The Treasury Department's Guidelines on Executive Pay

President Obama and Treasury Secretary Timothy F. Geithner stood together on Feb. 4, 2009, to announce the Treasury Department's new set of guidelines restricting executive compensation at financial institutions that receive governmental money. In his announcement, President Obama called the bonus payments made to senior executives in late 2008 by major financial firms that received bailout money “shameful and intolerable.” He indicated that the new Treasury guidelines were issued to ensure public funds are directed toward the public's interest in stabilizing our economy and are designed to align compensation of senior executives in the financial industry with interests of both shareholders and taxpayers.

Specifically, the guidelines indicate that they were designed to strike a balance between the financial industry's need to attract top talent to lead in the current economic climate and the public's interest in requiring transparency and accountability. The guidelines require not only disclosure of but an explanation and justification of the policy supporting certain compensation decisions. The guidelines are divided into two broad categories: 1) compliance and certification; and 2) limits on executive compensation.

Due to their limited application, chances are that your company will not be directly impacted by the guidelines. The caps on executive pay apply on a prospective basis and are currently limited to the financial industry. In addition, many of the restrictions can be waived by disclosure to the shareholders. To the extend the disclosure requirements in the guidelines apply, they go beyond the reporting requirements relating to executive compensation imposed by the Securities and Exchange Commission as part of the rule-making requirements of Sarbanes-Oxley, but the changes required by the guidelines pale in comparison to the magnitude of changes to the rules governing the design of executive compensation brought about by Code Section 409A.

Importantly, the new Treasury guidelines indicate that they mark the beginning of the President's examination of the relationship between the corporate governance and compensation rules and current financial circumstances. And, the language and tone of the guidelines suggest that the current administration intends further reform of the corporate governance and compensation rules. The guidelines also contain a provision entitled long-term regulatory reform, which further suggests that additional changes to executive compensation are forthcoming.

Compliance and Certification Requirements Under Treasury Guidelines

Under the Treasury guidelines, the Chief Executive Officer of any company who receives financial assistance must certify, on an annual basis, compliance with executive compensation restrictions imposed by statute, Treasury regulation and contractual obligation. Thus, such certification would require affirmation not only of the standards imposed by the guidelines but also of those previously imposed by Code Section 409A and other laws. Additionally, the guidelines require the compensation committee of each company receiving government assistance to explain the ways in which their compensation arrangements are designed to both avert unnecessary risk taking and to reward creation of long-term value.

Although the provision related to restrictions on expenses for entertainment and holiday parties, the use of aviation services, conferences and other events, and office or facility renovations is contained under the broad category of “limits on compensation,” the primary force of the restrictions come from the additional required disclosure. The guidelines require the Chief Executive Officer of all companies receiving federal funds to certify the business need for any expenditure that could be viewed as a luxury item or excessive. The guidelines expressly indicate that they are not designed to interfere with or prevent normal expenditures for normal business operations, including performance incentives, staff development, and sales conferences. Companies are also required to post the text of their expenditure policies on company Web sites, thereby mandating the policies be available not only to shareholders, but to the general public as well. This limitation appears to respond directly to the public outcry that resulted last fall when several automakers flew company planes at an estimated cost of $20,000 per round-trip flight between Detroit and Washington, DC, to request government financial assistance.

How Widespread?

Currently, these disclosures are only required by entities in the financial industry receiving government financial assistance. However, as mentioned above, as a consequence of the requirements of Sarbanes-Oxley, the Securities Exchange Commission now requires public entities to report compensation agreements involving executive officers and directors. The SEC also recently overhauled its executive officer and director compensation disclosure rules. Therefore, in light of language in the guidelines relating to long-term reform, it would not be surprising to see the SEC expand the disclosure requirements to include the certification requirements outlined in the guidelines for all public companies.

Conditions on Executive Compensation

The new guidelines distinguish between those entities seeking “exceptional assistance” and those that accept assistance under the generally available capital access program with respect to the conditions placed on compensation. The generally available program is essentially a “one size fits most” standard, with set terms and conditions for all recipients. It has a cap on the amount that each institution can receive and a uniform expected rate of return on taxpayer monies. The Capital Purchase Program announced last fall is an example of a generally available capital access program. Financial institutions that need assistance at a level exceeding what is available under a generally available program can apply for “exceptional assistance.” Exceptional assistance programs are specifically negotiated between the institution and Treasury. Some of the entities that currently have such agreements include Bank of America, Citigroup, and AIG.

In addition, the new guidelines contain restrictions that are much stronger than the restrictions put into place last fall. Current tax law permits a business to deduct all salaries that do not exceed $1 million, and performance-based compensation is excluded from this amount. Last fall, this amount was reduced to $500,000 for amounts paid to top executives at certain financial institutions, but the limit applied only when the business had over $300 million in dealings with the government under the bailout program. As such, the restriction applied to very few entities, and the restriction did not cap the amount paid, it only limited the deduction the company could take. In contrast, for entities receiving exceptional assistance, the new guidelines cap the total amount of compensation for senior executives as $500,000. Restricted stock or other similar long-term awards in excess of this amount are permitted, but executives receiving such restricted stock or long-term incentive compensation will be prevented from cashing in the award until the earlier of two events: the government has been repaid with contractual dividends, or at a specified period of time and according to conditions that account for repayment obligations, stability standards, and protection of taxpayer interests.

Entities that receive exceptional assistance must also change their compensation arrangements to include a provision permitting the entity to recoup bonuses and incentive compensation under certain circumstances. Specifically, the top 25 senior executives must repay incentive pay if the executive is found to have knowingly provided inaccurate information in the financial statements or performance measures used to calculate incentive pay. This is an expansion of the restrictions issued last fall, which included a clawback provision, but limited it to the top five executives. In addition, the top ten senior executives are prohibited from receiving any “golden parachute” payments upon severance, and the next 25 executives are limited to severance payments
of no greater than one year's compensation.

For companies that accept funds under the generally available programs, similar restrictions apply, but some of the restrictions can be waived by disclosure. A company can waive the $500,000 cap on senior executive pay by disclosure of the compensation and using a “say on pay” resolution with their shareholders. A company that accepts funds under a standard program will also be required to institute a clawback provision that would require repayment of bonuses or incentive pay by any of the top 25 senior executives in the event the executive is found to have knowingly engaged in providing false information as to the financial statements or performance measures on which their compensation is based. The top five executives are also prohibited from a golden parachute payment that exceeds one year's compensation. All companies accepting future funds will be required to explain how the compensation arrangements for not only senior executives but for all other employees are designed to prevent unnecessary and excessive risk taking.

Long-Term Reform Measures: What's Next?

The last section of the guidelines requires efforts to examine how company-wide compensation strategies may have rewarded excessive risk-taking and contributed to the current economic conditions. One of the recommended steps includes requiring all compensation committees of public financial institutions to review and disclose how executive and employee compensation are consistent with promoting sound risk management and long-term value for companies and shareholders. This provision indicates that such examination and disclosure is going to be required of all financial institutions, not just those that are receiving governmental assistance.

The guidelines also make suggestions regarding limits on stock incentives and stronger shareholder say on the policies behind executive compensation. Specifically, the guidelines indicate that serious consideration should be given to a blanket rule requiring top executives at financial institutions to hold stock for several years before being able to redeem the stock for cash payment. They also suggest that shareholders of all financial institutions should have a say on the amount of executive compensation and on how to structure incentive compensation to promote long-term value. The guidelines end by announcing that the Treasury Secretary will host a conference to further address executive pay reform at financial institutions. This further suggests that these guidelines are only the beginning of increased disclosure and accountability requirements.

Angela Marie Hubbell is a partner in the Business Transactions Department of Wildman, Harrold, Allen & Dixon LLP (Chicago), where she counsels employers on a broad range of employee benefits issues, including executive compensation. She can be reached at [email protected] or 312-201-2832.

President Obama and Treasury Secretary Timothy F. Geithner stood together on Feb. 4, 2009, to announce the Treasury Department's new set of guidelines restricting executive compensation at financial institutions that receive governmental money. In his announcement, President Obama called the bonus payments made to senior executives in late 2008 by major financial firms that received bailout money “shameful and intolerable.” He indicated that the new Treasury guidelines were issued to ensure public funds are directed toward the public's interest in stabilizing our economy and are designed to align compensation of senior executives in the financial industry with interests of both shareholders and taxpayers.

Specifically, the guidelines indicate that they were designed to strike a balance between the financial industry's need to attract top talent to lead in the current economic climate and the public's interest in requiring transparency and accountability. The guidelines require not only disclosure of but an explanation and justification of the policy supporting certain compensation decisions. The guidelines are divided into two broad categories: 1) compliance and certification; and 2) limits on executive compensation.

Due to their limited application, chances are that your company will not be directly impacted by the guidelines. The caps on executive pay apply on a prospective basis and are currently limited to the financial industry. In addition, many of the restrictions can be waived by disclosure to the shareholders. To the extend the disclosure requirements in the guidelines apply, they go beyond the reporting requirements relating to executive compensation imposed by the Securities and Exchange Commission as part of the rule-making requirements of Sarbanes-Oxley, but the changes required by the guidelines pale in comparison to the magnitude of changes to the rules governing the design of executive compensation brought about by Code Section 409A.

Importantly, the new Treasury guidelines indicate that they mark the beginning of the President's examination of the relationship between the corporate governance and compensation rules and current financial circumstances. And, the language and tone of the guidelines suggest that the current administration intends further reform of the corporate governance and compensation rules. The guidelines also contain a provision entitled long-term regulatory reform, which further suggests that additional changes to executive compensation are forthcoming.

Compliance and Certification Requirements Under Treasury Guidelines

Under the Treasury guidelines, the Chief Executive Officer of any company who receives financial assistance must certify, on an annual basis, compliance with executive compensation restrictions imposed by statute, Treasury regulation and contractual obligation. Thus, such certification would require affirmation not only of the standards imposed by the guidelines but also of those previously imposed by Code Section 409A and other laws. Additionally, the guidelines require the compensation committee of each company receiving government assistance to explain the ways in which their compensation arrangements are designed to both avert unnecessary risk taking and to reward creation of long-term value.

Although the provision related to restrictions on expenses for entertainment and holiday parties, the use of aviation services, conferences and other events, and office or facility renovations is contained under the broad category of “limits on compensation,” the primary force of the restrictions come from the additional required disclosure. The guidelines require the Chief Executive Officer of all companies receiving federal funds to certify the business need for any expenditure that could be viewed as a luxury item or excessive. The guidelines expressly indicate that they are not designed to interfere with or prevent normal expenditures for normal business operations, including performance incentives, staff development, and sales conferences. Companies are also required to post the text of their expenditure policies on company Web sites, thereby mandating the policies be available not only to shareholders, but to the general public as well. This limitation appears to respond directly to the public outcry that resulted last fall when several automakers flew company planes at an estimated cost of $20,000 per round-trip flight between Detroit and Washington, DC, to request government financial assistance.

How Widespread?

Currently, these disclosures are only required by entities in the financial industry receiving government financial assistance. However, as mentioned above, as a consequence of the requirements of Sarbanes-Oxley, the Securities Exchange Commission now requires public entities to report compensation agreements involving executive officers and directors. The SEC also recently overhauled its executive officer and director compensation disclosure rules. Therefore, in light of language in the guidelines relating to long-term reform, it would not be surprising to see the SEC expand the disclosure requirements to include the certification requirements outlined in the guidelines for all public companies.

Conditions on Executive Compensation

The new guidelines distinguish between those entities seeking “exceptional assistance” and those that accept assistance under the generally available capital access program with respect to the conditions placed on compensation. The generally available program is essentially a “one size fits most” standard, with set terms and conditions for all recipients. It has a cap on the amount that each institution can receive and a uniform expected rate of return on taxpayer monies. The Capital Purchase Program announced last fall is an example of a generally available capital access program. Financial institutions that need assistance at a level exceeding what is available under a generally available program can apply for “exceptional assistance.” Exceptional assistance programs are specifically negotiated between the institution and Treasury. Some of the entities that currently have such agreements include Bank of America, Citigroup, and AIG.

In addition, the new guidelines contain restrictions that are much stronger than the restrictions put into place last fall. Current tax law permits a business to deduct all salaries that do not exceed $1 million, and performance-based compensation is excluded from this amount. Last fall, this amount was reduced to $500,000 for amounts paid to top executives at certain financial institutions, but the limit applied only when the business had over $300 million in dealings with the government under the bailout program. As such, the restriction applied to very few entities, and the restriction did not cap the amount paid, it only limited the deduction the company could take. In contrast, for entities receiving exceptional assistance, the new guidelines cap the total amount of compensation for senior executives as $500,000. Restricted stock or other similar long-term awards in excess of this amount are permitted, but executives receiving such restricted stock or long-term incentive compensation will be prevented from cashing in the award until the earlier of two events: the government has been repaid with contractual dividends, or at a specified period of time and according to conditions that account for repayment obligations, stability standards, and protection of taxpayer interests.

Entities that receive exceptional assistance must also change their compensation arrangements to include a provision permitting the entity to recoup bonuses and incentive compensation under certain circumstances. Specifically, the top 25 senior executives must repay incentive pay if the executive is found to have knowingly provided inaccurate information in the financial statements or performance measures used to calculate incentive pay. This is an expansion of the restrictions issued last fall, which included a clawback provision, but limited it to the top five executives. In addition, the top ten senior executives are prohibited from receiving any “golden parachute” payments upon severance, and the next 25 executives are limited to severance payments
of no greater than one year's compensation.

For companies that accept funds under the generally available programs, similar restrictions apply, but some of the restrictions can be waived by disclosure. A company can waive the $500,000 cap on senior executive pay by disclosure of the compensation and using a “say on pay” resolution with their shareholders. A company that accepts funds under a standard program will also be required to institute a clawback provision that would require repayment of bonuses or incentive pay by any of the top 25 senior executives in the event the executive is found to have knowingly engaged in providing false information as to the financial statements or performance measures on which their compensation is based. The top five executives are also prohibited from a golden parachute payment that exceeds one year's compensation. All companies accepting future funds will be required to explain how the compensation arrangements for not only senior executives but for all other employees are designed to prevent unnecessary and excessive risk taking.

Long-Term Reform Measures: What's Next?

The last section of the guidelines requires efforts to examine how company-wide compensation strategies may have rewarded excessive risk-taking and contributed to the current economic conditions. One of the recommended steps includes requiring all compensation committees of public financial institutions to review and disclose how executive and employee compensation are consistent with promoting sound risk management and long-term value for companies and shareholders. This provision indicates that such examination and disclosure is going to be required of all financial institutions, not just those that are receiving governmental assistance.

The guidelines also make suggestions regarding limits on stock incentives and stronger shareholder say on the policies behind executive compensation. Specifically, the guidelines indicate that serious consideration should be given to a blanket rule requiring top executives at financial institutions to hold stock for several years before being able to redeem the stock for cash payment. They also suggest that shareholders of all financial institutions should have a say on the amount of executive compensation and on how to structure incentive compensation to promote long-term value. The guidelines end by announcing that the Treasury Secretary will host a conference to further address executive pay reform at financial institutions. This further suggests that these guidelines are only the beginning of increased disclosure and accountability requirements.

Angela Marie Hubbell is a partner in the Business Transactions Department of Wildman, Harrold, Allen & Dixon LLP (Chicago), where she counsels employers on a broad range of employee benefits issues, including executive compensation. She can be reached at [email protected] or 312-201-2832.