Strict New Executive Compensation Standards Under TARP

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1 Strict New Executive Compensation Standards Under TARP Treasury Announces Strict New Executive Compensation Guidelines Under TARP. Changes Follow Clarification of Existing Standards and Additional Reporting and Recordkeeping Requirements. SUMMARY The U.S. Department of the Treasury yesterday announced strict new executive compensation guidelines for financial institutions participating in the Troubled Asset Relief Program authorized under the Emergency Economic Stabilization Act of The new guidelines will apply to all institutions seeking new assistance but indicate that they will not apply retroactively to existing investments or programs. The guidelines limit the amount and type of executive compensation, impose tighter restrictions on severance and other separation payments, extend the clawback requirements, deepen annual compensation risk reviews and require participants to adopt policies relating to luxury expenditures. The guidelines were accompanied by a strongly worded statement from President Obama expressing concern about taxpayer funds... subsidizing excessive compensation packages on Wall Street, lavish bonuses, and massive severance packages. Regulations implementing the new guidelines have not yet been released. Previously, in the final days of the Bush administration, Treasury issued new regulations clarifying the preexisting TARP compensation standards and prescribed reporting and recordkeeping requirements. I. NEW TARP EXECUTIVE COMPENSATION GUIDELINES The Treasury guidelines draw a basic distinction between executive compensation standards that will apply to participants in any new generally available capital access program (such as the current Capital Purchase Program) and more stringent standards deemed to be suitable for institutions needing exceptional assistance involving institution-specific negotiated agreements with Treasury (such as AIG New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 or the Bank of America and Citi transactions). The guidelines state that the new standards will not apply retroactively to existing investments or to programs already announced such as the Capital Purchase program and the Term Asset-Backed Securities Loan Facility. A. NEW EXECUTIVE COMPENSATION STANDARDS Unlike the existing executive compensation standards, the Treasury guidelines state that new standards issued will in some instances apply to more executives than simply the CEO, CFO, and three next highest paid executive officers (referred to as the SEOs under the prior standards). In some cases, it appears that the extent of the limits will be subject to negotiation with Treasury. 1. Standards for Future Generally Available Capital Access Programs The Treasury announcement states that it intends to issue specific proposed guidance on executive compensation restrictions for future generally available capital access programs and that the public will have the opportunity to comment. The proposed standards would include the following: $500,000 limit on annual compensation other than restricted stock, unless limit waived with disclosure and shareholder vote. Senior executives would be prohibited from receiving more than $500,000 in annual compensation other than restricted stock and other similar long-term incentives. The restricted stock may also be subject to specific vesting or payout limits. Unlike companies that require exceptional assistance, participants in generally available capital access programs could waive the $500,000 plus Restricted Stock limit if there is full public disclosure of the compensation and, if requested, the compensation is submitted to a non-binding say on pay shareholder resolution. It is not clear what disclosure would be required and who could request the say on pay shareholder resolution. The current form of the guidance does not address some of the practical issues that could result from the new standards. In particular, because three of the five SEOs are determined by the amount of compensation earned, it is not clear how these executives would be identified after the $500,000 compensation limit has been imposed or if the SEOs could change year-to-year because they could be replaced by the three next highest paid executives who were not previously subject to the $500,000 limit. Expanded review of risk-taking. All companies participating in future capital access programs will be required to review and disclose the reasons that compensation arrangements with all employees (not only, as under the current Capital Purchase Program, the SEOs) do not encourage excessive and unnecessary risk-taking. Additional, expanded clawback for engaging in deceptive practices. In addition to the clawback of bonuses and incentive compensation that currently applies to the SEOs in the event that such pay is based on misstated financial statements or other metrics, the new Treasury guidelines would impose an additional clawback on the next 20 senior executives, if they have knowingly engaged in providing inaccurate information relating to financial statements or performance metrics used to calculate their own incentive compensation. Accordingly, although the additional clawback is expanded to an additional set of executives, it is tempered with a new knowingly standard. Tighter restrictions on golden parachutes. Upon a severance from employment, the golden parachute cap for SEOs will be reduced from three times annual compensation (under the current Capital Purchase Program) to one times annual compensation. Adoption of policy relating to luxury expenditures. The board of directors must adopt (and post on the company web site) a company policy on any expenditures related to aviation services, office and facility renovations, entertainment and holiday parties, and conferences and events. According -2-

3 to Treasury s guidelines, this policy would not be intended to cover reasonable expenditures for sales conferences, staff development, reasonable performance incentives and other measures tied to a company s normal business operations. The CEO would be required to certify for expenditures that could be viewed as excessive or luxury items. 2. Standards for Exceptional Assistance For financial institutions that receive exceptional assistance, the Treasury guidelines impose stricter standards. In addition, the standards apply to senior executives, a term that is left undefined and expected to be subject to negotiation with Treasury. Accordingly, the number of executives subject to the stricter limits may vary from company to company. $500,000 limit on annual compensation other than restricted stock. Senior executives would have their annual compensation capped at $500,000 per year other than restricted stock grants (and other similar long-term incentives) as described above for companies participating in the generally available capital access programs. However, the number of senior executives subject to the cap could exceed the SEOs, and no disclosure or say on pay alternative would permit the company to waive this limit. Any restricted stock over the $500,000 limit would be payable only after the government has been repaid including the contractual dividend payments that ensure taxpayers are compensated for the time value of their money or after a specified period according to conditions that consider among other factors the degree a company has satisfied repayment obligations, protected taxpayer interests or met lending and stability standards. It is not clear whether this requirement would also apply to participants in generally available capital access programs. Say on pay shareholder vote. The senior executive compensation structure and the reasoning as to how the compensation is tied to sound risk management would need to be disclosed and submitted to a non-binding shareholder say on pay vote. Additional, expanded clawback for engaging in deceptive practices. The same added clawback restrictions that apply to the new generally available capital access programs would apply to financial institutions that receive exceptional assistance. Ban on golden parachutes. Involuntary severance pay could not be paid to the top ten executives and, to the extent it exceeded one year s compensation, could not be paid to at least the next 25 executives. Adoption of policy relating to luxury expenditures. The same requirements with respect to luxury expenditures and the adoption of related company policies that apply to the generally available capital access programs would apply to firms that receive exceptional assistance. B. COMPLIANCE AND CERTIFICATION BY CEOS AND COMPENSATION COMMITTEES Treasury s guidelines require the CEOs of all companies that receive or have received any form of government assistance to certify and re-certify annually that the companies have complied strictly with statutory, Treasury, and contractual restrictions on executive compensation. In addition, the companies compensation committees must explain how their senior executive compensation arrangements avoid encouraging excessive and unnecessary risk-taking. C. LONG-TERM REFORM OF EXECUTIVE COMPENSATION Treasury s guidelines also call for a fresh look at the compensation strategies in place at financial institutions (not only those receiving financial recovery assistance), reform of current strategies, and a -3-

4 serious effort to both examine how... compensation strategies at financial institutions... may have encouraged excessive risk-taking that contributed to current market events and to begin developing model compensation policies.... To that end, according to the guidelines Increased disclosure. Treasury and the SEC may require compensation committees of all public financial institutions to disclose executive and certain employee compensation arrangements and explain how they are consistent with promoting sound risk management and long-term value creation for shareholders. Incentives encouraging long-term growth. To encourage a greater focus on firms long-term economic interests, senior executives at financial institutions may be required to hold stock for several years after it is awarded before it can be cashed out. Shareholder say on pay resolutions on executive compensation. Financial institutions may be required to provide non-binding shareholder resolutions on the level of executive compensation and on how the structure of compensation incentives promotes risk management and the creation of longterm value for the institution and the economy. White House-Treasury executive compensation reform conference. Treasury will convene a conference of policy makers, shareholder advocates, major public pension and institutional investor representatives, executives, academics, and others on reform of executive compensation at financial institutions. To establish best practices and guidelines, Treasury will obtain testimony, comments, and white papers on model executive pay initiatives. II. PROVISIONS RELATING TO EXISTING CAPITAL PURCHASE PROGRAM Previously, in the final days of the Bush administration, Treasury clarified certain aspects of the executive compensation standards under the existing TARP programs (including the Capital Purchase Program) and imposed additional reporting and certification requirements. This guidance could be revisited in the near future by incoming Obama administration Treasury appointees, but it seems likely that any changes would be given prospective effect. A. CLARIFICATIONS AND CHANGES The principal clarifications and changes are: SEO determination. The determination of who is a SEO is generally based on the compensation levels for the immediately preceding year for purposes of the ban on golden parachutes upon an involuntary termination of employment, the clawback of bonuses and incentive compensation if they are based on materially inaccurate financial statements, and the requirement that the financial institution take reasonable efforts to ensure that the incentive compensation arrangements do not encourage unnecessary and excessive risk taking. For purposes of the $500,000 tax deduction limit on annual compensation, the determination of who is a SEO is generally based on the compensation levels for the current year in which the deduction limit applies. Golden parachutes. For purposes of the ban on golden parachutes upon an involuntary termination, Treasury has also clarified that all payments on account of an involuntary termination that are made during or after the period that Treasury holds an equity or debt position in the financial institution (the TARP Period ) are taken into account for purposes of the rules prohibiting the golden parachute payments. This means that the financial institution cannot circumvent the golden parachute prohibition by obligating itself to make excess payments after Treasury no longer holds an equity or debt position in the financial institution. -4-

5 Clawback of compensation. Treasury has also clarified the clawback of bonuses and incentive compensation in two respects. First, any incentive compensation is subject to a clawback if the SEO obtains a legally binding right to the payment during the TARP Period. Thus, even if amounts are actually paid after the end of the TARP Period, they can still be subject to clawback. Second, a clawback of bonuses and incentive compensation would not be necessary where financial statements become materially inaccurate because of revisions to generally accepted accounting principles ( GAAP ), provided that the financial statements were accurate based on the GAAP applicable when the payment was made. Compensation committee certification. The compensation committee s certification that it has reviewed the SEO incentive compensation arrangements with senior risk officers and has made reasonable efforts to ensure that they do not encourage SEOs to take unnecessary and excessive risks that threaten the value of the financial institution is now required to be written in the Compensation Committee Report section of the proxy instead of the Compensation Discussion and Analysis section. B. REPORTING AND RECORDKEEPING REQUIREMENTS UNDER CAPITAL PURCHASE PROGRAM AND PSSFI The recently issued Treasury guidance prescribes reporting requirements relating to the executive compensation standards under the Capital Purchase Program and existing programs for Systemically Significant Failing Institutions ( PSSFI ). These reporting requirements mandate that a financial institution s principal executive officer ( PEO ) provide certain certifications: Within 120 days of the closing date of the agreement between the financial institution and Treasury, the PEO is required to certify that the financial institution s compensation committee has reviewed, within 90 days after Treasury s purchase under the program, the SEO incentive compensation arrangements with the financial institution s senior risk officers to ensure that the incentive compensation arrangements do not encourage the SEOs to take unnecessary and excessive risks that could threaten the value of the financial institution. Within 135 days of the completion of each fiscal year during any part of which the financial institution has participated in the Capital Purchase Program or the PSSFI, the PEO is required to certify that (1) the compensation committee has met at least once during the prior fiscal year with the senior risk officers to discuss and review the relationship between the risk management policies and practices of the financial institution and the SEO incentive compensation arrangements to ensure that the arrangements do not encourage the SEOs to take unnecessary and excessive risks, 2 (2) the compensation committee has certified to this review, (3) the financial institution has required that SEO bonuses and incentive compensation be subject to clawback by the financial institution if the payments were based on materially inaccurate financial statements or any materially inaccurate performance metrics, (4) the financial institution has prohibited any golden parachute payments to an SEO, (5) the financial institution has instituted procedures to limit the tax deduction for compensation to $500,000 for its SEOs and (6) certain named individuals are the SEOs for the current fiscal year. Within 135 days of each fiscal year after the first fiscal year during any part of which the financial institution has participated in the Capital Purchase Program or the PSSFI, the PEO is also required to certify that the financial institution has limited the tax deduction for compensation to $500,000 for each SEO for the fiscal year prior to the most recently ended fiscal year. Financial institutions are required to preserve the documentation and records that substantiate each certification for no less than six years after the date of certification. This information must be furnished promptly to the Chief Compliance Officer of the TARP if requested by a representative of the Chief Compliance Officer. An individual who provides fraudulent information or makes false certifications to -5-

6 Treasury related to the Capital Purchase Program s and the PSSFI s executive compensation standards may be subject to criminal penalties, including imprisonment of up to five years and fines. * * * ENDNOTES 1 2 For more information about the Emergency Economic Stabilization Act of 2008 and its executive compensation standards, please see our memoranda entitled Emergency Economic Stabilization Act and Financial Bailout Legislation Restricts Executive Compensation, both dated October 7, 2008, and Treasury Implements New Executive Compensation Standards dated October 21, The guidance does not make clear how the certification requirement described in clause (1) is to be satisfied by an institution that did not participate in the Capital Purchase Program or the PSSFI for a sufficient time during the prior fiscal year to permit its compensation committee to hold the meeting with senior risk officers during that prior fiscal year. The guidance does state, however, that, to the extent a PEO cannot provide any of the certifications in a timely manner, the PEO must explain why. Copyright Sullivan & Cromwell LLP

7 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York H. Rodgin Cohen cohenhr@sullcrom.com Matthew M. Friestedt friestedtm@sullcrom.com Michael A. Katz katzma@sullcrom.com Lawrence A. Pasini pasinil@sullcrom.com Max J. Schwartz schwartzma@sullcrom.com David B. Teigman teigmand@sullcrom.com Marc R. Trevino trevinom@sullcrom.com Washington, D.C. Rebecca S. Coccaro coccaror@sullcrom.com J. Mark Iwry iwryj@sullcrom.com -7- NY12529:

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