Announced by the United States Treasury on October 14, the Capital Purchase Program (CPP) created under the Emergency Economic Stability Act of 2008 allows the Treasury to allocate up to $250 billion for equity investment in banks and other financial institutions, with the goal of improving the flow of capital into the economy.

Participation in the CPP is not confined to large financial institutions. In fact, the Treasury has expressly invited medium and small banks and savings associations to apply for the program. Regardless of their size, however, institutions electing to participate in the CPP must agree to the program's conditions—including those aimed at restricting the nature and amount of compensation paid to that institution's executives.

Limits on an institution's executive pay practices have been established both in the act and now in additional rules and guidance issued by the Treasury. The act itself, which became law on October 3, obligated the secretary of the Treasury to require an institution in which the Treasury acquired an equity or debt interest, as part of the Treasury's direct purchase of troubled assets from the institution, to meet "appropriate standards for executive compensation and corporate governance standards." Under the act, such standards, which apply to the pay of "senior executive officers"—generally the chief executive officer, chief financial officer and the three most highly compensated executive officers (SEOs)—were to include:

• A ban on incentive compensation that encouraged "unnecessary and excessive risk" that threatened the value of the financial institution
• A clawback for bonuses or other incentive pay paid on the basis of earnings, gains or other statements that later were proved to be materially inaccurate
• A prohibition on "golden parachute payments"

The Treasury announcement of the CPP was accompanied by the issuance of interim regulations regarding executive pay that will apply to participating institutions. These regulations confirm the applicability of the three restrictions described above and add a fourth: the institution's agreement not to deduct compensation paid in a year to an SEO in excess of $500,000. The Treasury has furnished additional guidance on the restrictions in notices that offer a more detailed explanation of the scope of the limitations on executive pay and their practical application.

Prohibition on Incentive Compensation Encouraging Excessive Risk

The new guidance from the Treasury outlines a several-pronged procedure for institutions to follow to establish their compliance with the prohibition on SEO incentive compensation that encourages SEOs to take unnecessary and excessive risk that threatens the value of the financial institution.

The procedure requires the institution's compensation committee (or similar committee) to review with the institution's senior risk officers its incentive compensation arrangements for SEOs (or those acting in a similar capacity). This review must occur within 90 days after a purchase under the CPP. The compensation committee also must meet at least annually with senior risk officers to review the relationship between the institution's risk policies and its incentive compensation programs.

The review should include discussions between the compensation committee and the senior risk officers to determine the risks that threaten the value of that particular institution. The compensation committee should then identify features in the SEOs' incentive compensation arrangements that may encourage SEOs to take those risks.

The guidance requires the compensation committee to certify it has completed the required review of its incentive compensation for excessive and unnecessary risk. If the institution has securities registered under the federal securities laws, a statement of that certification should be furnished in its Compensation Discussion and Analysis under Item 402(b) of Regulation S-K. A private financial institution must file the certification with its primary regulatory agency.

Required Clawback for Bonuses Based on False Information

In instances where payment was based on inaccurate statements, the Treasury guidance offers greater detail on how and when mandatory clawback of a bonus paid to a SEO applies.

Aimed at discouraging fraud, financial manipulation or other misconduct, the required forfeitures apply if bonus or other incentive compensation was based on materially inaccurate financial statements or any other materially inaccurate performance criteria.

The Treasury guidance makes clear that this standard is broader than the standard contained in section 304 of the Sarbanes-Oxley Act, which requires forfeiture by a CEO or CFO of certain compensation and profits from sales of the company's securities during the 12 months following a materially non-compliant financial report. In contrast to the Sarbanes-Oxley forfeiture requirement, the mandatory clawback for CPP participants applies not just to the CEO and CFO, but the other three most highly compensated officers of the institution; is not limited to circumstances involving an accounting restatement; has no limit on the recovery period; and covers any inaccuracy—not just financial—applicable to a performance metric upon which a bonus was paid.

As a practical matter, establishing a right to recover a bonus paid to a SEO will not be easy. The institution will not only have to establish the fact of the inaccuracy, but also demonstrate that such inaccuracy was "material."

No Golden Parachutes for Departing Senior Executives

The guidance issued by the Treasury permits better understanding of the broad prohibition on golden parachute payments to SEOs. Golden parachute payments, as defined by reference to a new Internal Revenue Code section 280G(e), are compensation paid to an SEO on account of the SEO's involuntary termination or in the event of the institution's bankruptcy or entering receivership.

A golden parachute payment does not include all severance payments. Rather, it refers only to the excess of all such payments over three times the executive's "base amount," which is generally the executive's average compensation for the preceding five taxable years.

Under new guidance issued by the Treasury regarding Section 280G(e), the payments counted in determining whether the "three times base amount" threshold has been exceeded are those made in an "applicable taxable year." An applicable taxable year for a participating institution is one in which the aggregate amount of troubled assets acquired by the Treasury (including assets acquired in prior years) reaches or exceeds $300 million (unless assets were acquired solely in direct purchases by the Treasury) during the "authorities period"—the period during which the secretary of the Treasury has the authority to acquire troubled assets. "Applicable taxable year" also includes any taxable year thereafter during the authorities period.

It is not clear, however, that the Treasury intended to limit considered severance payments to those made in an applicable taxable year in the CPP context. If a participating institution is not otherwise selling troubled assets in direct purchases or in auctions, or is selling only a small amount of such assets, there will be no applicable taxable year for those institutions. This would effectively eliminate the prohibition on golden parachute payments as applied to those institutions.

Agreement to Forego Deduction for Executive Pay Over $500,000

The act amended Section 162(m) of the Internal Revenue Code to add new Section 162(m)(5) limiting the deductibility for pay to SEOs in excess of $500,000 in an "applicable taxable year" (defined, for this purpose, in the same manner as in the case of golden parachute payments). The act confined application of new Section 162(m)(5) to institutions that sold to the Treasury $300 million or more in troubled assets not solely through a direct purchase by the Treasury.

In an exercise of its authority to set executive compensation and corporate governance standards under the act , the Treasury requires CPP participating institutions to agree to apply the limits of Section 162(m)(5) for the period during which the Treasury continues to hold an equity interest in the institution.

Those familiar with Section 162(m), which limits the deductibility of aggregate remuneration in excess of $1 million for certain executive officers of public companies, will notice that Section 162(m)(5) differs in some significant respects. Unlike Section 162(m), new Section 162(m)(5) is not limited to public companies or even corporations. It applies to five executive officers, rather than four, and includes the CFO. In determining what amounts are included in executive remuneration, it does not exclude performance-based compensation or deferred compensation.

The Treasury guidance now offers a better understanding of these features. For instance, the new guidance clarifies how different forms of deferred compensation will be included in the calculation of executive remuneration for a given year. Generally, the rule allocates deferred compensation to the taxable year in which the services relating to such remuneration were performed if the employee had a legally binding right to the remuneration.

If the employee's deferred remuneration is subject to a substantial risk of forfeiture tied to the performance of substantial future services, the remuneration is allocated pro rata over the period of time that the employee was required to perform the services. For example, if an employee has a right to a payment of $300,000 that cliff vests after three years of service, $100,000 will be allocated to each of the three years of service.

The guidance also confirms the ability of the institution to allow an available deduction amount to "tag along" with the payment of compensation deferred in the same year. Therefore, if an SEO is paid remuneration of $375,000 in a taxable year and defers $75,000 to a later year, the $125,000 available deduction amount may be applied to a later payment of $200,000 (representing the $75,000 plus accumulated earnings) in a subsequent year.

The new guidance also makes clear that the limitation on the deductibility of deferred compensation earned in a year when Section 162(m)(5) applied to an SEO's executive remuneration is carried into the subsequent year or years when that deferred compensation is finally paid—even if the payment occurs well after Section 162(m)(5) has otherwise ceased to apply to the institution.

Closing Conditions Related to Executive Pay Restrictions

Under the term sheet issued by the Treasury to describe the requirements for participation in the CPP, an institution must agree to certain closing conditions intended to ensure compliance with the program's restrictions on executive pay. Prior to closing of any transaction under the CPP, the participating institution and its SEOs must complete the following:

• Modify or terminate the institution's benefit plans, arrangements and agreements to the extent necessary to comply with the act's executive compensation and corporate governance requirements, including any related Treasury guidance or regulations issued on or before the closing date
• Agree to be bound by those requirements for as long as the Treasury holds equity or debt securities of the institution
• Grant a waiver releasing the Treasury from any claims that the institution or any of the SEOs would otherwise have as a result of the issuance of regulations that modify the terms of the institution's benefit plans, arrangements and agreements to eliminate any provision that would not be in compliance with those requirements

If you have any questions or would like more information, please contact one of the following Faegre & Benson ERS Task Force lawyers: