in which the deferred deduction executive remuneration allocable to that applicable taxable year is otherwise deductible, and the remaining unused limit is then applied to the payment of the deferred deduction executive remuneration.

Notice 2008-94 provides the following examples:

Example A:

 

Applicable Taxable Year

 

Amount of Compensation

 

Allowable Deduction

 

2009

 

$400,000 Salary

 

Employer can deduct full $400,000 cash salary since it is under the $500,000 limit. Unused portion is $100,000.

 

Right to receive deferred remuneration of $250,000 in 2015 attributable to services performed in 2009

 

$250,000 Deferred Deduction Executive Remuneration

 

Employer’s deduction in 2015 for the $250,000 is limited to $100,000, the unused portion of the $500,000 limit from 2009. No deduction allowed for remaining $150,000.

Example B:

 

Applicable Taxable Year

 

Amount of Compensation

 

Allowable Deduction

 

2009

 

$400,000 Salary

 

Employer can deduct full $400,000 cash salary since it is under the $500,000 limit. Unused portion is $100,000.

 

Right to receive deferred remuneration of $250,000 in 2010 attributable to services performed in 2009

 

$500,000 Salary paid in 2010, and $250,000 Deferred Deduction Executive Remuneration

 

Employer’s deduction in 2010 for the $250,000 paid in 2010 is limited to $100,000. Employer can deduct entire $500,000 of salary earned in 2010.

It is important to note that the deduction limit for deferred deduction executive remuneration for services performed in an applicable taxable year applies for deductions in all subsequent taxable years until the deferred deduction executive remuneration for services performed in that applicable taxable year is completely paid.

New Paragraph (e) of Section 280G.  Section 280G(b)(2) and (e) defines a “parachute payment” as compensation to, or for the benefit of, an employee or independent contractor who performs personal services for a corporation and who is an officer, shareholder, or highly compensated individual of the corporation (a “disqualified individual”). A parachute payment is contingent on a change in the ownership or effective control of a corporation, or on a change in the ownership of a substantial portion of the corporation’s assets (an “acquired corporation”). A parachute payment excludes payments of amounts that the taxpayer establishes by clear and convincing evidence is reasonable compensation for services to be performed on or after the date of the change in ownership or control.

When the present value of a disqualified individual’s parachute payments equal or exceed three times that individual’s base amount, the payments in excess of the base amount are not deductible by the employer under Code Section 280G, and are subject to a nondeductible 20% excise tax on the disqualified individual under Code Section 4999. The base amount is the average annual compensation payable by the acquired corporation and includible in the individual’s gross income for the five taxable years preceding the taxable year in which the change in ownership or control occurs.

Section 302(b) of the EESA expands the definition of a parachute payment to include certain severance payments made to a senior executive officer of an applicable employer. Senior executive officer and applicable employer has the same definitions as under Section 162(m)(5).

A parachute payment means a payment in the nature of compensation to or for the benefit of a senior executive officer made during an applicable taxable year on account of an “applicable severance from employment” during the TARP Authorities Period. Once the aggregate present value of the parachute payments equals or exceeds three times the senior executive officer’s base amount, the parachute payments in excess of the base amount are not deductible by the employer, and are subject to a nondeductible excise tax on the senior executive officer.

Section 280G(e)(2)(B) defines an applicable severance from employment as any severance from employment of a senior executive officer: (1) by reason of the employer’s involuntary termination of the officer, or (2) in connection with a bankruptcy, liquidation, or receivership. A termination is involuntary if it is due to the employer’s independent exercise of its unilateral authority to terminate the officer’s services when the officer was willing and able to continue to perform them. It also includes the employer’s failure to renew a contract at the time the contract expires as long as the officer was willing and able to execute a new contract with terms and conditions substantially similar to those in the expiring contract, and able to continue to perform services.

A senior executive officer’s voluntary termination is an involuntary termination if the termination is for good reason due to a material negative change in the officer’s employment relationship as defined under the Section 409A regulations dealing with nonqualified plans of deferred compensation.

A “payment on account of an applicable severance from employment” means a payment that would not have been payable had the applicable severance from employment not occurred. It also includes amounts that would otherwise have been forfeited due to severance from employment, and amounts that are accelerated on account of the applicable severance from employment. Further, the exclusion for payments for reasonable compensation for services does not apply. Finally, payments on account of an applicable severance from employment do not include amounts paid to the officer under tax-qualified retirement plans.

If a payment treated as a parachute payment under Section 280G(e) is a parachute payment under Section 280G on account of a change in control without regard to Section 280G(e), then Section 280G(e) does not apply to the payment.

Section 280G(e) is effective for parachute payments made during an applicable taxable year for applicable severances from employment that occur during the TARP Authorities Period.

The Treasury Department has invited the public to comment on its guidance. We invite you to contact Steven H. Sholk or Lawrence Cohen if you have any questions on the guidance.


1 A “covered employee” is the principal executive officer (or an individual acting in such capacity), as defined by reference to the Exchange Act, or an employee among the three most highly compensated officers for the taxable year, ), also as defined by reference to the Exchange Act, other than the principal executive officer or principal financial officer, as of the last day of the taxable year. IRS Notice 2007-49, 2007-1 C. B. 1429, and Section 1.162-27(c)(2) of the Treasury Regulations.

2 Deferred deduction executive remuneration means remuneration that would be executive remuneration for services performed by a covered executive in an applicable taxable year but for the fact that the deduction is allowable in a subsequent taxable year (determined without regard to Section 162(m)(5)). The amount paid as deferred deduction executive remuneration is taken into account, without distinction between the amount deferred in the taxable year in which the services were performed and earnings thereon.