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ARRTA Amends the Executive Compensation Restrictions of EESA

Financial Services Task Force Update James D. Friedman

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Tax Act of 2009 (the "Act"), codifying various executive compensation limits for recipients of Troubled Asset Relief Program ("TARP") funds. The Act contains many provisions that were first introduced several weeks ago by the United States Department of the Treasury ("Treasury") as "Guidelines." The Act amends the Emergency Economic Stabilization Act of 2008 ("EESA") and is designed to ensure that public funds are directed toward financial stability and not inappropriate private gain. The Act applies to all past and future recipients of TARP funds, and the executive compensation restrictions remain in place until the TARP recipient no longer has outstanding TARP funds. However, government-held warrants for TARP recipient common stock do not count as outstanding TARP funds for this purpose. A summary of the Act's key executive compensation provisions follows.

Prohibited Activities

The Act specifically disallows golden parachutes for senior executive officers ("SEOs"), defined as the top five most highly paid executives, as well as for the next five most highly compensated employees. In addition, the Act grants the Secretary of the Treasury (the "Secretary") the authority to limit compensation in such a manner as to offer no incentives for SEOs to take unnecessary and excessive risks that may threaten the health of the TARP recipient. Finally, TARP recipients are prevented from instituting any compensation plan that would encourage the manipulation of reported earnings to enhance employee compensation.

Bonuses, Retention Awards, and Incentive Compensation

The Act places stringent restrictions on a TARP recipient's ability to pay bonuses, retention awards and incentive-based compensation to certain key employees. TARP recipients are prohibited from paying or accruing any such benefits other than long-term restricted stock that (1) does not fully vest while TARP funds are still outstanding and (2) has a value no greater than one-third of the total annual compensation of the employee or employees receiving the stock. The Act also allows the Secretary to place additional conditions and restrictions on the long-term stock as he deems to be in the public interest. The Act is not clear as to whether an executive's bonuses, retention awards and incentive-based compensation, while TARP funds are outstanding, are limited to one-third of the total annual compensation amount in the aggregate or on an annual basis.

As a TARP recipient's level of federal assistance increases, so to does the number of employees subject to the bonus restrictions. If the TARP recipient receives less than $25 million in assistance, then only the most highly compensated employee is subject to the restrictions. If the TARP recipient receives more than $25 million but less than $250 million, then the five most highly compensated employees are covered by the Act. If the assistance is greater than $250 million but less than $500 million, then the fifteen most highly compensated employees are covered. For TARP recipients receiving greater than $500 million, the 25 most highly compensated employees are subject to the restrictions. While the Act codifies the number of employees affected, it also grants the Secretary discretion to increase the number as he determines is in the public interest. The Act also does not prohibit bonuses that are part of written employment contracts executed before February 12, 2009.

Clawback Provisions

The Act contains two clawback provisions in regard to bonuses, retention awards and incentive-based compensation. The first provision protects TARP recipients by allowing the entities to recover any bonuses, retention awards or incentive-based compensation paid to the 25 most highly compensated employees. TARP recipients may recover such amounts if the payments were based on materially inaccurate statements of earnings, revenues or gains. The second provision is designed to protect taxpayers by allowing the Secretary to review bonuses, retention awards and incentive-based compensation paid prior to passage of the Act to the 25 most highly compensated employees. If the Secretary determines the payments to be inconsistent with the purpose of the Act or contrary to the public interest, the Act requires the Secretary to enter negotiations with the TARP recipient and the employee at issue to determine how to reimburse the government - as opposed to the TARP recipient - for the appropriate amount.

Board Compensation Committee

The Act requires each TARP recipient to establish a Board Compensation Committee. The committee is tasked with reviewing employee compensation plans and evaluating any risks posed to the TARP recipient by the plans. The committee must be composed entirely of independent directors and must meet at least semiannually. However, if a TARP recipient has received no more than $25 million in assistance and does not register its common or preferred stock, then the duties of the committee may be given to the board of directors of the entity.

Miscellaneous Provisions

Say-on-Pay Provisions

On an annual basis, TARP recipients are required to permit a separate, non-binding shareholder vote to approve executive compensation, which is disclosed according to Securities and Exchange Commission ("SEC") rules.

Luxury Expenditures

The Act requires the board of directors of each TARP recipient to adopt a companywide policy regarding excessive and luxury expenditures. The Secretary has ultimate authority regarding what constitutes an excessive or luxury expenditure. However, the Act does provide guidance by advising TARP recipients of the key areas to monitor: (1) entertainment or events, (2) office and facility renovations, (3) aviation or other transportation services and (4) other activities that are not reasonable and within the normal course of business.

Limitation on Deductible Compensation

When the EESA was passed, it included a $500,000 cap on deductible executive compensation for financial institutions that sold a large number of assets through the TARP program. Under the new Act, this provision of the EESA was extended to all TARP recipients.

CEO and CFO Certification

The Act requires the CEO and CFO of each TARP recipient to provide written certification of compliance with all requirements of the Act. Public companies must present the certification to the SEC, while private companies must report to the Secretary.

Repayment of TARP Funds

Under the Act, the Secretary must accept repayment of TARP funds without regard to whether the TARP recipient replaced the funds with other capital, as was previously required. However, the Act requires the TARP recipient to consult with its federal banking agency prior to such repayment. Also, once the TARP funds are repaid, the Secretary must liquidate all warrants associated with the TARP recipient at the current market price.

Future Treasury Initiatives

The provisions contained in the Act appear to take precedence over slightly different provisions contained in the February 4, 2009 Treasury Guidelines. In the near future, the Treasury will likely issue additional clarifications regarding the implementation of ARRTA, outlining precisely what TARP recipients must do to comply with the Act. The Treasury will also likely move forward with several initiatives related to executive compensation that were first mentioned in the Guidelines. For example, the Treasury and the SEC are likely to investigate the feasibility of requiring all public financial institutions - not just TARP recipients - to have compensation committees to review and disclose the compensation arrangements of executives and high-level employees. In addition, the government is considering requiring top financial institution executives to hold stock issued as compensation for several years after its award. By doing so, the government seeks to encourage executives to base decisions upon a more long-term approach. Finally, the government would like to broaden "say-on-pay" shareholder voting requirements to include all financial institutions. In the near future, the Treasury plans to host a conference with shareholder advocates, major public pension and institutional investor leaders, policy-makers, executives and academics to discuss executive pay reform issues.

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For more details, or if you have any questions, please contact Jim Friedman at 414-277-5735 / jdf@quarles.com, Spencer Larche at 414-277-5571 / slarche@quarles.com, or your Quarles & Brady LLP attorney.