The Emergency Economic Stabilization Act of 2008 ("EESA"), which President Bush signed into law on October 3, 2008, created the Troubled Asset Relief Program ("TARP") under which the United States Treasury (the "Treasury") is generally authorized to purchase troubled assets from certain financial institutions. EESA establishes different sets of restrictions for financial institutions based on whether they sell troubled assets directly to the Treasury or whether they sell troubled assets through an auction process. EESA also modified certain tax code provisions that placed limitations on the deductibility of compensation paid to certain executives. This blog provides a brief overview of EESA provisions that address the executive compensation practices of financial institutions participating in TARP.
Restrictions Where Troubled Assets Are Sold Directly to the Treasury
If a financial institution makes a direct sale of troubled assets to the Treasury where no bidding process or market prices are available and the Treasury receives a meaningful equity or debt position in the financial institution, then the financial institution must meet standards relating to executive compensation and corporate governance that include the following:
1. Limits on incentive compensation that encourage executive officers to take unnecessary and excessive risks that threaten the value of the financial institution;
2. Prohibition on the financial institution from making any golden parachute payments to its "senior executive officers"; and
3. Clawback of any bonus or incentive compensation that has been paid to a senior executive officer based on statement of earnings, gains or other criteria that are later proven to be materially inaccurate.
All of the foregoing restrictions would remain in effect for the duration of the period the Treasury holds an equity or debt position in the financial institution.
Restrictions Where Troubled Assets Are Sold Through An Auction Process
If a financial institution sells troubled assets through an auction process, upon the Treasury purchasing an aggregate of $300 million or more of the financial institution’s troubled assets (including direct purchases), then the financial institution will be prohibited from entering into new employment contracts with its senior executive officers that provide for golden parachute payments in the event of an involuntary termination of employment, bankruptcy, liquidation or receivership. The forgoing restriction will remain in effect for as long as TARP remains in effect, which is through December 31, 2009, and for up to two years from the date of EESA’s enactment if so extended by the Treasury, regardless of the length of a financial institution’s participation in TARP. It is worth noting that the restriction only applies to new employment contracts and would not impose additional restrictions on payments to senior executive officers under employment contracts that existed prior to EESA’s enactment; provided, however, payments made under existing employment contracts may be affected by EESA’s changes to the Internal Revenue Code of 1986, as amended (the "Code"), discussed below.
Tax Code Changes Related to the Deductibility of Certain Executive Compensation
EESA amends Sections 162(m) and 280G of the Code with respect to compensation paid to "covered executives" of public and private financial institutions that sell troubled assets to the Treasury through the auction process if the aggregate amount of auction and direct purchases by the Treasury for all tax years exceeds $300 million. On October 14, 2008, the Internal Revenue Service published Notice 2008-94 which provides guidance on the new Sections 162(m)(5) and 280G(e) of the Code that were added by EESA.
Code Section 162(m) Limit on Excessive Compensation
Under pre-EESA law, the otherwise allowable deduction for compensation paid with respect to a "covered employee" of a publicly-held corporation is generally limited to no more than $1 million per year under Code Section 162(m). A "covered employee" for Code Section 162(m) purposes includes the principal executive officer of the corporation and the three highest compensated officers (other than the principal executive officer and principal financial officer).
For tax years ending on or after the enactment of EESA, the $1 million limit under Code Section 162(m) is reduced to $500,000 of compensation paid to a covered executive for any applicable tax year of an "applicable employer," which includes any employer for which one or more troubled assets are acquired under TARP if the aggregate amount of the troubled assets acquired for all tax years exceeds $300 million. Thus, unlike under pre-EESA law, the deduction limitation under Code Section 162(m), as modified by EESA, is not limited to publicly-held corporations. Notice 2008-94 provides guidance on special rules in connection with acquisitions, merger or reorganizations. In particular, in the event that a financial institution (the "target") that sold troubled assets under TARP is acquired by an entity that is not related to the target in an acquisition of any form, the troubled assets sold under TARP by the target prior to the acquisition are not aggregated with any assets sold by acquirer prior to or after the acquisition. If, after an acquisition, troubled assets of the target are sold by the acquirer’s controlled group, those assets must be aggregated with any assets sold by acquirer, whether prior to or after the acquisition, for purposes of determining whether acquirer is an applicable employer.
Another notable difference between pre- and post-EESA law with respect to the application of Code Section 162(m) is that the $500,000 limit will apply to all compensation paid to the covered executive, including any "qualified performance based compensation", which was generally excluded from the limit under Code Section 162(m). In other words, there is no performance-based compensation exception from the $500,000 deduction limit under Code Section 162(m) as modified by EESA. Moreover, Notice 2008-94 provides that no deduction is allowed for any taxable year for "deferred deduction executive remuneration" for services performed during any applicable taxable year by a covered executive, to the extent that the amount of the deferred deduction executive remuneration exceeds $500,000, minus the sum of (i) the executive remuneration for that applicable taxable year, plus (ii) the portion of the deferred deduction executive remuneration for such services taken into account in a preceding taxable year. "Deferred deduction executive remuneration" means remuneration that would be executive remuneration for services performed by a covered executive in an applicable taxable year but for the fact that the deduction is allowable in a subsequent taxable year (determined without regard to new Section 162(m)(5) of the Code).
Code Section 280G Limit on Excess Parachute Payments
Under pre-EESA law, Code Section 280G disallowed deductions to certain corporations for excess parachute payments, which are also known as "golden parachute payments", paid to disqualified individuals incident to a change in ownership or control. EESA modifies Code Section 280G by applying the deduction limitation on golden parachute payments to executives of employers participating in TARP. In particular, a "covered executive" of an "applicable employer" as such terms are defined above, is treated as a disqualified individual for purposes of the golden parachute rules under Code Section 280G. Thus, Code Section 280G as modified by EESA will apply to any compensation to or for a covered executive on account of his or her severance from employment because of an involuntary termination, or in connection with the employer’s bankruptcy, liquidation, or receivership, even in the absence of a change in ownership or control. Notice 2008-94 provides that an "involuntary termination" means a severance from employment due to the independent exercise of the unilateral authority of the applicable employer to terminate the covered executive’s services, other than due to the covered executive’s implicit or explicit request, where the covered executive was willing and able to continue performing services. Additionally, a covered executive’s voluntary termination of employment constitutes an involuntary termination if the termination from employment constitutes a termination for good reason due to a material negative change in the covered executive’s employment relationship.
In addition to the loss of the deduction to the applicable employer under Code Section 280G as modified by EESA, EESA also applies the 20% excise tax payable under Code Section 4999 to the covered executive that receives an excess parachute payment, which previously would have applied only to payments that are contingent upon a change in ownership or control. Moreover, the pre-EESA Code Section 280G rules providing for exceptions for payments that the employer establishes are reasonable compensation or that are made by small business corporations, do not apply with regard to a covered executive.
Alternative Minimum Tax Relief – Incentive Stock Options
Although a discussion of the alternative minimum tax ("AMT") and the AMT relief provided by EESA are generally beyond the scope of this blog, the relief with respect to the treatment of incentive stock options issued in reliance on Code Section 422 ("ISOs") for AMT purposes will have an impact on executive compensation. For regular income tax purposes, the exercise of ISOs is generally not a taxable event. However, for AMT purposes, the exercise of ISOs is treated as a taxable event. Thus, as a result, the optionee takes into account as ordinary income for purposes of computing AMT income the excess of the fair market value of the stock at the date of exercise over the amount paid for the stock.
Under EESA, any underpayment of tax outstanding on the date of EESA’s enactment which is attributable to the application of the alternative minimum tax adjustment for ISOs (including any interest or penalty relating thereto) is abated. This provision has the potential to reduce large tax liabilities for some taxpayers who exercised ISOs when the stock value was high and stock later depreciated in value. Additionally, EESA provides that the AMT refundable credit amount and the AMT credit for each of the first two tax years beginning after December 31, 2007, are increased by one-half of the amount of any interest and penalty paid before October 3, 2008 (i.e., the date of EESA’s enactment) on account of the application of the alternative minimum tax adjustment for ISOs, which can further assist with reducing tax liabilities for some taxpayers.
ANY TAX ADVICE HEREIN WAS NOT INTENDED OR WRITTEN BY THE AUTHOR TO BE USED, AND IT CANNOT BE USED BY ANY RECIPIENT, FOR THE PURPOSE OF AVOIDING ANY TAX PENALTIES THAT MAY BE IMPOSED ON ANY PERSON. THERE IS NO LIMITATION IMPOSED ON A RECIPIENT HEREOF BY THE AUTHOR HEREOF ON DISCLOSURE OF THE TAX TREATMENT OR TAX STRUCTURE OF ANY TRANSACTION. EXCEPT WITH PRIOR WRITTEN CONSENT OF THE AUTHOR, NOTHING HEREIN MAY BE USED OR REFERRED TO IN PROMOTING, MARKETING OR RECOMMENDING A PARTNERSHIP OR OTHER ENTITY, INVESTMENT PLAN OR ARRANGEMENT TO ANY PERSON.
 "Senior executive officers" is defined, for publicly held companies, to be the individuals who are the top five executive officers and whose compensation is required to be disclosed pursuant to the Securities Exchange Act of 1934, and any regulations issued thereunder. For non-publicly held companies, senior executive officers are the counterparts of the public company definition as expressed in the preceding sentence.
 A "covered executive" includes any individual who is the chief executive officer ("CEO") or the chief financial officer ("CFO") of an applicable employer. It also includes any employee who is one of the three highest compensated officers of the applicable employer other than the CEO or the CFO.
 An "applicable employer" does not include an employer for which troubled assets are acquired by the Treasury solely through direct purchases. Also, assets sold by one or more financial institutions that are part of parent-subsidiary controlled groups are aggregated for purposes of determining whether the $300 million threshold has been exceeded. The rules for brother-sister controlled groups and combined groups are disregarded.