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

With respect to this provision, if a company has entered into an employment agreement with a Covered Officer, the agreement must be amended to reflect this clawback provision.

Section 111(b)(2)(C)

Section 111(b)(2)(C) of EESA prohibits an institution from making any golden parachute payment to a Covered Officer.

As provided under Section 280G(e) of the Code, a “golden parachute payment” means any payment in the nature of compensation to (or for the benefit of) a Covered Officer made on account of an applicable severance from employment to the extent the aggregate present value of such payments equals or exceeds an amount equal to three times the Covered Officer’s base amount. The term “base amount” for a Covered Officer has the meaning set forth in Section 280G(b)(3).

Historically, Section 280G has only been applied to change-in-control payments. The IRS adopted revisions to 280G (as required by EESA) to provide that a “change in ownership or control” is treated as referring to an “applicable severance from employment,” thereby, expanding, for purposes of 280G, termination payments subject to that section.

It should be noted that the revisions to the golden parachute rules will make involuntary terminations and terminations caused by bankruptcy subject to the penalties imposed under Section 280G for amounts paid in excess of the three year base—20% excise tax on the employee and the loss of deductibility for the company. This calculation is to be made even though a change of control had not occurred. It should be noted that the DOT rule prohibits any golden parachute payment. Thus, it is arguable that any payment in excess of the three-year base amount may not be made even if the institution and the employee wish to incur the penalties set out in
Section 280G.

Section 280G (prior to the adoption of Section 280G(e)) permitted a company to deduct from the parachute payment calculation the value of future services to be performed after a change in control (such as a covenant not to compete).

Section 280G(e) does not allow such amounts to be deducted when calculating the parachute payment.

However, it appears that this deduction limitation (and the other provisions of Section 280G(e)) will only apply if a Covered Officer is terminated and there is no change in control. Section 280G(e) states that it does not apply if a traditional change of control occurs. Consequently, Section 280G(e) should only apply if a Covered Officer is terminated and there is no change in control.

An applicable severance from employment means any Covered Officer’s severance from employment with the financial institution (i) by reason of involuntary termination of employment with the financial institution; or (ii) in connection with any bankruptcy filing, insolvency or receivership of the financial institution.

An involuntary termination from employment means a termination of a Covered Officer due to the independent exercise of the unilateral authority of the employer to terminate the Covered Officer, other than due to the Covered Officer’s implicit or explicit request to terminate employment, where the Covered Officer was willing and able to continue performing services.

An involuntary termination from employment may occur if the institution fails to renew a contract at the time such contract expires if the Covered Officer was willing and able to execute a new contract providing terms and conditions substantially similar to those in the expiring contract and to continue providing such services.

In addition, a Covered Officer’s voluntary termination from employment constitutes an involuntary termination from employment if the termination from employment constitutes a termination for good reason due to a material negative change in the Covered Officer’s employment relationship. For example, if a Covered Officer quits due to a reduction in salary, that could be deemed an involuntary termination from employment.

A severance from employment by a Covered Officer is by reason of involuntary termination even if the Covered Officer has voluntarily terminated employment where the facts and circumstances indicate that absent such voluntary termination the financial institution would have terminated the Covered Officer’s employment and the Covered Officer had knowledge that he or she would be so terminated. Thus, a Covered Officer who quits knowing he would be fired is subject to this rule.

A payment on account of an applicable severance from employment means a payment that would not have been payable if no applicable severance from employment had occurred (including amounts that would otherwise have been forfeited if no applicable severance from employment had occurred) and amounts that are accelerated on account of the applicable severance from employment.

Payments on account of an applicable severance from employment do not include amounts paid to a Covered Officer under a tax qualified retirement plan.

Companies will need to review their employment agreements with Covered Officers to determine whether the payments due upon an involuntary termination would exceed the 280G three year base amount. If it does and the company does not provide a gross-up provision (grossing up the payments to the Covered Officer until he receives the full value of what he would have received if the 280G rules did not apply), the company will need to amend the agreement to provide that payments in the event of an involuntary termination are subject to the 280G limits. An agreement that does contain a gross-up provision may need to be modified to make sure that it provides that payments upon involuntary termination are covered by the gross-up provision.

It should be noted that the DOT rule prohibits any golden parachute payment. Thus, it is arguable that any payment in excess of the three-year base amount may not be made even if the institution and the employee wish to incur the penalties set out in Section 280G. This may call into question the enforceability of gross-up provisions.

In order to participate in CPP, companies must make sure their employment agreements with Covered Officers comply with these rules.

162(m)(5) of the Code
The regulations set forth an additional standard for executive compensation and corporate governance under Section 111(b)(1) of EESA. Under this standard, a financial institution cannot deduct for federal income tax purposes any remuneration paid to a Covered Officer that would not be deductible under Section 162(m)(5) of the Code (i.e., any compensation in excess of $500,000).

Section 162(m)(5) limits the amount of compensation that may be deducted for federal income tax purposes to $500,000 per year for each Covered Officer. This Section was added to the Code as part of ESSA.

Under 162(m) there has been a $1 million cap on the deductibility of Covered Officer compensation but when calculating such compensation, performance-based compensation is excluded. Thus, a Covered Officer who has received $1.2 million in compensation, $300,000 of which was performance based, did not exceed the $1 million cap.

Section 162(m)(5) provides that performance-based compensation is not to be excluded when determining whether Covered Officer’s compensation exceeds the $500,000 cap.

The interim rules for the CPP state that a financial institution must agree to act as though it is subject to Section 162(m)(5) and that Section 162(m)(5) “only limits the amount of the deduction that may be claimed.” Consequently, an institution must include performance-based compensation when calculating the $500,000 cap; conversely, performance-based compensation is excluded if the calculation is to be made under Section 162(m) when the $1 million cap applies.

For example, if a Covered Officer received $700,000 in compensation and $300,000 was performance-based, the DOT rule requires that the performance-based compensation be counted towards the $500,000 cap. Therefore, $200,000 of the Covered Officer’s compensation will not be deductible.

The DOT rules state that when calculating the $500,000 cap the “special rules relating to deferred deduction executive remuneration would also apply.” The IRS recently adopted rules to implement Section 162(m)(5) which also prohibit the deduction in any taxable year of deferred deduction executive remuneration for services performed in the applicable tax year. The rules state that deferred deduction executive remuneration means remuneration for services performed by a Covered Officer in an applicable tax year but for the fact that the deduction is allowable in a subsequent taxable year. Companies should review their compensation practices in light of the IRS rule and determine what impact the rule would have when calculating the $500,000 cap.

In order to ensure compliance with Section 162(m)(5), companies will need to establish internal controls so that they do not take improper deductions when calculating the $500,000 cap.

Companies participating in the CPP will need to review their compensation arrangements with Covered Officers to determine what impact Section 162(m)(5) will have on their ability to deduct the officers’ compensation for federal income tax purposes. An SEC registered company will need to review its compensation discussion in its proxy materials to determine whether these discussion needs to be revised if Section 162(m)(5) impacts the federal income tax deduction for Covered Officer compensation.

Acquisitions
If a financial institution that sold troubled assets to the DOT through the CPP is acquired by an entity that is not related to the target, the acquirer will not become subject to section 111(b) of EESA as a result of the acquisition. With respect to the target, any employees of the target who are Covered Officers prior to the acquisition will be subject to section 111(b)(2)(C) of EESA until after the first anniversary following the acquisition.

For further information on this article, please contact Timothy M. Sullivan, 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.