President Bush Signs Bail Out Legislation: Executive Compensation Provisions

On October 3, 2008, President Bush signed legislation that includes the Emergency Economic Stabilization Act of 2008 (the "Stabilization Act") and the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (the "Tax Extenders Act"). The combined legislation has a significant and immediate impact on:

• Financial institution employers and their executives: Financial institutions that take advantage of the program created under the Stabilization Act permitting the U.S. Treasury to purchase certain troubled mortgage-related assets held by those institutions (or possibly to purchase preferred interests in those institutions) are subject to immediate restrictions on executive compensation.
• Offshore entities and their compensation arrangements: Common compensation arrangements of offshore hedge fund and other entities are considered deferred compensation and will need to be modified (during a period to be specified by the Treasury in later guidance) or the compensation will become subject to immediate taxation, plus 20% excise tax and interest penalties.

The following summarizes the principal provisions of the Stabilization Act and the Tax Extenders Act that apply to executive compensation:

A. The Stabilization Act — Financial Institution Employers

To promote financial market stability, the Stabilization Act allows the Treasury to purchase troubled assets from financial institutions under the newly established Troubled Asset Relief Program ("TARP"), effective the date of enactment through December 31, 2009. The TARP program permits the Treasury to purchase mortgage-related assets of financial institutions originating on or before March 14, 2008. The TARP program's immediate authority is limited to assets or instruments based on or derived from residential or commercial mortgages.

The Treasury may, however, after consultation with the Federal Reserve, recommend the purchase of other financial instruments to promote financial market stability. Any such request must be submitted to Congressional committees. This provision presumably is the basis for a capital infusion in a financial institution in exchange for the Treasury receiving preferred interests or equity in that institution.

A financial institution employer that participates in the bail out program will need to consider the executive compensation rules described below with respect to any compensation paid to executives. Financial institution is defined under Section 3 of the Stabilization Act to include a bank, savings association, credit union, security broker or insurance company established and regulated in the United States or its territories.

The new executive compensation restrictions apply to "senior executive officers" of the financial institution, which is defined to mean:

• One of the top five highly paid executives of a public company, as determined under the Securities Exchange Act of 1934 and any regulations thereunder; and
• Their counterparts if the employer is a non-public company.

In the event of a "direct sale" of troubled assets under TARP to the Treasury, the Treasury will require the financial institution to meet certain standards for executive compensation and corporate governance. These standards include:

• Limits on incentive compensation for senior executive officers of the financial institution that encourage them to take unnecessary and excessive risks that threaten the value of the financial institution.
• A claw-back provision that allows the financial institution to recover any bonus or incentive compensation paid to a senior executive officer based on financial statements that are later proven to be materially incorrect.
• A prohibition on the financial institution from making any golden parachute payment to a senior executive officer. Golden parachute payment is not defined for this purpose, but likely is meant to include severance.

These standards will apply during the period the Treasury holds an equity or debt position in the financial institution, except with respect to the claw-back provision, which is not so limited.

In the event of an "auction sale" of troubled assets under TARP where such purchases exceed $300 million for the affected financial institution, the Treasury will prohibit any new employment contract with a senior executive officer that provides for a golden parachute in the event of involuntary termination, bankruptcy filing, insolvency or receivership. The Treasury is directed to issue guidance by December 3, 2008 related to auction sales, which will be effective upon issuance.

Amendments to Existing Executive Compensation Tax Rules

The Stabilization Act also directs financial institutions under TARP to comply with certain new tax provisions relating to executive compensation. Section 302 of the Stabilization Act amends the following tax provisions:

• Section 162(m) of the Internal Revenue Code of 1986, as amended (the "Code") ($1 million deduction limitation).
• Section 280G of the Code (golden parachute provisions).

Section 162(m) of the Code. A new provision under Section 162(m) of the Code provides for special limitations on the deduction of executive remuneration to a covered executive of an applicable employer who participates in the TARP program.

Deduction by an applicable employer is limited to:

• $500,000.
• Deduction also is limited in the case of a deferred deduction that exceeds $500,000 (reduced by any executive remuneration for the applicable tax year or if taken into account in any prior taxable year). A deferred deduction means executive remuneration the deduction for which is allowable in a subsequent taxable year.

The restriction on deductibility applies to any initial tax year in which any portion of the period the employer participates in the TARP program and the aggregate amount of all troubled assets acquired exceeds $300 million, and includes any subsequent taxable year that includes any portion of the period.

Applicable employer for this purpose is defined as any employer (whether public or private) who participates in the TARP program if the aggregate of troubled assets purchased exceeds $300 million (direct purchases by the Treasury are disregarded for this purpose). The applicable employer includes all persons who are in the same controlled group within the meaning of Sections 414(b) and (c) of the Code (generally 80% parent-subsidiary ownership and without regard to brother-sister combined group rules).

The deduction limitation applies to covered executives, which is defined to include the chief executive officer, the chief financial officer and the top three highly-paid employees during any period in which the TARP program is in effect. Once an executive is a covered executive, the executive will be a covered executive for all subsequent taxable years in which there is deferred deduction.

Executive remuneration for this purpose includes commissions and performance-based compensation that would otherwise be subject to an exception under Section 162(m) of the Code.

Section 280G of the Code. A new provision under Section 280G of the Code applies to employers participating in the TARP program. Any covered executive, as defined under the new provisions of Section 162(m) of the Code described above, will be treated as a disqualified individual under Section 280G of the Code. This means that the covered executive automatically will be subject to the 20% excise tax on excess parachute payments. The Stabilization Act is silent as to whether a gross-up would be permitted under this new section of Section 280G of the Code, however, a gross up would appear to not be within the spirit of this provision.

• If a covered executive has an "applicable severance from employment," any payment made during an applicable taxable year of the employer on account of such severance from employment will be treated as an excess parachute payment and subject to the 20% excise tax. Exceptions under Section 280G of the Code for reasonable compensation and small businesses do not apply for this purpose.
• An "applicable severance from employment" means an involuntary termination of the executive or any severance from employment in connection with any bankruptcy, liquidation or receivership of the employer. The Treasury is authorized to prescribe guidance to prevent the avoidance of this provision by mischaracterizing a severance from employment as other than an "applicable severance from employment."
• This rule will apply to severances occurring during the period in which the TARP program is in effect.

B. The Tax Extenders Act - Offshore Entities

The Tax Extenders Act imposes certain tax penalties on executive compensation that may be paid, deferred or provided by an employer located outside of the United States, such as an offshore investment or hedge fund. This legislation is aimed at employers who have established offshore entities, such as in Bermuda or the Cayman Islands, to make and hold investments in a tax-efficient structure. It is not intended to apply to compensation offshore that is subject to a comprehensive foreign income tax. To comply with these new rules, a hedge fund or other employer that is part of a controlled group with an offshore investment fund structure will need to modify its compensation arrangements, including deferred compensation, carried interests, phantom equity, phantom units or other incentive based compensation.

The Tax Extenders Act adds a new provision, Section 457A to the Code, entitled - Nonqualified Deferred Compensation from Certain Tax Indifferent Parties. This new statute requires the immediate taxation of compensation under nonqualified deferred compensation plans of nonqualified entities when there is no substantial risk of forfeiture of the rights to such compensation, as well as a 20% excise tax and interest penalties. A nonqualified entity is defined to mean:

• Any foreign corporation, unless substantially all of its income is effectively connected with the conduct of a trade or business in the United States or is subject to a comprehensive foreign income tax; or
• Any partnership, unless substantially all of its income is allocated to persons other than foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax and organizations exempt from tax.

Section 457A of the Code defines nonqualified deferred compensation as having the same meaning under Section 409A(d) of the Code. The definition of nonqualified deferred compensation also includes earnings related to such compensation and such plans will be aggregated in accordance with the controlled group rules under Section 414(b) and (c) of the Code.

There is one important qualification, nonqualified deferred compensation under Section 457A of the Code specifically includes any plan that is based on the appreciation in value of a specified number of equity units of the service recipient. Nonqualified deferred compensation would appear to include carried interests, phantom equity, phantom units, as well as back-to-back arrangements with service providers (but likely excluding profits interests as transfers of property).

Section 457A of the Code provides that the rights to compensation are considered subject to a substantial risk of forfeiture if such person's rights are conditioned on the future performance of substantial services. This definition is consistent with the definition of substantial risk of forfeiture under Section 409A of the Code, which specifically provides that non-competes and related covenants do not constitute a substantial risk of forfeiture.

There are two limited exceptions from the definition of nonqualified deferred compensation, as follows:

• The rights to compensation will not be treated as nonqualified deferred compensation if the compensation is paid no later than 12 months following the end of the taxable year of the service recipient during which the right to such compensation is no longer subject to a substantial risk of forfeiture.
• Certain gain on investments assets will not be considered nonqualified deferred compensation.
• If compensation is determined only by reference to a gain recognized on disposition of an investment asset, the compensation will be treated as subject to a substantial risk of forfeiture until the date of such disposition. (The 12-month payment rule described above does not apply to the investment asset exception.)
• Investment asset is defined for this purpose to mean any single asset (other than an investment fund or entity) that is acquired directly by an investment fund or entity, the entity or any related person does not participate in the active management of the asset (or, if the asset is an interest in the entity, the active management of the activities of the underlying entity) and substantially all of any gain on the disposition is allocated to investors in the entity. This special exception would appear to exclude any "side pocket" investments where gain in the disposition of assets in the investment fund is aggregated over an extended period.

Section 457A of the Code applies to amounts deferred that are attributable to services performed after December 31, 2008. There is limited grandfathering for amounts deferred attributed to services performed before January 1, 2009 if the amounts are included in a taxable year beginning before 2018. The amounts must be included in gross income in the later of the last taxable year beginning before 2018 or the taxable year in which there is no substantial risk of forfeiture as defined under Section 457A of the Code.

The Treasury is directed to issue guidance within 120 days of the effective date of the Act for deferred compensation attributable to services performed on or before December 31, 2008 (and back-to-back arrangements) providing for a transition period to amend such arrangements to comply with Section 457A of the Code (without violating the requirements of Section 409A of the Code).

If you have any questions regarding this Client Alert, please contact the attorney in our Employee Benefits Group with whom you generally work, or feel free to contact any of the lawyers in the Group listed below:

Gretchen Harders
New York
212-351-3784
gharders@ebglaw.com