http://www.financialcrisisupdate.com/2009/02/by-james-hamilton-jd-llm-principal-analyst-cch-federal-securities-law-reporterand-cch-derivatives-regulation-law-rep.html

February 13, 2009

Stimulus Bill Mandates Corporate Governance and Say on Pay

The
Act further prohibits golden parachutes to senior executives and
imposes strong corporate governance mandates on TARP companies,
including a requirement to have an independent compensation committee.
In addition, it rescinds a controversial IRS ruling on acquisitions by
financial institutions.

The
provisions fall under a title of the bill added by Senate Banking
Committee Chairman Christopher Dodd, D-Conn. The Dodd Amendment applies
strong executive compensation restrictions to all recipients of TARP
funds, regardless of whether they receive a capital injection or sell
troubled assets at auction.

The
Act also prohibits any compensation plan that creates incentives for
employees to manipulate reported earnings or take unnecessary and
excessive risks that threaten the company’s value. The board must also
adopt a company-wide policy on luxury expenditures.

The
Dodd Amendment bans bonuses for many highly-paid executives of
TARP-recipient firms under a sliding scale regime based on the amount
of financial assistance the TARP recipient received.

The
Act defines “senior executive officer” to mean an individual who is one
of the top five most highly-paid executives of a public company and
whose compensation must be disclosed pursuant to Securities and
Exchange Commission executive compensation rules. Under SEC rules,
these are the principal executive officer, the principal financial
officer, and the company’s other three most highly-compensated
executives.

The
Act defines a TARP recipient to mean any entity that has received or
will receive financial assistance provided under the TARP. The Act’s
restrictions apply during the period when the TARP recipient has
outstanding obligations arising from financial assistance provided
under TARP. The Act states that the period in which any obligation
arising from financial assistance provided under the TARP remains
outstanding does not include any period during which the federal
government only holds warrants to purchase common stock of the TARP
recipient.

Say on Pay

During
the period in which any obligation arising from TARP assistance remains
outstanding, any proxy or consent or authorization for an annual or
other meeting of the shareholders of any TARP company must permit a
separate shareholder vote to approve the compensation of executives, as
disclosed pursuant to SEC rules. This disclosure must include the
compensation discussion and analysis, the compensation tables and any
related material. Within one year of enactment, the SEC must issue
final rules and regulations required by this section.

The
shareholder vote will be nonbinding. Moreover, the Act provides that
the vote may not be construed as overruling a decision by the company’s
board or as creating any additional fiduciary duty of the board.
Similarly, the advisory vote cannot be construed to restrict
shareholders from making proposals for inclusion in proxy materials
related to executive compensation.

Compensation Committee

As
a matter of sound governance, the Act requires each TARP company to
have a compensation committee composed entirely of independent
directors. The compensation committee must discuss and evaluate, at
least semiannually, the employee compensation plans and their potential
risk to the company’s financial health.

In
the case of any TARP recipient that has received $25,000,000 or less of
TARP assistance and that has common or preferred stock that is not
registered pursuant to the Securities Exchange Act of 1934, the duties
of the compensation committee must be carried out by the board of
directors.

Retroactive Compensation Review

The
Act also requires a retroactive review of bonuses, retention awards and
other compensation already paid out by companies that received TARP
funds. Under this provision, The Treasury must review bonus and
retention awards and other compensation paid to executives of TARP
recipients to determine whether any payments were inconsistent with the
Emergency Economic Stabilization Act or the TARP or otherwise contrary
to public interest. If they are, the Treasury must negotiate with the
recipient and the subject employee for appropriate reimbursement of the
compensation or bonuses to the federal government.

Repayment of TARP Funds and Loan Modifications

The
Act provides that, after consulting with the appropriate federal
banking agency, the Treasury must permit a TARP recipient to repay any
assistance previously provided under the TARP without regard to whether
the financial institution has replaced such funds from any other source
or to any waiting period, and when such assistance is repaid, the
Treasury must liquidate warrants associated with such assistance at the
current market price. The Treasury is ordered to adopt regulations
implementing the repayment program.

The
Act also provides that the Treasury must not be required to apply the
executive compensation restrictions, or to receive warrants or debt
instruments, solely in connection with any loan modification under the
Emergency Economic Stabilization Act.

Governance and Compensation Standards

During
the period in which any obligation arising from financial assistance
provided under TARP remains outstanding, each TARP recipient will be
subject to the corporate governance and executive compensation
standards established by the Treasury under the Act and the provisions
of Internal Revenue Code Section 162(m)(5).

Tracking
SEC executive compensation disclosure rules, the five executive
officers covered by Section 162(m)(5) are the chief executive officer,
the chief financial officer, and the three highest-compensated officers
other than the CEO or CFO. For the purpose of determining the three
officers, “compensation” is defined as it is in the SEC rules to mean
total compensation, whether or not it is includible in the officer’s
gross income. However, unlike the SEC rules that determine the highest
three officers by reference to total compensation for the last
completed fiscal year, the measurement period under 162(m)(5) for
purposes of determining the three officers for an applicable taxable
year is that taxable year.

For
purposes of Section 162(m)(5), including the determination of whether
the aggregate amount of assets acquired from an employer exceeds $300
million, two or more persons who are treated as a single employer under
Section 414(b) (employees of a controlled group of corporations) and
Section 414(c) (employees of partnerships, proprietorships, etc., that
are under common control) are treated as a single employer.

An
applicable employer for purposes of Section 162(m)(5) is not limited to
a publicly traded corporation or even to the corporate business form.
Thus, an entity, whether or not publicly traded, is an applicable
employer if it sells troubled assets pursuant to the Treasury’s
program. Also, unlike the general 162(m) calculation of employee
remuneration subject to the deductible limit, 162(m)(5) remuneration
includes commissions and performance-based compensation.

Under
the Act, the Treasury must require each TARP recipient to meet
detailed, appropriate standards for executive compensation and
corporate governance. These standards must include limits on
compensation that exclude incentives for senior executive officers to
take unnecessary and excessive risks that threaten the value of the
company during the period that any obligation arising from TARP
assistance is outstanding. The standards must also include a clawback
provision for the recovery of any bonus, retention award, or incentive
compensation paid to a senior executive officer and any of the next 20
most highly-compensated employees of the TARP company based on
statements of earnings, revenues, gains or other criteria that are
later found to be materially inaccurate.

Further,
the corporate governance standards must include a prohibition of any
golden parachute payment to a senior executive officer or any of the
next five most highly-compensated employees during the period that any
obligation arising from TARP assistance is outstanding. The Act defines
“golden parachute” to mean any payment to a senior executive officer
for departure from a company for any reason, except for payments for
services performed or benefits accrued.

There
must also be a prohibition of any compensation plan that would
encourage manipulation of the reported earnings of a TARP recipient to
enhance the compensation of any of its employees.

The
Act also requires TARP recipients to establish a compensation committee
of the board of directors composed entirely of independent directors
for the purpose of reviewing compensation plans. The Act directs the
compensation committee of each TARP recipient to meet at least
semiannually to discuss and evaluate employee compensation plans in
light of an assessment of any risk posed to the TARP recipient from
such plans.

Another
required corporate governance standard for TARP recipients is that they
are prohibited from paying or accruing any bonus, retention award, or
incentive compensation during the period in which any obligation
arising from financial assistance provided under the TARP remains
outstanding, except that any such prohibition must not apply to the
payment of long-term restricted stock if it does not fully vest during
the period in which any obligation arising from financial assistance
provided to the TARP recipient remains outstanding and has a value that
is not greater than one third of the total amount of annual
compensation of the employee receiving the stock; and also is subject
to any other conditions the Treasury may impose in the public interest.
The prohibition on the paying of bonuses by TARP companies will apply as follows:

• For financial institutions that received TARP financial assistance of $25,000,000 or less, the prohibition will apply only to the company's most highly compensated employee.
  


• For financial institutions that received TARP financial assistance of between $25,000,000 and $250,000,000,
  the prohibition will apply to the five most highly-compensated
  employees, or such higher number as determined by the Treasury as being
  in the public interest.


• For financial institutions that received TARP assistance of between $250,000,000 and $500,000,000,
  the prohibition will apply to the senior executive officers and at
  least the next 10 most highly compensated employees or a higher number
  determined by the Treasury as in the public interest.


• For any financial institution receiving TARP assistance of $500,000,000 or more,
  the prohibition will apply to the senior executive officers and at
  least the 20 next most highly compensated employees or such higher
  number as the Treasury may determine as in the public interest.

But
the Act also provides that the bonus prohibitions will not be applied
to prohibit any bonus payment required to be paid pursuant to a written
employment contract entered into on or before Feb. 11, 2009, as
determined by the Treasury. The TARP company CEO and CFO must provide a
written certification of compliance by the company with the executive
compensation and corporate governance requirements. In the case of a
TARP company whose securities are publicly traded, the certification
must be provided to the SEC, together with annual filings required
under the securities laws. For nonpublic companies, the certification
must be filed with the Treasury.

Luxury Expenditures

The
board of directors of any TARP recipient must implement a company-wide
policy regarding excessive or luxury expenditures, as identified by
Treasury. These may include excessive expenditures on:

• entertainment or events;
  


• office and facility renovations;
  


• aviation or other transportation services; or
  


• other
  activities or events that are not reasonable expenditures for
  conferences, staff development, reasonable performance incentives or
  other similar measures conducted in the normal course of business
  operations.

Acquisition Losses

The
Act prospectively repeals IRS Notice 2008-83 that interprets Section
382 of the Internal Revenue Code to allow financial institutions
pursuing acquisitions to write off acquired losses stemming from
takeovers of other banks to offset future income. Notice 2008-83 came
under intense criticism by many in Congress.

Congress
enacted Section 382 to prevent tax-motivated acquisitions of loss
corporations. On Sept. 30, 2008, Notice 2008-83 effectively removed the
limit on the taxable income a purchasing bank, thrift, industrial loan
company or trust company could deduct post-acquisition. The Notice was
designed to help the struggling banking sector recover by allowing
acquiring banks to deduct the built-in tax losses of any banks they
acquire that have a loan portfolio that has diminished in value.

The
Act states that Congress finds that the delegation of authority to the
Treasury under Section 382(m) does not authorize the Secretary to
provide exemptions or special rules that are restricted to particular
industries or classes of taxpayers. Also, the statute says that IRS
Notice 2008-83 conflicts with the congressional intent of Section
382(m) and that the legal authority to prescribe 2008-83 is doubtful.

With
two exceptions, the provision states that Notice 2008-83 will not have
any effect for any ownership changes after Jan. 16, 2009. One exception
is for ownership changes pursuant to a binding contract executed on or
before that date. The second exception is for changes pursuant to an
agreement that was executed on or before that date and was described in
a public announcement or in an SEC filing.

Senator
Charles Grassley, R-Iowa, Ranking Member of the Finance Committee, has
noted that Section 382 was not enacted lightly by Congress, but rather
after extensive scholarly reflection by the staffs of the Senate and
House tax-writing committees and the Joint Committee on Taxation. It
has been an established part of the law since 1986. In the senator’s
view, Notice 2008-83 changed this law. He observed that many tax law
scholars have opined that the Treasury simply did not have authority to
make this change. One of the country’s largest law firms at one point
estimated that this IRS waiver could cost the U.S. Treasury $140
billion in taxes that would have otherwise been paid. Further, the
senator was troubled that this notice came out on Sept. 30, 2008, the
day after the House voted down the first bailout bill and two days
before Wells Fargo acquired Wachovia.

In
a letter to the Treasury and IRS, Senator Charles Schumer, D-N.Y.,
demanded to know why the IRS issued a notice allowing financial
institutions pursuing acquisitions to write off acquired losses
stemming from takeovers of other banks to offset future income. Sen.
Schumer questioned the need for the tax change after the implementation
of the Treasury’s capital injection program. He expressed concern that
the change would result in tens of billions of lost tax dollars for the
federal government, which has already committed $700 billion to many of
these same financial institutions under the rescue plan approved by
Congress.

The
Act also amends Section 382 to provide a special rule for ownership
changes. Under that rule, the limitations contained in Section 382(a)
will not apply in the case of an ownership change pursuant to a
restructuring plan, which is required under a loan agreement or a
commitment for a line of credit entered into with the Department of the
Treasury under the Emergency Economic Stabilization Act and is intended
to result in a rationalization of the costs, capitalization and
capacity with respect to the manufacturing workforce.