Developments in TARP Executive Compensation Restrictions

Developments in TARP Executive Compensation Restrictions

By Sheryl Vander Baan, CPA, and Kevin F. Powers, CPA

The American Recovery and Reinvestment Act of 2009 (ARRA), signed into law on Feb. 17, 2009, imposes sweeping changes to the executive compensation rules for all recipients of any Troubled Asset Relief Program (TARP) financial assistance, including both past and future recipients under the Capital Purchase Program (CPP).

Background
Since the Emergency Economic Stabilization Act of 2008 (EESA) authorized the U.S. government to create TARP last fall, the U.S. Department of the Treasury has moved forward with purchasing the preferred stock of financial institutions under the CPP. The CPP imposed strict executive compensation restrictions on institutions participating in the program.

Banks participating in the CPP were originally subject to significant restrictions on both the amount of executive compensation that is tax deductible and the amount of severance compensation that could be paid to departing executives. The provisions under ARRA expand those restrictions and add considerable new limitations on the amount of bonus compensation that can be paid. These new rules apply to both public and private financial institutions that have already received or will receive TARP funds.¹ The decision makers at these institutions must understand how the rules and restrictions have changed and adjust their policies accordingly.

Who’s Covered
Generally, the restrictions apply to the five most highly paid executives, referred to as senior executive officers (SEOs). Many of the restrictions, however, have been expanded to also include the next five, 10, or even 20 highest-paid employees, as outlined below.

Existing Restrictions – Limits on Executive Compensation Deductibility
Internal Revenue Code (IRC) Section 162(m) limits the amount a public company can deduct for executive compensation to $1 million annually per covered employee. Performance-based compensation that satisfies certain requirements is excluded from this limit.

Under TARP, however, the limit for deductible executive compensation is reduced to $500,000, with no exclusion allowed for performance-based compensation. The limitation applies to any compensation that is earned in the current year, even if payment is deferred to a later tax year. Thus, it applies to virtually every form of compensation earned by the five SEOs during the period that TARP financial assistance is outstanding – regardless of when the compensation is actually paid.

Expanded Restrictions – Golden Parachute Payments
Prior to EESA and ARRA, IRC Section 280G limited the amount an employer could deduct for “golden parachute payments” – certain compensation paid to an executive upon a change in control of the company. The executive recipient of the golden parachute payment was required to pay a 20 percent excise tax on any amount the company could not deduct.

Under EESA, TARP recipients went from a simple limitation on tax deductibility to an actual restriction on how much they could pay an SEO who departs due to involuntary termination or severance in connection with a bankruptcy, liquidation, or receivership of the company. The rules restricted any compensation payment in excess of 2.99 times the employee’s average five-year base compensation. Only payments from a tax-qualified retirement plan were excluded from this restriction.

ARRA expands the limitations even further, broadly defining a golden parachute payment as any payment for departure for any reason, except payments for services performed or benefits accrued. During the time TARP assistance is outstanding, a financial institution cannot make golden parachute payments to the five SEOs or the next five most highly compensated employees.

New Restrictions – Incentive Compensation
TARP recipients cannot pay or accrue to certain employees any bonus, retention, or incentive compensation award, except for long-term restricted stock. The restricted stock cannot fully vest during the period TARP funds are outstanding, and the stock cannot have a value exceeding one-third of an employee’s total annual compensation.

The number of employees affected is determined by the amount of outstanding financial assistance:

Financial Assistance Outstanding	Number of Employees Affected
Less than $25 million	The most highly compensated employee
$25 million but less than $250 million	The five most highly compensated employees
$250 million but less than $500 million	The 15 most highly compensated employees
$500 million or more	The 25 most highly compensated employees

This prohibition does not apply to any bonus payment required to be made pursuant to a written employment contract executed on or before Feb. 11, 2009. The U.S. secretary of the Treasury has the authority to determine what constitutes a valid employment contract.

More Restrictions – Corporate Governance
There are other compensation-related restrictions as well – some old, some new, some expanded:

Compensation programs must provide for recovery from the 25 most highly compensated employees of any bonus, retention award, or incentive compensation paid based on statements of earnings, revenues, gains, or other criteria later found to be materially inaccurate.
Compensation plans cannot encourage manipulation of the reported earnings of a TARP recipient to enhance employee compensation or induce SEOs to take unnecessary and excessive risks that threaten the institution’s value.
The board of directors must adopt a companywide policy restricting excessive or luxury expenditures as identified by the Treasury secretary, including entertainment, offices and facilities, aviation, other transport, and staff development.
Annual shareholder meetings must permit a separate shareholder vote approving executive compensation arrangements as disclosed per Securities and Exchange Commission (SEC) rules. Note, however, that the shareholder vote is not binding on the board of directors.
TARP recipients must create a compensation committee, if one does not already exist, composed entirely of independent directors who must meet at least semiannually to evaluate employee compensation plans in light of the TARP restrictions.
The chief executive officer and chief financial officer must certify annually the company’s compliance with TARP requirements – publicly traded companies to the SEC and nonpublicly traded companies to the Treasury secretary.

What if You Already Received TARP Funds?
These new rules apparently are meant to apply retroactively to financial institutions that already received funds under the CPP or other TARP programs. The Treasury secretary is directed to establish standards, which must include the requirements above. How quickly the Treasury secretary will issue these standards and exactly how and when they will apply is unclear.

The legislation directs the Treasury secretary to review bonuses, retention awards, and other compensation, paid before the enactment date of ARRA to the 25 most highly compensated employees of a TARP recipient to determine whether any such payments were inconsistent with TARP restrictions. The Treasury secretary is also directed to negotiate with the financial institution and the employee for reimbursement of any payments determined to be inconsistent with the purposes of TARP or contrary to the public interest.

In establishing these new restrictions in a retroactive manner, legislators removed impediments to a current TARP recipient’s withdrawal from the program. Provided a financial institution’s federal banking regulator approves, a TARP recipient may repay the assistance it has received at any time, without regard to the original waiting periods or any requirement to replace the funds through other sources. When the assistance is repaid, the Treasury secretary will liquidate related outstanding stock warrants at the current market price.

What to do Now?
The new rules under ARRA introduce strict new provisions that financial institutions – public or private – never before faced. As the devil is typically in the details, these rules create a lot of questions on specific application and, therefore, impact on TARP recipients and their employees. The Treasury secretary is directed to issue final rules and regulations to carry out this statute by Feb. 17, 2010. Hopefully, guidance will be forthcoming much sooner so that institutions already participating in TARP and those considering participation can determine what to do next.

Contact Information
Sheryl Vander Baan is an executive with Crowe Horwath LLP in the Grand Rapids, Mich., office. She can be reached at 616.752.4255 or sheryl.vanderbaan@crowehorwath.com.

Kevin Powers is an executive with Crowe Horwath LLP in the Oak Brook, Ill., office. He can be reached at 630.586.5140 or
kevin.powers@crowehorwath.com.

¹ Note: The provisions discussed in this article apply during the time that financial assistance under TARP remains outstanding, but this period does not include any time when the federal government holds only warrants to purchase common stock of a TARP recipient.

Download PDF

Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.