Jack And The Beanstalk: Taking The Ax To Executive Compensation

Sunday, March 1, 2009 - 01:00

After 25 years of largely counterproductive efforts to restrain executive compensation by imposing excise taxes on golden parachutes, limiting deductions for incentive compensation that did not meet rudimentary performance standards, and confining deferred compensation to a regulatory straightjacket, Congress has run out of patience. Outright prohibitions on offending pay practices are beginning to replace tax disincentives as the preferred method of attacking the disparity between top executive and average worker pay.

The last-minute compensation provisions of the American Recovery and Reinvestment Act of 2009 (ARRA or, in the case of the incentive compensation limitations, perhaps it will come to be known as ERRA) represent a frustrated, broad-brush, and in some respects, ill-conceived response to incentive compensation that continued to reward executives as the financial industry imploded. For covered employees at the more than 400 institutions that have taken federal assistance to date under the Troubled Asset Relief Program (TARP), ARRA creates startling new pay limitations that continue to apply until the assistance is paid back.

Applying ARRA's compensation rules may prove to be a challenge: The statute includes few definitions, provides no delayed effective dates, and gives the Secretary of the Treasury broad latitude to promulgate whatever regulatory standards are thought to be appropriate, regardless of what the statute says. The rules are effective immediately and may in some cases have retroactive effect. Covered institutions will need to figure out who is a covered employee, set pay levels, restrict departure payments, and file proxy statements before regulations are issued.

Incentive/Bonus Limits

No more retention or incentive compensation awards may be paid or accrued for covered employees unless they are paid in the form of restricted stock that represents no more than one third of total annual pay. Restricted stock awards may not fully vest during the period in which any obligation arising from financial assistance provided under TARP remains outstanding. No more annual cash bonuses may be paid or accrued unless they are required by a written employment contract signed before February 12, 2009.

The "no accrual" rule would seem to rule out attempts to avoid the limits by deferring the payment of incentive compensation for current services into a future payment year. While there is no limit on the amount of non-incentive-based compensation that can be paid, such payments will continue to be subject to the $500,000 deduction limit of Internal Revenue Code Section 162(m)(5) if the recipient is a "senior executive officer."

The new rules should do an excellent job of preventing underperformers from being overcompensated. They will also likely insure that top performers are undercompensated, because all covered employees will generally be paid without regard to individual performance. In a world where institutions will continue to need new equity to rebuild capital, restricted stock may take a long time to deliver value. Given these constraints, recruiting and retaining top performers will present a difficult challenge at a time when top people are most needed.

No Severance Rule

The definition of "golden parachute payment" has been expanded so that no severance payments can be paid to a covered employee on departure for any reason, unless the payments are "for services performed or benefits accrued." This definition may leave some wiggle room. For example, payments of previously accrued supplemental pension benefits and previously earned deferred compensation would seem to be unaffected by the "no severance" rule and could still be paid on termination assuming a timely and proper payment election.

Who Is A Covered Employee?

This is an elastic concept. Most of the rules apply to "senior executive officers" of both public and private companies that have received TARP assistance (SEOs). SEOs are the top five most highly paid executives of a public company whose compensation is required to be disclosed under the securities laws, and their non-public company counterparts. The "no severance" rule is fixed - it applies to SEOs and the next five most highly compensated employees. The scope of the incentive/bonus limits depends on the amount of TARP assistance received. If assistance is less than $25 million, only the most highly compensated employee is covered. If assistance is at least $500 million, all SEOs and at least the next 20 most highly compensated employees are covered. The number of covered employees scales down for intermediate levels of assistance, but in the case of all institutions receiving at least $25 million in assistance, the number of covered employees can be increased if the Secretary of the Treasury determines that to be in the public interest.

When Are SEO Determinations Made?

ARRA does not address this question, but early guidance would logically track the guidance issued under the Emergency Economic Stabilization Act of 2008 (EESA), since the definitions of SEO are largely the same in both statutes.1Under this approach, SEO status for the current fiscal year would be based on compensation received with respect to the prior fiscal year. Thus 2009 covered employee status may be dependent on calculation and payment of 2008 bonuses.

This rule is perplexingly circular. For securities laws purposes, a bonus paid in one year for a prior year is generally considered compensation for the prior year. Where the 2008 bonus might otherwise create covered employee status, ARRA may prevent the payment of that bonus in 2009. In that case, the executive's compensation might no longer be subject to disclosure under the securities laws, or total compensation could drop below the threshold for SEO status. In any event, covered employee status is tested annually, and the operation of ARRA pay limits in one year may depress compensation to the point that there could be a number of new players in the set of covered employees for the following year.

Another pressing question, both for the covered institution and for the potential covered employee considering whether to accept employment, is how to deal with pre-existing and ongoing bilateral contractual commitments entered into with an employee who could potentially become a covered employee in a later year. This will be especially problematic if the covered executive has deferred compensation that is otherwise required to be paid in a year in which ARRA prohibits the payment from being made. Employment contracts and other compensation plans may need to include standard, boilerplate TARP override payment limitations.

Expansion Of EESA Compensation Standards

EESA established two separate sets of compensation limits. One applied to recipients in which the Treasury acquired a "meaningful" equity or debt position by means of direct purchases of troubled assets. The other applied to recipients in which the Treasury acquired more than $300 million of troubled assets through auction purchases alone or through a combination of auction purchases and direct purchases.

For purposes of applying its compensation standards, ARRA does away with the distinction between direct purchases and auction purchases. ARRA also eliminates the threshold level of TARP assistance that must have been provided before its standards apply. If an institution has received, or will receive, $1 of TARP assistance, it will become subject to ARRA's restrictions on compensation. These standards will continue to apply for as long as any obligation arising from financial assistance provided under TARP remains outstanding. ARRA clarifies that this period does not include any period during which the Treasury holds only warrants to purchase common stock of the TARP recipient.

In addition to the incentive/bonus limits and the "no severance" rule discussed above, ARRA expands upon EESA's direct purchase standards by requiring the Secretary of the Treasury to establish and apply the following standards to all TARP recipients:

• TARP recipients must establish limits on compensation that exclude incentives for SEOs to take unnecessary and excessive risks that threaten the value of their employer.

• TARP recipients must implement policies to claw back any bonus, retention award, or incentive compensation paid to SEOs or any of the next 20 most highly compensated employees that is based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.

ARRA also created the following new standards to promote greater accountability to shareholders and to the federal government:

• TARP recipients must prohibit compensation that encourages manipulation of reported earnings to enhance the compensation of any employees.

• The board of directors of each TARP recipient must establish a new "Board Compensation Committee" composed of independent directors. This committee must meet at least semiannually to assess the risks posed by the institution's employee compensation plans. For TARP recipients receiving less than $25 million of assistance, this duty must be carried out by the full board.

• The board of directors of each TARP recipient must implement a company-wide policy regarding payment of excessive or luxury expenditures, as identified by the Secretary of the Treasury, for entertainment or events, office and facility renovations, aviation or other transportation services, and other activities or events that are not reasonable expenditures for staff development or reasonable performance incentives conducted in the normal course of business operations.

• TARP recipients must permit in their proxy or consent for authorization for any shareholder meeting a nonbinding shareholder vote on the named executive officer compensation disclosed therein. The SEC has been tasked with publishing final guidance no later than February 2010, although it would appear that these rules are effective for current proxy statements.

• The chief executive officer and chief financial officer of each publicly traded TARP recipient shall provide to the SEC a written certification of compliance with the new standards. Private companies must make the same certification to the Secretary of the Treasury. These certifications will likely need to follow the guidance provided under EESA.2

• The Secretary of the Treasury has also been directed to review bonuses, retention awards, and other compensation paid to SEOs and the next 20 most highly compensated employees of each entity that received TARP assistance prior to February 17, 2009, to determine whether any such payments were inconsistent with the standards set forth above or were otherwise contrary to the public interest. If payments are found to be inconsistent, the Secretary is further directed to seek to negotiate with both the TARP recipient and the employee for appropriate reimbursement.

In the face of overwhelming public irritation, Congress has begun to take a far stronger stand than ever before in setting the boundaries of acceptable compensation practices. Some of ARRA's provisions, notably the almost total limits on incentive compensation and the new restrictions on traditional severance pay, seem likely to have been misguided. Retention and recruiting at the top levels will be difficult. One of the first steps a board will need to consider is whether to pay back prior TARP assistance (a step that ARRA specifically allows) to avoid putting its company at an enormous competitive disadvantage.

For TARP recipients for which this is not feasible, time will tell whether the best people will stick around to participate in the recovery. In the meantime, the net effect of ARRA's new compensation limits will be to increase dramatically the scrutiny on their compensation committees, which will face more pressure than ever before to make value judgments about overall compensation levels and to try to differentiate between fair and windfall compensation. For SEOs and the next 20 covered executives who have already received high rewards while their institutions floundered, there will be mounting public and perhaps government pressure to give something back. It will be an interesting laboratory experiment to watch unfold. 1See Frequently Asked Questions (FAQs) Executive Compensation Requirements under the Capital Purchase Program (CPP), at http://www.treas.gov/ press/releases/reports/tarp%20_executive%20compensation%20faqs.pdf.

2See Treasury Notice 2008-PSSFI, at http:// www.treas.gov/initiatives/eesa/docs/Exec%20Comp%20PSSFI%20Notice.pdf.

Stephen T. Lindo is a Partner and Chair of the Executive Compensation and Employee Benefits Practice Group at Willkie Farr & Gallagher LLP in New York. He negotiates employment and severance arrangements on behalf of public and private companies and senior executives. Jason R. Ertel is an Associate with the Firm in the same Practice Group.

Please email the authors at slindo@willkie.com or jertel@willkie.com with questions about this article.