On June 10, 2009, the U.S. Department of the Treasury (“Treasury”), issued long awaited guidance in the form of an interim rule (“Interim Rule”) implementing Section 111 of the Emergency Economic Stabilization Act of 2008 (“EESA”), as amended by the American Recovery and Reinvestment Act of 2009 (“ARRA”).  Since the passage of the ARRA on February 17, 2009, there has been confusion as to the application of the executive compensation and corporate governance standards applicable to an entity receiving financial assistance (“TARP recipient”) under the Troubled Asset Relief Program (“TARP”).  In an attempt to eliminate this confusion, the Interim Rule consolidates all of the executive compensation and corporate governance related provisions applicable to TARP recipients and supersedes all prior guidance on the subject.

Generally, Section 111 of the EESA, as amended, imposes corporate governance and executive compensation requirements on TARP recipients.  These requirements apply for so long as any obligation arising from financial assistance under the TARP remains outstanding (the “TARP period”), but do not apply at any time that the Treasury only holds warrants to purchase common stock of the TARP recipient.

In this update we provide highlights of the more significant considerations raised by the Interim Rule related to executive compensation.  Shortly following this update, we will provide highlights of the more significant matters related to the Interim Rule with respect to corporate governance.

Identifying the Senior Executive Officers and the Most Highly Compensated Employees

The provisions of the Interim Rule for executive compensation apply to a TARP recipient’s senior executive officers (“SEO”) and certain other highly compensated employees.

The determination of the SEOs is based on the executive compensation disclosure requirements under the federal securities laws, which generally include the chief executive officer, chief financial officer and the 3 most highly compensated executive officers.  The identification of the 3 most highly compensated executive officers and the other most highly compensated employees is based on annual compensation for the prior year calculated in accordance with the federal securities laws.

Separation Payments for Departure

Under the Interim Rule, a TARP recipient is prohibited from making golden parachute payments to a SEO or any of the next 5 most highly compensated employees during the TARP period.  The term “golden parachute payment” includes any payment for the departure from a TARP recipient for any reason, or any payment due to a change in control of the TARP recipient, except for payments for services performed or benefits accrued.

The Interim Rule clarifies that a golden parachute payment does not include: (1) payments made pursuant to a qualified pension or retirement plan, (2) payments made by reason of the employee’s death or disability, or (3) severance or similar payments required to be made pursuant to a state statute applicable to employers within such jurisdiction.

A payment made, or a right to a payment arising under a plan, contract, agreement, or other arrangement, will be considered “for services performed or benefits accrued” only if the payment was made, or the right to the payment arose, for current or prior services to the TARP recipient.  Whether a payment is for services performed or benefits accrued is determined based on all the facts and circumstances.  However, a payment, or a right to a payment, generally will be treated as a payment for services performed or benefits accrued only if:

• the payment would be made regardless of whether the employee departs or the change in control event occurs; or
• the payment is due upon the departure of the employee, regardless of whether the departure is voluntary or involuntary.

Further, a payment from a benefit plan or a deferred compensation plan is treated as a payment for services performed or benefits accrued only if certain specified conditions are met as set forth in the Interim Rule.

Bonus Payments and Accruals

A TARP recipient is prohibited from paying or accruing any bonus, retention award, or incentive compensation to certain highly compensated employees or SEOs, except in certain circumstances as discussed below.  The number of employees to which this prohibition applies depends upon the amount of financial assistance provided to the TARP recipient in accordance with the following schedule:

Accruals and Anti-Abuse.  Under the Interim Rule, the Treasury could recharacterize subsequent year payments in certain situations where the bonus was not permitted to accrue in the previous year.  This avoids potential circumvention of the Interim Rule by merely delaying bonus payments until after the employee is no longer subject to the prohibition, or granting retroactive service credits after the employee is no longer subject to the prohibition.  For example, a bonus that was not permitted to accrue during the year an employee was covered by the bonus limitation cannot be paid as some other form of payment such as a salary increase or a stock option grant to the employee in the subsequent year when the employee is not covered by the bonus limitation.

Multi-Year Service Periods.  Certain bonus payments may relate to a multi-year service period, during some portion of which the employee is a SEO or highly compensated employee and during some portion of which the employee is not.  In these circumstances, the employee will not be treated as having accrued a prohibited bonus payment if the bonus payment is reduced by the amount attributable to the portion of the service period during which the employee was a SEO or highly compensated employee.

Commissions and Stock Compensation.  Under the Interim Rule, commission payments for sales, brokerage and asset management services for unrelated customers will not be subject to the bonus restrictions.  Additionally, a TARP recipient is permitted to pay all or a portion of salary in the form of stock as long as it is based on a dollar amount, is fully vested and accrues as a cash salary would.

Exceptions.  The prohibition on bonus payments and accruals has two exceptions: (1) payments or accruals of bonus amounts if the amounts are payable as long-term restricted stock and (2) bonus payments required to be made under written employment contracts executed on or before February 11, 2009.

Long-Term Restricted Stock.  The TARP recipient is permitted to award long-term restricted stock to the employees whose compensation is limited by the prohibition on bonus payments, provided that the value of the grant may not exceed one-third of the employee’s annual compensation as determined for that fiscal year.  Additionally, the Interim Rule requires that the long-term restricted stock must not fully vest until the repayment of all financial assistance by the TARP recipient and that the employee provide services to the TARP recipient for at least two years after the date of the grant before he can vest in such stock.

Written Employment Contract.  The prohibition on bonus payments does not apply to bonus payments required to be paid under a valid written employment contract if the employee had a legally binding right under the contract to a bonus payment as of February 11, 2009.  In addition, the bonus payment must be made in accordance with the terms of the contract as of February 11, 2009, such that any subsequent amendment to the contract to increase the amount payable, accelerate any vesting conditions, or otherwise materially enhance the benefit available to the employee under the contract will result in the bonus payment being treated as not made under the employment contract executed on or before February 11, 2009.  However, amendment of a valid employment contract executed on or before February 11, 2009 to reduce the amount of the bonus payment or to enhance or include service-based or performance-based vesting requirements or holding period requirements will not result in this treatment.

Additional Matters

Recovery or “Clawback”.  A TARP recipient is required to institute a provision to recover any bonus, retention award, or incentive compensation paid to a SEO and any of the next 20 most highly compensated employees of the TARP recipient if the compensation was based on materially inaccurate statements of earnings, revenues, gains, or other criteria.

Whether a financial statement or performance metric criteria is materially inaccurate depends on all the facts and circumstances.  However, for this purpose, a financial statement or performance metric criteria shall be treated as materially inaccurate with respect to any employee who knowingly engaged in providing inaccurate information (including knowingly failing to timely correct inaccurate information) relating to those financial statements or performance metrics.  The TARP recipient must exercise its clawback rights except to the extent it demonstrates that it is unreasonable to do so, such as, for example, if the expense of enforcing the rights would exceed the amount recovered.

Unnecessary and Excessive Risks and Manipulation of Reported Earnings.  At least every six months, the compensation committee of a TARP recipient must discuss, evaluate, and review with the TARP recipient’s senior risk officers any unnecessary and excessive risks (including both long-term and short-term) that could threaten the value of the TARP recipient.  The compensation committee must identify the features in the TARP recipient’s SEO compensation plans that could lead SEOs to take these risks and the features in other employee compensation plans that pose risks to the TARP recipient, including any features in such plans that would encourage behavior focused on short-term results and not on long-term value creation.  The compensation committee is required to limit these features to ensure that the SEOs are not encouraged to take risks that are unnecessary or excessive and that the TARP recipient is not unnecessarily exposed to such risks.

Additionally, the compensation committee must discuss, evaluate, and review at least every six months the terms of each employee compensation plan and identify and eliminate the features in these plans that could encourage the manipulation of reported earnings of the TARP recipient to enhance the compensation of any employee.

Limitation on Tax Deduction.  A TARP recipient must agree to limit to $500,000 its federal income tax deduction for the annual compensation paid to each SEO, which includes performance-based compensation such as bonuses and gains on stock options.

Perquisite Disclosure.  A TARP recipient must annually disclose during the TARP period any perquisite the total value of which for the TARP recipient’s fiscal year exceeds $25,000 for each of the SEOs and highly compensated employees that are subject to the prohibition related to bonus payments.  TARP recipients must provide a narrative description of the amount and nature of these perquisites, the recipient of these perquisites, and a justification for offering these perquisites.  Such disclosure must be provided within 120 days of the completion of a fiscal year any part of which is a TARP period.

Prohibition on Gross-Ups.  A TARP recipient is prohibited from providing any reimbursement or “gross-up” of taxes owed with respect to any compensation to any of its SEOs and its next 20 most highly compensated employees during the TARP period.  For this purpose, providing a gross-up includes providing a right to a payment of such a gross-up at a future date.

Action Items

The Interim Rule suggests a number of matters which TARP recipients will need to consider.  TARP recipients should begin to identify its SEOs and most highly compensated employees.  The calculations used to make these determinations require equity valuations, examination of perquisites and examinations of other items of compensation.  This process will likely take some time to establish the group of covered employees.

Once the covered employees are identified, the TARP recipient should review the compensation of the identified employees for compliance with the Interim Rule and take appropriate action, including:

• Restructuring compensation as a combination of an appropriate salary and permissible long-term restricted stock;
• Analyzing whether compensation structures contain prohibited golden parachute payments or gross-ups;
• Analyzing whether deferred compensation plans contain features that could be viewed as impermissible bonus or retention payments;
• Identifying and limiting the features in the compensation plans that could lead SEOs to take unnecessary and excessive risks, including any features in such plans that would encourage behavior focused on short-term results and not on long-term value creation;
• Identifying and eliminating the features in any employee compensation plan that could encourage the manipulation of reported earnings of the TARP recipient to enhance the compensation of any employee;
• Ensuring that required “clawbacks” are in place; and
• Analyzing perquisites to determine whether they will need to be disclosed and justified for any of the covered employees.

Although the Interim Rule furnishes guidance regarding implementing the executive compensation and corporate governance standards applicable to TARP recipients, many of these standards will have to be addressed and resolved on an individual basis through careful planning and experience.  Bracewell regularly advises and provides regulatory insight to a range of financial-institution clients, including multinational and interstate banks as well as community-owned and mid-market institutions.  We draw on our in-depth understanding of applicable regulations and first-hand knowledge of the objectives of regulators to help clients achieve satisfactory results.