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Treasury Issues Interim Final Rule On Executive Compensation Standards Under TARP

Financial Services Task Force Update James D. Friedman, Joseph D. Masterson, John P. Vail, Anneke Diem

On June 10th, 2009, the United States Department of the Treasury released an Interim Final Rule (the "Rule"), providing guidance to entities receiving financial assistance under the Troubled Asset Relief Program ("TARP") of the Emergency Economic Stabilization Act of 2009 ("EESA") on the executive compensation and corporate governance provisions of section 111 of the EESA, as amended by the American Recovery and Reinvestment Act of 2009 ("ARRA").

The purpose of this update is to provide an overview of significant changes to the executive compensation and corporate governance standards under EESA, as applied to TARP recipients.

Application of the Rule

The Rule applies to any entity that has received or will receive financial assistance under TARP and also includes any entity in which the TARP recipient owns at least 50% or which owns at least 50% of the TARP recipient ("TARP Recipients")1. The restrictions contained in the Rule apply during any period in which any obligation arising under TARP remains outstanding, provided, however, that if the federal government only holds a warrant to purchase common stock of the TARP Recipient the restrictions will not apply.

The executive compensation restrictions generally apply to (a) Senior Executive Officers ("SEOs") of the TARP Recipient and (b) certain most highly compensated employees. Under the Rule, the term "Senior Executive Officer" is defined as any individual who is employed by the TARP Recipient and would qualify as a "named executive officer" under Instruction 1 to Item 402(a)(3) of Regulation S-K under the federal securities laws. This generally means that a SEO is the Chief Executive Officer, the Chief Financial Officer and the three most highly compensated officers other than the Chief Executive Officer and the Chief Financial Officer. Smaller reporting companies that are subject to this definition must identify at least five SEOs, provided, that, no employee other than the Chief Executive Officer or Chief Financial Officer that receives $100,000 or less in total annual compensation will be deemed to be a SEO. Private companies must apply the rules under Item 402(a)(3) as well to determine who qualifies as a SEO. In most cases, the Chief Executive Officer, the Chief Financial Officer and the other three most highly compensated officers and/or employees will be deemed to be SEOs. It should be noted that the restrictions with respect to a most highly compensated employee apply even if he or she may not be an officer.

Compensation Committee

Consistent with prior guidance, the Rule requires the TARP Recipient's compensation committee to meet at least once every six months to evaluate the company's employee compensation plans to ensure that they do not encourage the manipulation of reported earnings or the taking of unnecessary risks that could adversely affect the TARP Recipient. For TARP Recipients whose securities are not registered with the SEC and who have received $25 million or less in financial assistance under TARP, the duties of the Compensation Committee may be carried out by the board of directors of the TARP Recipient. In connection with the required review, the Compensation Committee or the board of directors, as the case may be, must prepare on an annual basis a narrative description identifying how it limited features in "(1) SEO compensation plans that could encourage SEOs to take unnecessary and excessive risks that could threaten the value of the TARP Recipient, including how these SEO compensation plans do not encourage behavior focused on short-term results rather than long-term value creation; (2) employee compensation plans to ensure that the TARP Recipient is not unnecessarily exposed to risks, including how these employee compensation plans do not encourage behavior focused on short-term results rather than long-term value creation; and (3) employee compensation plans that could encourage the manipulation of reported earnings of the TARP Recipient to enhance the compensation of an employee."2 For TARP Recipients whose securities are registered with the SEC, these disclosures must be included in the Compensation Committee Report required under Item 407 of Regulation S-K and submitted to the Treasury. For smaller reporting companies and private companies, this information must be disclosed to the Treasury and its primary regulatory agency within 120 days of the completion of any fiscal year in which the TARP obligations remain outstanding.

Restrictions on Golden Parachute Payments

Under the Rule, TARP Recipients are prohibited from making golden parachute payments to any SEO and any of the next five most highly compensated employees. The definition of "golden parachute payment" includes any payment made as a result of the individual's departure from the company for any reason, including change of control payments which were not specifically referenced under the ARRA. Interestingly, the Treasury treats golden parachutes as being paid at the time of the employee's departure from the company even if such payments are made at some later date. For instance, an employment agreement that gives an employee the right to receive a payment upon his or her termination from the company and provides that such amount is not payable until the TARP period expires would violate the restriction on golden parachute payments. For TARP purposes the payment will be deemed to have been made on the date the employee left the company and thereby obtained the right to such payment. There is no longer any exception for any amount of a golden parachute as was allowed under the Treasury's October 2008 rule.

Restrictions on Bonus Payments

TARP Recipients are prohibited from paying or accruing bonuses for certain employees. A bonus payment is defined as any payment that is, or is in the nature of, a bonus, incentive compensation or retention award. Examples of payments that may be prohibited include payments made pursuant to certain stock or option plans, signing bonuses, and compensation given to newly hired employees which are intended to provide them with a continuation of benefits received while at their previous place of employment. However, awards under long-term restricted stock plans are permitted so long as the value of the stock is no greater than 1/3 of the employee's annual compensation and must not vest during the period in which the TARP assistance remains outstanding. The employees to whom this prohibition applies depends upon the amount of the financial assistance the TARP Recipient received. For companies that received less than $25 million, the prohibition applies to the most highly compensated employee of the company. For companies that received at least $25 million but less than $250 million, the prohibition applies to the five most highly compensated employees of the company. For companies that have received at least $250 million but less than $500 million, the prohibition will apply to the SEOs and the next ten most highly compensated employees. Finally, for companies that have received $500 million or more, the prohibition will apply to the SEOs and the next twenty most highly compensated employees.

If an employee is not currently a SEO or one of the most highly compensated employees, but was previously a SEO or most highly compensated employee, any bonus paid to the employee, based on services performed during the period the employee was a SEO or highly compensated employee, is prohibited under the Rule. To illustrate this concept, the Treasury provided a few examples, including the following:

Example 1. Employee A is a SEO of a TARP Recipient in 2010, but not in 2011. The TARP Recipient maintains an annual bonus program, generally paying bonus payments in March of the following year. Employee A may not be paid a bonus in 2010 (for services performed in 2009 or any other year). In addition, Employee A may not be paid a bonus payment in 2011 to the extent such bonus payment is based on services performed in 2010.3

One of the most significant aspects of the Rule is its interpretation of the grandfathering provisions in the ARRA with respect to bonus payments arising from employment contracts entered into prior to February 11, 2009. The ARRA provides that the restriction on the payment and accrual of bonuses does not apply to bonus payments required to be paid pursuant to written employment contracts executed on or before February 11, 2009.4 The Rule, however, provides that the prohibition does not apply to bonus payments required to be paid under a valid employment contract only if the employee had a legally binding right under the contract to a bonus payment as of February 11, 2009. For purposes of determining whether an employee had a legally binding right to payment, the Rule defers to the rules set forth in Section 409A of the Internal Revenue Code. Under the terms of Section 409A, an employee may not have a legally binding right to compensation if the compensation may be reduced unilaterally or eliminated by the company after the services have been performed. In other words, if the board of directors has the discretion to eliminate or unilaterally reduce a bonus payment, the employee may not have a legally binding right to such payment.

The Treasury has provided an example where an employee of a TARP Recipient is entitled participate in a restricted stock plan. Under the terms of the plan, restricted stock units are traditionally granted each July 1. The employee in question received grants of restricted stock on July 1, 2007 and July 1, 2008. Under the Rules, these grants are excluded from the prohibition on bonus payments because the employee obtained a legally binding right to the units prior to February 11, 2009. However, the employee is not entitled to receive a similar grant in July of 2009.  Although the plan was in existence prior to February 11, 2009, the Treasury takes the view that the employee did not receive a legally binding right to the units until July 1, 2009 because the actual grant did not occur until such date. As a result, the grant would be prohibited under the Rule.5

The Rule also provides that any amendments to a contract entered into before February 11, 2009 which serve to increase the amounts payable thereunder, accelerate any vesting conditions or otherwise materially enhance the benefits available to the employee may cause the agreement to fall outside of this grandfathering exemption.

Clawback of Bonus Payments

The ARRA provides that a TARP Recipient must provide for the recovery of any bonus, retention award or incentive compensation paid to a SEO or any of the next 20 most highly compensated employees of the TARP Recipient that was based on materially inaccurate financial statements or criteria.6 This is commonly referred as the "clawback provision." Under the terms of the Rule, a TARP Recipient is required to exercise its clawback rights unless it can demonstrate that it would be unreasonable to do so.

Adoption of Excessive or Luxury Expenditures

Under the ARRA, each TARP Recipient is required to adopt a company-wide policy regarding excessive or luxury expenditures.7 The Rule requires that the policy be filed with the Treasury and the TARP Recipient's primary regulator and posted on the company's website before the later of 90 days after the closing date of the TARP transaction or 90 days after June 15, 2009. The Rule requires that the policy:

  1. Identify the types and categories of expenses prohibited or requiring prior approval;

  2. Adopt approval procedures for those expenses requiring prior approval;

  3. Mandate Chief Executive Officer and Chief Financial Officer certification of the prior approval of any expenditures requiring prior approval;

  4. Mandate prompt internal reporting of any violation of the policy; and

  5. Mandate accountability for adherence to the policy.8

Say On Pay

After the passage of the ARRA, many companies had questions about how to comply with the requirement under the ARRA that the TARP Recipient permit a nonbinding shareholder vote on executive compensation in its proxy materials. Unfortunately, the Rule provides very little guidance on this issue. It merely states that TARP Recipients must comply with any SEC guidance, rules or regulations issued with respect to this requirement.  At a meeting held on July 1, 2009, the SEC proposed changes to the proxy rules under the Securities Exchange Act of 1934 which would address this requirement.  The SEC subsequently released a proposed rule on this subject which is now available on the SEC's website.  Comments on the proposed rule will be accepted for a period of 60 days after its publication in the Federal Register. 

Additional Requirements

In addition to the foregoing, the Rule also contains certain requirements which were not previously addressed in the ARRA. These requirements include the following:

  1. TARP Recipients must disclose to the Treasury and its primary federal regulator, on an annual basis, any perquisites with a value in excess of $25,000 for any employee who is subject to the limitations on bonus payments. The TARP Recipient must also provide a justification for offering this benefit.

  2. The TARP Recipient must disclose to the Treasury and its primary federal regulator whether it has engaged a compensation consultant and the types of services the consultant or any of its affiliates have provided during the past three years.

  3. The TARP Recipient generally may not provide any tax gross-up or other reimbursement for tax expenses to any SEOs and the next 20 most highly compensated employees.

The Rule also addresses the application of the executive compensation requirements to entities that are either acquired by or acquire existing TARP Recipients.

Certifications of Compliance

The Rule provides that the Chief Executive Officer and the Chief Financial Officer must certify their compliance with the requirements of the Rule within 90 days of the completion of each fiscal year in which the financial assistance under TARP remains outstanding. For public companies, these certifications must be provided in Exhibit 99.1 to the TARP Recipient's annual report on Form 10-K. The Rule contains a draft of the certification upon which companies may rely. The Rule also provides that each TARP Recipient must maintain any documentation needed to substantiate each certification for at least six years and must furnish the documentation to the Treasury upon its request.

Establishment of Office of Special Master

Finally, the Rule also establishes the Office of the Special Master for TARP Executive Compensation within the Treasury Department ("Special Master"). The Special Master is charged with reviewing the executive compensation and corporate governance policies of TARP Recipients and has the authority to provide guidance, interpretations or opinions related to the standards set forth in the Rule. In addition, the Special Master will review bonuses, retention awards and other compensation paid before February 17, 2009 to employees of TARP Recipients to ensure that they comply with Section 111 of the EESA.

Effectiveness of Rule

The Rule became effective on June 15, 2009. It supersedes the October 2008 Interim Final Rule and other guidance previously issued by the Treasury. However, the bonus payment limitations under the Rule do not apply to bonuses, retention awards and incentive compensation paid or accrued by TARP Recipients prior to June 15, 2009. In addition, the increased restrictions on golden parachute payments do not apply to any amounts paid prior to June 15, 2009.

This update discusses significant aspects of the Rule on executive compensation and corporate governance, but is not a comprehensive analysis of the Rule. If you have questions about the applicability of the Rule, please contact Jim Friedman at 414-277-5735 / jim.friedman@quarles.com, Joseph Masterson at 414-277-5169 / joseph.masterson@quarles.com, John Vail at 312-715-5042 / john.vail@quarles.com, Anneke Diem at 312-715-5088 / anneke.diem@quarles.com or your Quarles & Brady attorney for assistance.




1 31 CFR Part 30, Summary p. 16.
2 31 CFR Part 30, Summary at p. 22.
3 31 CFR Part 30 §30.10.
4 ARRA Title VII, Sec. 7001(b)(3)(D)(ii).
5 See 31 CFR Part 30 §30.10.
6 ARRA Title VII, Sec. 7001(b)(2)(B).
7 ARRA Title VII, Sec. 7001(d).
8 31 CFR Part 20 §30.12.