Publications & Resources

March/April 2009
Focus: Got Capital?

 

The Troubled Asset Relief Program and Its Effect on Executive Compensation

By Gayle J. Appelbaum

The Emergency Economic Stabilization Act of 2008 was signed into law on October 3, 2008. On October 14, 2008, Treasury issued notices and rules regarding executive compensation standards for financial institutions that participate in TARP. This new law attempts to establish standards regarding executive compensation for financial institutions participating in the various relief programs under this act. If your institution participates in TARP, this can clearly affect your compensation programs and require yet another iteration or evolution of executive compensation.

Under the Capital Purchase Program (“CPP”), the federal government takes an equity position in participating financial institutions in the form of preferred stock and warrants to purchase common stock. For CPP participants, there are four compensation standards that must be adhered to during the period in which Treasury holds an equity or debt position in the institution. These standards must be applied to a class of officers referred to as the Select Executive Officers (“SEOs”) which includes the CEO, CFO and the next three highest paid executive officers, generally determined based on proxy disclosure rules.

The Four Standards
Prohibition of Unnecessary and Excessive Risk:  Incentive compensation plans and arrangements must not encourage participants to take unnecessary and excessive risks that would threaten the value of the institution. The Compensation Committee must review applicable compensation programs with senior risk officers within 90 days after Treasury acquires an equity or debt position, make necessary changes and annually certify that these standards have been met.   

Compensation Deduction Limitations: No tax deduction is permitted for annual compensation over $500,000 that is considered earned during the period. For CPP participants, this changes the annual allowable deduction under Section 162(m) from $1 million to $500,000, with no exception for “performance-based” compensation. The $500,000 limit and compensation paid may be pro-rated for the portion of a taxable year that Treasury holds an equity or debt position in the bank. 

Golden Parachute Restrictions: In the event of an involuntary separation, benefits are limited to 2.99 times an executive’s 5-year average W-2 compensation. Any amount in excess of this limit is viewed as a golden parachute payment and is prohibited. Payments payable to an executive upon voluntary separation (vested retirement benefits or vested elective deferred compensation payable upon termination) are not limited.

Incentive Compensation Clawbacks: A financial institution participating in CPP must implement a policy to recover any bonus or incentive compensation paid to senior executives if such payments are based on materially inaccurate financial statements or other materially inaccurate performance metric criteria. This is the case whether or not the executive was at fault, any misconduct occurred, or the financials were restated.

For institutions, this means new standards and new rules; for compensation committees, this translates into new issues to be aware of, monitor, and adhere to. This also requires certifications during the institution’s participation in the program. This all boils down to additional complexity, workload, liability and risk for directors.

For publicly traded organizations filing 2009 proxy statements, participation in ESSA will impact the content of the Compensation Discussion and Analysis (CD&A). CD&As for participants are expected to vary significantly from those of non-participating institutions. Participating companies will need to address whether or not compensation programs are in compliance with the Act’s required standards, changes that have been made to compensation programs and differences over prior years. The compensation committee’s annual assessment of the incentive compensation plans for senior officers should be discussed, including the process used as well as identifying items that could potentially encourage taking unnecessary or excessive risks. If an institution previously had any of these standards in place (e.g. clawback or recovery policy) this should be noted. In the area of golden parachutes, it is recommended that the CD&A discuss the purpose for severance and change-in-control agreements and how they fit into the institution’s overall compensation philosophy and compensation program. In other words, participation in this program requires disclosure of many more issues than for non-participants.

As with any new legislation, best practices are evolving in response to ESSA. Early signs indicate that organizations are amending plans to adhere to the required standards, at least while Treasury holds an equity or debt position in the institution. Clawback and recovery policies are being evaluated and adopted. Employment and change-in-control agreements remain prevalent within the banking industry but are being modified, where appropriate, to adhere to the golden parachute requirements. Gross-ups and double gross-ups are going by the wayside at banks that are TARP participants. As of this writing, specific definitions of “unnecessary and excessive risk” have not been provided; institutions are reviewing incentive compensation plans and attempting to adhere to this yet undefined standard. Additional best practices are expected as TARP money is distributed and the program is fully in place. Participants need to watch for future program modifications that could necessitate additional requirements. 

Gayle J. Appelbaum is managing director & founder of Amalfi Consulting in Bloomington, Minn. She can be reached at 952-893-6795 or gayle.appelbaum@amalficonsulting.com.

Unauthorized reproduction of all or part of this material without the express written consent of the author is strictly prohibited. All rights reserved.