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November 21, 2008

Executive Compensation Standards Required of Financial Institutions Participating in the U.S. Treasury Capital Purchase Program

The purpose of the Emergency Economic Stabilization Act of 2008, or EESA, is to provide authority and facilities that the Secretary of the United States Department of Treasury can use to restore liquidity and stability to the U.S. financial system. Pursuant to the Troubled Asset Relief Program (TARP) established under the EESA, the Treasury Department has established the Capital Purchase Program under which the Treasury Department acting through the Secretary of Treasury purchases preferred shares and warrants for common shares from eligible financial institutions.

Executive Compensation and Corporate Governance Standards

Section 111 of the EESA and the interim final regulations issued by the Treasury Department impose certain executive compensation and corporate governance standards on financial institutions participating in the Capital Purchase Program as follows:

  1. Financial institutions must have limits on compensation that exclude incentives for senior executive officers to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity position in the financial institution. The financial institution's compensation committee must within 90 days after the stock purchase identify the features in the senior executive compensation arrangements that could lead such officers to take unnecessary risks that threaten the value of the financial institution. In addition, the compensation committee must meet at least annually with the financial institution's senior risk officers to review the relationship between risk management policies and practices and senior executive officer incentive compensation arrangements. Compensation committees must certify that these reviews have been completed. "Senior executive officer" is defined under the interim regulation to include the chief executive officer, the chief financial officer and three most highly compensated executive officers.
  2. A "claw-back" provision that allows recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer if it was based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate or on any other materially inaccurate performance metric criteria. This provision apparently imposes a strict liability standard that applies regardless of the subjective intent or culpability of the executive. It is unclear whether this provision creates a private right of action or whether it would be enforced solely by government prosecution.
  3. A prohibition on the financial institution making any golden parachute payment to its senior executive officers during the period that the Secretary holds an equity position in the financial institution. "Golden parachute payment" is defined in the interim final regulations as having generally the same meaning as in Section 280G of the Internal Revenue Code of 1986, as amended (IRC), that is, any payment in the nature of compensation to (or for the benefit of) a covered executive made during an applicable tax year on account of an "applicable severance from employment" during the period in which the Secretary of the United States Department of Treasury has authorities under EESA, if the aggregate present value of the payments is at least three times the executive's average annualized compensation for the previous five years. Under Section 302 of EESA, "applicable severance from employment" means any severance from employment by reason of an involuntary termination, bankruptcy, insolvency or receivership. Regardless of participation in the Capital Purchase Program, the payment of a golden parachute payment is non-deductible by the employer to the extent the golden parachute payment exceeds the executive's average annualized compensation for the previous five years that is allocable to such payment. In addition, the executive is subject to a 20% excise tax on the non-deductible amount.

In the Securities Purchase Agreement pursuant to which a participating financial institution would issue preferred stock to the Treasury Department under the Capital Purchase Program, the institution must agree that as long as the Treasury Department holds an equity interest in the institution, the institution will take all necessary action to ensure that its benefit plans with respect to its senior executive officers comply in all respects with the standards set forth in Section 111 of EESA, as implemented by any guidance or regulations issued thereunder.

Limitations on Deduction for Certain Executive Compensation

EESA also amends certain provisions of the IRC with respect to executive compensation. In addition to the amendment to Section 280G discussed above, Section 302 of EESA added new § 162(m)(5) to the IRC. Section 162(m) generally limits the deduction that the financial institution may take for compensation paid to certain executives. The amendment to §162(m) reduces the $1 million deduction limitation to $500,000 for certain taxable years and provides that certain exceptions to the deduction limitation, including the exception for performance-based compensation, are not applicable. This amendment removes the opportunity that participating financial institutions would otherwise have to shift as much executive compensation as possible into performance-based bonuses so as not to exceed the threshold above which compensation is subject to unfavorable tax treatment.

Executive Compensation Principles Applicable to All U.S. Banking Organizations

In addition, in a Joint Interagency Statement issued on November 12 by the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision and applicable to all U.S. banking organizations, the Federal banking agencies outlined principles relating to executive compensation. Consistent with safety and soundness principles and existing supervisory standards, banking organizations are expected to regularly review their management compensation policies to ensure that they are aligned with the long term prudential interests of the institution, provide appropriate incentives for safe and sound behavior, and prevent short-term payments for transactions with long term horizons.

If you have questions about the executive compensation provisions applicable to the Capital Purchase Program, please contact Holly Hoehner or any member of the Financial Institutions and Lending Practice Area.


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