On October 20, 2008, the United States Department of the Treasury (DOT) published rules concerning the treatment of executive compensation with respect to those institutions that elect to participate in the DOT’s Capital Purchase Program (CPP). On January 16, 2009, the DOT issued further guidance that provided two clarifications to the October rules. It also set forth reporting and recordkeeping requirements.

This memo summarizes the changes made to the October rules.

Under the rules, participating institutions will have to comply with Section 111(b) of the Emergency Economic Stabilization Act of 2008 (EESA). Section 111(b)(1) of the EESA requires financial institutions to meet appropriate standards for executive compensation and corporate governance as set forth by the DOT. These standards apply to the Covered Officers (as defined below) of participating financial institutions while the DOT holds an equity or debt position in the financial institution acquired under the CPP.

Section 111(b)(2) of the EESA requires participating financial institutions to comply with three executive compensation standards.

Section 111(b)(2)(A) of the EESA requires “limits on compensation that exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution.” The October rules require the institution’s compensation committee to certify that it has conducted a review of the incentive compensation arrangements of Covered Officers.

Section 111(b)(2)(B) of the EESA requires that “a provision [be included in incentive compensation arrangements] for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate” (the Clawback).

Section 111(b)(2)(C) of the EESA prohibits a “financial institution [from] making any golden parachute payment to its senior executive officer during the period that the Secretary [of the Treasury] holds an equity or debt position in the financial institution.”

Participating financial institutions will also have to comply with Section 162m(5) of the Internal Revenue Code (Code), which limits the federal income tax deduction for executive remuneration to Covered Officers to $500,000.

Under the rules, Covered Officers are the CEO, CFO and the three most highly compensated executive officers.

Clarifications

The January rule requires that the compensation committee certification of a financial institution whose securities are registered with the SEC be provided in the Compensation Committee Report required pursuant to Item 407(e) of Regulation S-K. The October rule required that these certifications be provided in the Compensation Discussion and Analysis required pursuant to Item 402 of Regulation S-K.

Under the January rule, any bonus and incentive compensation earned during the period in which the DOT holds an equity or debt position acquired under the CPP will be subject to the Clawback. Bonus and incentive compensation is considered paid to a Covered Officer if the Covered Officer obtains a legally binding right to that payment during the DOT holding period. Therefore, bonus and incentive compensation earned but not paid during such a holding period will be subject to the Clawback.

Reporting Requirements

Under the January rules, a company’s principal executive officer (PEO) must provide three certifications to the Chief Compliance Officer (CCO) of the Troubled Assets Relief Program (TARP); copies are also to be provided to the applicable transfer agent under the CPP.

Within 120 days of the closing of the sale of the equity or debt to the DOT, the PEO is required to certify that the compensation committee of the institution has reviewed the Covered Officer incentive compensation arrangements with the senior risk officers of the institution to ensure that the Covered Officer incentive compensation arrangements do not encourage the Covered Officers to take unnecessary and excessive risks, which could threaten the value of the financial institution (see discussion of Section 111(b)(2(A) of the EESA, above).

Within 135 days of the completion of each fiscal year during any part of which the financial institution has participated in the CPP, the PEO must certify that:

• the compensation committee has met at least once during the prior fiscal year with the senior risk officers to discuss and review the relationship between the risk management policies and practices of the institution and the Covered Officer incentive compensation arrangements;
• the compensation committee has certified to this review;
• the institution has required that Covered Officer bonus and incentive compensation be subject to a Clawback if the payments were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria;
• the institution has prohibited any golden parachute payment to a Covered Officer;
• the institution has instituted procedures to limit the deduction for remuneration for federal income tax purposes to $500,000 for each Covered Officer for the most recently ended fiscal year as if Section 162(m)5 of the Code applied to the financial institution; and
• a list of the names of the Covered Officers for the current fiscal year based on the compensation of such individuals during the prior fiscal year.

Within 135 days of the completion of each annual fiscal year of the institution after the first fiscal year during any part of which the institution has participated in the CPP, the PEO must certify that the institution in fact has limited the deduction for remuneration for federal income tax purposes to $500,000 for each SEO for the fiscal year prior to the most recently ended fiscal year as if Section 162(m)(5) of the Internal Revenue Code applied to the institution.

If the PEO is unable to provide any of these certifications in a timely manner, he or she is required to provide the CCO an explanation of the reason such certification has not been provided.

The financial institution must preserve appropriate documentation and records to substantiate each certification for no less than six years after the date of the certification; the first two years of such records must be easily accessible. The institution must promptly furnish to the CCO such documentation and records as requested.

Anyone making or providing false information or certifications to the DOT relating to a purchase under section 111 of the EESA or the related rules is subject to the criminal penalties under Title 18 of the U.S. Code or other provision of federal criminal law.

For further information, please contact Timothy M. Sullivan, Mark F. Palma or Michael D. Morehead, or your regular Hinshaw attorney.

Tax Advice Disclosure: To ensure compliance with the Internal Revenue Service regulations governing the issuance of advice on Federal tax issues, we advise you that any tax advice in this communication (and any attachments) is not written with the intent that it be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code.

This alert has been prepared by Hinshaw & Culbertson LLP to provide information on recent legal developments of interest to our readers. It is not intended to provide legal advice for a specific situation or to create an attorney-client relationship.