On Friday, October 3, 2008, the House of Representatives approved, and the President signed, the eagerly awaited Emergency Economic Stabilization Act of 2008, commonly referred to as the "bailout" or "rescue" legislation. The principal purpose of the act is to authorize the Treasury Secretary to establish the Troubled Assets Relief Program (TARP), under which the Treasury can purchase, from financial institutions, residential or commercial mortgages and any related securities, obligations, or other instruments that were issued or originated on or before March 14, 2008. The initial funding authorized under the act is $250 billion, which Congress can increase to as much as $700 billion if certain requirements are met. This alert focuses on the limits imposed on executive compensation for troubled financial institutions that participate in the TARP. Please visit our website for discussions of other provisions and ramifications of the act.

Impact on Executive Compensation Arrangements

The act incorporates several provisions designed to limit and discourage financial institutions that participate in the TARP from paying excessive compensation, particularly severance, to senior executives. The act establishes separate restrictions for financial institutions that sell troubled assets directly to the Treasury and for those that sell assets through an auction process.

Requirements When Direct Sales Occur. Where a financial institution makes a direct sale of troubled assets to the Treasury in a transaction where no bidding process or market prices are available and the Treasury receives a meaningful debt or equity position in the institution as a result of the transaction, the institution must meet "appropriate standards for executive compensation and corporate governance," including:

  • a complete ban on making any parachute payments to senior executives;
  • unspecified limits on any incentive compensation that encourages executive officers to take "unnecessary and excessive risks that threaten the value of the financial institution;" and
  • a clawback of any bonus or other compensation that has been paid to a senior executive based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate. 

These standards must remain in effect for as long as the Treasury retains its debt or equity position in the financial institution.

Requirements in Auction Purchases. Any financial institution from which the Treasury purchases an aggregate of $300 million or more of distressed assets (including both auction and direct purchases) is barred from entering into any new employment contract with a senior executive officer that provides a "golden parachute" payment to the executive in the event of the executive's involuntary termination, or in connection with the bankruptcy, liquidation, or receivership of the institution. This prohibition will last for as long as the TARP remains in effect, which is through December 31, 2009, subject to extension by the Secretary for to up to two years from the date of enactment. The act directs the Treasury Secretary to issue additional guidance to carry out these limitations within two months of the act’s enactment. By its terms, this provision applies only to new employment contracts and would not impose limits on payments to senior executives under existing contracts.

Tax Law Changes.  The act also discourages firms from paying excessive compensation to senior executives by reducing the tax deductions available to participating institutions. Under Section 302 of the act, an "applicable employer" (an employer from whom troubled assets are acquired in the TARP in excess of $300 million, other than through certain direct purchases, for all taxable years) is subject to restrictions on the deductibility of executive compensation with respect to any "covered executive." Covered executives include the CEO, the CFO, and the three other most highly compensated employees for the relevant tax year, determined using the shareholder disclosure rules for compensation under the Securities Exchange Act of 1934.

Institutions are specifically discouraged from paying to covered executives "applicable severance" (payments made in the event of involuntary termination of the executive by the employer, or in connection with the bankruptcy, liquidation, or receivership of the employer). Affected employers would be denied a deduction for applicable severance payments during the period that the TARP remains in effect (including payments made under contracts entered into before the act’s enactment), and executives would face a 20 percent excise tax on such payments. The deduction limit and excise tax provisions for affected employers are implemented through changes to I.R.C. §§ 280G and 4999, which previously had applied only to payments that are contingent upon a change in ownership or control of the employer.

The act also amends I.R.C. § 162(m) to prohibit applicable employers from deducting any senior executive compensation in excess of $500,000 per year while the employer participates in the TARP. This represents a reduction, for these participating institutions only, from the current $1 million cap on the amount of executive compensation that is deductible against corporate income for payments made to a CEO, CFO, or one of the three other highest-paid officers. For this purpose, the act counts commissions and other performance-based compensation paid by an applicable employer towards the $500,000 limit.

Section 302 of the act also contains provisions that extend the reach of the above limitations and tax law changes to deferred executive compensation earned, but not paid, during one of the applicable taxable years.

The act makes the executive compensation changes applicable to both companies that file periodic reports with the SEC under the Securities Exchange Act and companies that are not reporting companies. Ballard can assist financial institutions that may be affected in determining the executive compensation that will be subject to these new requirements.

Copyright © 2008 by Ballard Spahr LLP.
(No claim to original U.S. government material.)

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This newsletter is a periodic publication of Ballard Spahr LLP and is intended to alert the recipients to new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and specific legal questions you have.