By Michael G. Kushner, Esq. Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY
The IRS has issued Interim Final Regulations1 on the executive compensation provisions of the Emergency Economic Stabilization Act of 2008 (“EESA”),2 and the American Recovery and Reinvestment Act of 2009 (“ARRA”),3 generally effective June 15, 2009. The rules implement an increasingly restrictive executive compensation regime for financial institutions that received government funds under the federal TARP program but have not yet repaid them to the government. Original speculation that the Treasury would set a hard cap on annual compensation for top executives of such entities, such as $500,000, however, proved to be unfounded. The regulations establish what has been called a “pay czar” to help enforce the provisions of the law and Treasury further has announced its intention to seek legislation that would apply similar restrictions to all publicly traded companies.
The CEO and CFO of an entity that holds TARP funds must certify compliance with these executive compensation rules to the Treasury and, in the case of a publicly traded company, the SEC or, in the case of a nonpublicly traded company, to its primary regulator. The regulations refer to the period during which an institution holds un-repaid TARP funds as the “TARP period.” While these restrictions impose reasonable limitations designed to make certain that TARP funds are used for their intended purpose; to assure adequate capitalization of financial institutions and to free up frozen credit markets, the Treasury's push for legislation to extend similar provisions to non-TARP recipients and to all other publicly traded companies, is of greater concern, as it could impose significant retention and compliance burdens on companies that have been operating within the law. The key points of the Interim Final Regulations are as follows.
1. Covered Executives. The rules generally apply to senior executive officers (“SEOs”) and the other top five officers of a recipient that is a public company whose compensation must be disclosed on the company's proxy statement under SEC rules.
2. Bonuses. Senior executives of a recipient cannot receive or accrue any bonus, retention award or incentive compensation. This rule can cover up to 25 of a company's executives depending on how much it received in TARP funds. Bonus accruals and payments can be made under qualified retirement plans and other broad-based plans, including non-qualified deferred compensation arrangements Equity awards, such as stock options and SARs, however, generally are prohibited forms of “incentive compensation,” as are amounts payable upon completion of a transaction and certain cases of forgiveness of employer-employee loans. A “clawback” rule requires recipients to recover any bonus or incentive pay paid to an SEO and any of the next 20 highest-paid employees that later turns out to have been based upon financial statements or performance metrics that were inaccurate. Recipients must annually disclose to Treasury and their primary federal regulator any executive perks worth more than $25,000 in the aggregate to any covered executive. The disclosure must describe the perks and the reason they are being offered. Recipients also must disclose to Treasury and their primary federal regulator annually whether the recipient, its board of directors or its compensation committee has hired a compensation consultant and, if so, it must detail the services provided by the consultant, including any benchmarking used to establish compensation levels.
3. Restricted Stock and RSUs. The Regulations clarify that the statutory exemption for “long-term restricted stock” applies to restricted stock units (“RSUs”) as well. Such forms of equity based compensation cannot exceed one-third of an executive's annual pay.” An executive must forfeit such a grant if he or she terminates employment within two years of grant, unless the termination is due to executive's death or disability or due to a change in control of the recipient. Restricted shares may become transferable, and RSUs may be paid, ratably in 25% increments as the recipient repays the TARP funds to the government.
4. Severance Pay. Recipients cannot make golden parachute payments to an SEO or any of the next five highest-paid employees during the TARP period. All payments with change-in-control triggers are considered parachute payments. Executives cannot circumvent this rule by deferring such amounts beyond the TARP period. Distributions from qualified plans, payments due to death or disability and certain deferred compensation payments are not considered parachute payments, nor is the government's taking over an employer's stock.4
5. Luxury Expenses. The recipient's board of directors must adopt a policy on “excessive or luxury expenditures,” which must be filed with the IRS and posted on the company's website. The policy must list prohibited types of expenditures and set forth the approval process for permitted ones.
6. Tax Gross-Ups. The common practice of tax gross-up payments is prohibited for senior executives of TARP recipients. No gross-up or other reimbursement of taxes may be made to any SEO and the next 20 highest paid employees relating to severance payments, executive perks or similar pay. International tax equalization arrangements, however, are not covered.
7. Compensation Committee. Recipients must establish a compensation committee consisting of independent directors that meets at least semi-annually to discuss executive pay. The committee is responsible for preventing undue risks from being imposed upon the recipient as a result of excessive executive compensation, particularly compensation that might adversely affect the recipient's value. The committee also must review whether any features of the recipient's plans encourage executives to manipulate earnings and must eliminate any such features that they uncover.
The Treasury's recent actions on executive pay, including these Interim Final regulations and the announcement of its intent to seek broader legislation, although well-intended, raise concerns about the unintended consequences that such measures may have. Among them is whether subjecting to these restrictions the very institutions that need TARP funds will allow them to attract and retain top executive talent to unravel their problems. Some financial institutions already have repaid their TARP money to the government, so it is no longer true that executives lack alternatives for employment that effectively force them to remain at TARP covered institutions. Second, one way that Treasury apparently intends to deal with the foregoing problem, and of excessive executive compensation in general, is by imposing similar limits on the top executives of all publicly traded companies. This may motivate many publicly traded companies to go private and it is precisely in the area of private capital where opaque disclosure significantly contributed to the current economic crisis.
Clearly there have been abuses in the area of executive compensation, some on a staggering scale. History, however, shows that when these types of abuses occur Congress and the executive branch have a tendency over-react to public outcry, imposing such stringent remedies that often parties that have done no wrong and who are not the intended targets of the measures nonetheless are caught up in their net, becoming subject compensation restraints and burdensome compliance requirements. Regardless of how one views about Sarbanes-Oxley, enacted in the aftermath of the Enron, many agree that, while SOX serves a good purpose, it also has significantly increased the compliance costs and burden on public corporations. This may contribute to companies taking public offerings that otherwise might be made in New York, to London instead. Some view SOX as a significant contributing factor to London replacing New York as the world's financial capital. Furthermore, both London and New York face increasing competition from the Mumbai, Dubai and Shanghai stock exchanges. Adding additional compliance costs could accelerate the loss of market share in financial business from the U.S. to overseas, a disturbing trend at a time when the financial sector has come to represent such a significant portion of the U.S. economy, even as traditional industries, such as manufacturing, have declined.
Certainly, in light of what we have witnessed, updating our regulatory structure is necessary to bring it into the 21st century. It is important, however, that any such actions be targeted to the specific abuses involved and not cast so wide a net as to deter financial institutions and publicly traded companies from doing business in the U.S. or to reduce the profitability of those that do. Executive compensation arrangements, when drafted appropriately, tie executive pay to corporate performance and thereby align the interests of a company's executives with those of its shareholders. Equity-based pay and executive compensation arrangements comprise a significant segment of such executive compensation. The key is not to eliminate these forms of compensation, but to ensure that the amount of pay is reasonable under §162, that poor performance is not rewarded and that company finances are not manipulated in a way that is beneficial to executives, but not necessarily to the long-term interests of their companies.
Arguably, we already have many of the tools at our disposal to deal with abuses and the problem has been more the lack of enforcement than the lack of authority.
Certainly, taxpayers would benefit by including more objective criteria in the regulations under §162. The current “facts and circumstances” test leaves considerable leeway and can lead to abuse. Guidance requiring that executive compensation be related to performance metrics that are aligned with shareholders' interests would do much to police this problem from a tax standpoint. Furthermore, even in the world of private capital, arguably the problems have come from the failure of the SEC and other regulatory agencies to keep watch over such pools of capital, although more disclosure clearly is warranted. Finally, corporate directors and executives owe a fiduciary duty to shareholders. It should be made clear that this duty includes the duty to make certain that the payment of excessive or inappropriate executive compensation does not endanger the corporation's interests nor significantly impair shareholder equity and that executive compensation be appropriately aligned with shareholder interests. Again, however, this type of regulation is available under current fiduciary responsibility statutes in corporate law, including the duty of loyalty, so the enforcement of existing law, coupled with increased shareholder activism, can provide the tools necessary to curb abuses without imposing burdensome administrative costs. Although modernization of our financial and compensation regulatory structure is needed, hopefully such action will not take the form of an over reaction with negative unintended consequences, casting a broad “TARP” of excessive regulation over law-abiding companies.
For more information, in the Tax Management Portfolios, see Brisendine, Veal and Drigotas, 385 T.M., Deferred Compensation Arrangements, and in Tax Practice Series, see ¶5710, Nonqualified Deferred Compensation.
1 RIN 1505-AC09 (6/15/09).
2 P.L. 110-185.
3 P.L. 111-5.
4 See Notice 2009-49, 2009-25 I.R.B. 1093.
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