Treasury Bailout Program Restricts Executive Pay for Participating Asset Holders

The Emergency Economic Stabilization Act of 2008, signed into law by President Bush on October 3, 2008, creates a program to purchase "troubled assets" from the holder of those assets. The Act comes in response to the current credit crisis in the financial sector brought about by the collapse or near-collapse of banks, broker-dealers, insurance companies and other institutions with significant assets tied to subprime mortgage loans.

The Act creates the Troubled Asset Relief Program, or TARP, giving the U.S. Department of the Treasury the authority to purchase troubled assets from an asset holder whose long-term survival is in immediate danger, and to use auctions to facilitate the purchase of troubled assets. The Act also permits the Treasury Department to acquire an equity or debt interest in a participating asset holder, so that taxpayers will benefit if and when the asset holder recovers. The program is available not only to banks, savings associations, credit unions and other financial institutions, but to other holders of troubled assets, including pension plans.

Perhaps unsurprisingly, the Act seeks to limit the extent to which asset holders, or their top executives, will benefit from the federal government bailout, and to discourage those asset holders or their executives from engaging in fraud or taking on inappropriate risk. Accordingly, most asset holders that choose to participate in the program will be subject to certain limitations on executive pay.

The Act imposes two restrictions on executive pay at any time that the Treasury holds a "meaningful" equity or debt interest in an asset holder participating in the program, where the Treasury acquired that interest through purchases from the asset holder where no bidding process or market prices were available. First, it prohibits the asset holder from offering senior executives (in general, the asset holder's top five highest-paid executives) incentives to take "unnecessary or excessive" risk that would threaten the asset holder's value. This would prevent the asset holder from designing bonus programs that would tempt executives to gamble on risky investments in the hopes of reaping big bonuses, even while the asset holder's continued viability is in doubt.

Second, it prohibits the asset holder from making "golden parachute payments." These are severance payments, often a multiple of base salary and historical bonuses, to senior executives whose employment has been terminated.

To guard against fraud and self-dealing by senior executives, the Act also requires these asset holders to "clawback," or recover, from senior executives any incentive payments they receive that were based on earnings statements or other performance measures that are later proved to have been false at the time those payments were made.

The Act contains a separate provision which mandates that those asset holders participating in TARP which have more than $300,000,000 in auctioned assets (including direct purchases by the government) may not include golden parachute provisions in any new employment agreements offered to senior executives.

The Act also amends certain portions of the Internal Revenue Code to further discourage separation payments to senior executives and limit tax deductions for executive pay. Any asset holder participating in TARP that pays a separation payment to an executive who is involuntarily terminated or who is terminated because the asset holder is in bankruptcy, liquidation or receivership, may not be allowed to deduct a portion of the payment under Section 280G of the Code. Payments subject to these rules include amounts that vest or are accelerated by reason of the executive's severance. The ability to deduct the separation payment will depend upon the amount of the separation payment relative to the executive's average annual compensation for the last five years – i.e., the executive's "base amount." If the total separation payments equal or exceed three times the executive's base amount, the amount of the parachute payment in excess of the executive's base amount – the "excess parachute payment" – will not be deductible. If the total separation payments do not equal or exceed three times the executive's base amount, there is no restriction.

The senior executive who receives a separation payment will be subject to a 20% excise tax on any portion that is an excess parachute payment, although there does not appear to be any prohibition on the asset holder providing the executive a "gross up" payment for the excise tax owed. It is unclear whether the provisions also would attach in the event of "good reason" voluntary termination that operates as a constructive discharge. The IRS is instructed to draft regulations that prevent avoidance of the limits by means of mischaracterization of a separation.

To address the issue of high pay to executives benefiting from TARP, the Act amends the Internal Revenue Code to deny a tax deduction to any asset holder participating in the program for remuneration paid to a senior executive in excess of $500,000. This applies regardless of the business form of the asset holder, and regardless of whether the asset holder is a public company. This applies with respect to the CEO, the CFO, and the three highest paid officers other than the CEO or CFO. The deduction limit is in effect for a given tax year only after the troubled assets acquired by the Treasury from the asset holder and its affiliates under TARP exceed $300,000,000 in the aggregate for the year and prior years.

The deduction limit also applies to any amount that is attributable to service performed in a tax year for which the deduction limit is in effect and that is deferred – i.e., deferred compensation. To the extent that current cash compensation does not utilize the full $500,000 deduction limit, the difference can "tag along" with the deferred compensation attributable to services performed during that year. When the deferred compensation, together with earnings on such amounts, is paid, the unused deduction room associated with the deferral year can then be used, but the remainder of the payment will not be deductible. For example, if there remains $100,000 of room in the deduction limit for a given year, the $100,000 can be associated with deferred compensation attributable to that year. If the executive has $75,000 of deferred compensation in that same year, and that grows to $150,000 when it is paid, the $100,000 deduction room can be applied to that payment, with $50,000 then being nondeductible.

The deduction limit applies to all taxable amounts, without any exceptions for performance-based pay.