On Tuesday, February 17, 2009, President Obama signed the American Recovery and Reinvestment Act of 2009 (the “Act”), which further limits executive compensation for financial institutions receiving assistance under the Troubled Asset Relief Program (“TARP”) enacted in the Emergency Economic Stabilization Act of 2008 (“EESA”). The Act amends Section 111 of EESA by modifying the non-tax TARP executive compensation rules included in Section 111 of EESA and adopting certain aspects of the rules set out in the Treasury releases (issued on October 14, 2008 and January 16, 2009) implementing Section 111 of EESA.

For an analysis of the Treasury’s rules under the TARP Capital Purchase Program (“CPP”) which were adopted prior to these amendments, please see the alerts posted at http://www.hinshawlaw.com/update-of-treasury-executive-compensation-rules-for-those-participating-in-the-capital-purchase-program-01-20-2009/, http://www.hinshawlaw.com/amendments-to-treasury-executive-compensation-rules-for-those-participating-in-the-capital-purchase-program-01-20-2009/ and http://www.hinshawlaw.com/hinshaw-special-alert-10-17-2008/.

These rules apply only during the time the TARP recipient has outstanding obligations to the federal government arising from its financial assistance (the “TARP Period”). They do not apply if the federal government is only holding warrants to purchase common stock. A TARP recipient is anyone who “has received or will receive” financial assistance under TARP.  See Section 111(g) below for a discussion of returning TARP funding.

Retroactive Effect. The executive compensation limitations and governance provisions imposed by the amendments to Section 111 of EESA appear intended to apply retroactively to all TARP recipients, including to financial institutions that received funds under the CPP and other TARP programs.

Treasury Rulemaking. The Treasury must adopt rules to implement this legislation. While this may take a few weeks, as noted below (see discussion of Section 111(f) of ESSA), the Treasury will be required to review all compensation paid to the top 25 most highly paid employees prior to February 17, 2009, to determine if such payments were “inconsistent with the purposes” of the new rules or “otherwise contrary to the public interest.”

Salaries.  There are no caps on salaries but the federal income tax deduction for compensation paid to the SEOs is capped at $500,000 (see discussion of Section 111(b)(1)(B) below). However, due to the restrictions on bonuses (see Section 111(b)(3)(D) below), salaries are likely to increase for senior officers and employees.

Compensation Standards.  The Act requires the Treasury to adopt rules regarding compensation, including limitations that will apply to the five most highly paid senior executive officers whose compensation is reported on the TARP recipient’s proxy statement (“SEOs”); in some cases these rules will apply to a broader group of employees. The Act requires Treasury to adopt the following:

111(b)(3)(A)  Limits on Risk Compensation. The standards require a TARP recipient to place limits on compensation arrangements so that they do not encourage the taking of unnecessary and excessive risks that threaten the value of the TARP recipient. This adopts the similar requirement contained in EESA and the initial guidance issued under the CPP.  Previously, the Treasury had issued a rule that requires the compensation committee or similar body of a TARP recipient to review senior management compensation arrangements with its risk officers to ensure that such arrangements do not encourage risk taking and comply with certain certification procedures (see also discussion of Section 111(b)(3)(F) of EESA below).

111(b)(3)(B) Clawback. The standards will include a provision to recover any bonus, retention award or incentive compensation paid to senior executive officers and the next 20 most highly compensated employees based on earnings, revenues, gains or other criteria that are later found to be materially inaccurate. This mirrors the provision included in EESA and in the rules adopted under the CPP. However, the clawback has been extended beyond SEOs to include the next 20 most highly compensated employees.

111(b)(3)(C) Prohibited Severance. The standards must prohibit any “golden parachute” payment, which is defined to include any payment to an SEO and the next five most highly compensated employees for departure from a company for any reason, except for payments for services performed or benefits accrued. The definition of “golden parachute” (Section 111(a)(3) of EESA) now includes all severance and not just severance that would not be deductible for federal income tax purposes. The comparable CPP provision only applied to SEOs; the new provision adds the next five highest paid employees.

111(b)(3)(D) Limit Incentive Compensation Except for Certain Restricted Stock. The standards must prohibit paying certain executives any bonus, retention or incentive compensation other than certain long-term restricted stock that meets the following criteria:

• does not fully vest during the TARP Period,
• has a value not greater than one-third of the total annual compensation of the employee receiving the stock, and
• is subject to such other restrictions as the Treasury may determine are in the public interest.

Thus, the officers subject to the provision will only be able to receive bonuses payable as restricted stock, which bonuses will be limited to one-third of their compensation. For example, an office whose salary is $250,000 per year would be eligible to receive restricted stock awards with a value of up to $125,000. This restriction may cause an increase in the salaries of senior executives and employees who may not be inclined to have their bonuses capped or only payable in unvested restricted stock awards.

The determination of which executives will be subject to these limitations depends on the amount of funds received by the TARP recipient as indicated in the following table. Note that these restrictions are not limited to senior officers. It should be noted that arrangements pursuant to a written employment agreement executed on or before February 11, 2009, are grandfathered from these limits on incentive compensation:

TARP Financial Assistance Covered Executives

<$25,000,000	Most highly compensated employee only
$25,000,000 to <$250,000,000	Five most highly compensated employees or higher public interest number
$250,000,000 to <$500,000,000	SEOs and 10 next most highly compensated employees or higher public interest number
$500,000,000 or more	SEOs and 20 next most highly compensated employees or higher public interest number

111(b)(3)(E) Ban on Plans that Encourage Earnings Manipulation. The standards will prohibit any compensation plan that would encourage manipulation of the reported earnings of a TARP recipient to enhance the compensation of any of its employees.

111(b)(3)(F) and 111(c) Required Compensation Committee and Functions. The Act requires that TARP recipients have a compensation committee that satisfies the following:

• is comprised entirely of independent directors and
• meets at least semiannually to discuss and evaluate employee compensation plans in light of any assessment risk posed to the TARP recipient by such plans.

Under CPP, the Treasury has already issued rules which required the compensation committee of CPP participants to conduct assessments of compensation arrangements to make sure they do not encourage the taking of any necessary risks.

111(b)(1)(B) Limitation on TARP Recipient’s Compensation Tax Deductions. The Act also provides that a TARP recipient will be subject to the provisions of Section 162(m)(5) of the Internal Revenue Code of 1986, as amended; this provision limits the deduction for compensation paid to SEOs to $500,000. This requirement was imposed by the initial TARP and has been expanded it to all TARP recipients.

111(d) Limits on Luxury Expenditures. A TARP recipient must establish a company-wide policy regarding excessive or luxury expenditures, as identified by the Treasury, which may include entertainment or events, office and facility renovations, aviation or other transportation services, or other activities or events that “are not reasonable expenditures for staff development, reasonable performance incentives, or other similar measures conducted in the normal course of the business operation of the TARP recipient.”

111(e) Shareholder Non-Binding “Say on Pay.” Each TARP recipient will have to allow its shareholders the opportunity to participate annually in a non-binding vote on senior executive compensation. For a public company, this can be accomplished through a non-binding resolution to approve the compensation of executives as disclosed pursuant to the SEC rules which would be voted on by the company’s shareholders. 

It is not clear whether this will apply to the 2009 annual meeting season as the Act directs the SEC to adopt rules within one year.

The shareholder vote will not be construed as overruling a decision by the board of directors nor does it create or imply any additional fiduciary duty by the board. Furthermore, it does not restrict or limit the ability of shareholders to make other proposals related to executive compensation. 

111(b)(4) Compliance Certifications. A TARP recipient’s chief executive officer and chief financial officer (or their equivalents) will have to provide a written certification of compliance with the provisions of Section 111 of ESSA discussed herein. For a public company, the certification is to be made to the SEC with its annual filings; for other TARP recipients, the certification is to be made to the Treasury.

On January 16, 2009, the Treasury adopted rules requiring the CEO of a CPP participant to provide various certifications to the Treasury certifying compliance with the CPP compensation rules.

111(f) Treasury Review of Excessive Bonuses Previously Paid. The Treasury is also directed under the Act to review all compensation paid to SEOs and the next 20 most highly compensated employees of each TARP recipient who received funds before February 17, 2009 in order to determine whether any such payments were “inconsistent with the purposes” of the new rules or were “otherwise contrary to the public interest.” If the Treasury makes this determination, it is directed to negotiate with the company and the employee for appropriate reimbursements to the federal government.

111(g) Return of TARP Funding. The Treasury may permit a TARP recipient to repay any assistance previously provided without regard to whether or how the institution has replaced the funds, provided such assistance may only be repaid following consultation with the appropriate federal banking agency. If repayment occurs, the Treasury is instructed to liquidate any warrants for common stock associated with the assistance at the current market price.

Once the TARP funds have been repaid, the rules will no longer apply. However, because the repayment will be based on a consultation with the primary banking agency, the ability to repay the TARP funding may be illusory. Previously, CPP funding could not be repaid in full for three years, unless the recipient raised equity in an amount equal to the CPP funding.

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.