The Sarbanes-Oxley Act contains an umbrella clawback provision requires that the CEO and CFO give back incentive compensation and stock sale profits in a year prior to any restatement that was caused by misconduct or fraud. Last year, the SEC filed a landmark complaint against the CEO of CSK Auto Corp (see the SEC Press Release) that sought to recoup incentive compensation resulting from accounting fraud without actually alleging that the CEO participated in the fraud. While Sarbanes-Oxley does not require that the executive actively participate in the fraud in order for the clawback provision to be invoked, this case marked a first for the SEC to open a case against an executive without alleging actual misconduct on the part of the individual.
For individual companies, a clawback is a contractual provision that provides the company with a means of recouping incentive compensation or stock sale profit from executives or top employees. The provision may apply to fraud, incentive resulting from incorrect financials, violation of non-compete provisions, or other violation of other specific restrictions within the agreement. Companies may include both equity compensation and cash bonuses in clawback provisions.
The existence of a clawback provision does not mean that a situation that violates the restrictive provisions will automatically result in funds being returned to the company. Most likely, the company will need to initiate legal proceedings in order to recoup any profits. Additionally, unless the agreement between the company and the executive details the repayment process, the company may need to negotiate the timing and manner of repayment.
Shareholders
Shareholders are most interested in performance-based clawback provisions that recoup profits resulting from accounting fraud. These types of clawbacks provide a critical protection to shareholders by forcing the executives to share in the financial losses related to inaccurate financial statements. This goes beyond performance-based pay arrangements where the executive only benefits if certain goals are reached (with the intention of aligning executive pay-out with shareholder benefit) because it reaches back to profits already realized by the executive rather than reducing future payout.
The use of clawback provisions can be helpful when companies are justifying their executive compensation.
Recent or Pending Legislation
Companies participating in the TARP are required to have clawback provisions relating to “materially inaccurate” financial statements. Additionally, TARP companies are required to exercise their clawback rights except in cases where they can demonstrate that it would be “unreasonable” to do so. This was further highlighted in the October determinations from the Treasury (see our alert). For more information on the TARP or other provisions under the Emergency Economic Stabilization Act of 2008, see our Economic Stimulus Legislation portal.
The proposed Senate bill, Restoring American Financial Stability Act (also known as the Dodd bill), goes one step further and recommends that all public companies be required to set clawback policies pertaining to inaccurate financial statements.
For Stock Plan Administrators
Hopefully, you will not need to deal with enforcing any clawback provisions your company may have. However, it’s a good idea to know if the company has clawback provisions in place and if there is a corporate policy on initiating repayment if they are triggered. One issue with clawbacks is that they may not be included in documentation that is normally accessible to stock plan administrators. They may be part of an employment or other separate agreement.
If you want to really take it one step further, educate yourself on the additional implications of recouping profit under a clawback provision. This may include how to handle previously remitted tax withholding or whether there are any 409A issues relating to the repayment method.
For more information on clawbacks and other provisions, check out the materials and audio from the Executive Compensation Conference, which we offered free of charge this year to everyone who attended the NASPP Conference.
More NASPP Value
We’ve added a new portal to the NASPP site, Shareholder Approval. It includes information on shareholder approval of stock plans, compensation, and options exchanges. Additionally, you will find exchange listing rules, legislation, proxy advisory firm recommendations, and more!
On October 22nd, the Treasury’s Special Master for TARP Executive Compensation announced his determinations on the compensation packages of the executive officers and most highly paid employees at the seven companies under his review. Some of the changes that he requires of these companies are surprisingly significant.
Aligning with Shareholder Interests
We’ve seen a real push recently to encourage companies to structure compensation, for executives in particular, in a way that better protects shareholder interests. Government initiatives include say on pay, compensation committee independence, and assessment of how compensation programs may lead to excessive risk-taking. What truly stands out about these determinations is that when the government is given the opportunity to directly influence compensation structure, it has turned to equity compensation as the solution.
Cash is not King
The Special Master’s rulings drastically reduced the cash compensation received by the most highly paid individuals at the companies under his review. For AIG, Bank of America, and General Motors, cash compensation was reduced by more than 90%! In lieu of cash, these employees will receive vested stock that comes with very specific holding requirements intended to ensure repayment of TARP funds and continued financial stability for these companies. These percentages are so high because cash compensation is capped at $500,000 for most of the relevant employees.
Performance and Holding Requirements
In addition to this major shift from cash to equity in base salary, the Special Master’s determinations also impose a pretty specific structure for incentive compensation. He looks to performance-based restricted stock with minimum vesting periods as well as holding requirements on the vested stock. This two-pronged approach is designed to encourage specific outcomes in company performance as well as adjust the focus of top employees from short-term gain to long-term growth.
The Big Picture
Companies will be taking a look at how the Treasury has dealt with executive compensation at these seven companies and trying to decide what that means to them directly. What these determinations do is give us a window into exactly what the Treasury feels is a compensation structure that aligns executives with shareholder interest and discourages excessive risk-taking for short-term gain. Other companies will want to keep that in mind as they review their own executive compensation structures.
For the Equity Compensation Professional
These determinations mean that more companies will be reviewing their own compensation practices. The savvy stock plan administrator will be looking for a way to at least be a part of the conversation so that the grants come out of any new compensation structure can be managed without exposing the company to additional risk due to excessively complex features. Get some guidance on how to do this at our NASPP Conference Session, Wagging the Dog: Stock Plan Administrator Meets Compensation Consultant. Since it’s pretty clear that restricted stock, performance-based vesting, and some way to encourage top employees to hold onto their company stock as a long-term investment are looked upon as favorable practices, stock plan managers will want to reach out and learn as much as they can about administering plans with these features.
Only 4 days until the 17th Annual NASPP Conference! The Conference is sold out, but you can still sign up for the live nationwide video webcasts of the 4th Annual Proxy Disclosure Conference and the 6th Annual Executive Compensation Conference–you get both webcasts for the price of one.
You can hear any–and all–of the NASPP Conference sessions by purchasing the downloadable audio. Purchase just the sessions you want or save by purchasing one of the package deals.
Recipients of Troubled Assets Relief Program (TARP) funds may be finding it hard to keep up with the restrictions associated with their participation. The TARP was introduced as a part of the Emergency Economic Stabilization Act of 2008 (EESA), which I blogged about in November. The EESA offers several ways for financial institutions, large and small, to gain access to funds. Access to funds comes with initial restrictions attached, many of which impact the stock plan administration of those companies. These restrictions include limits on senior executive severance benefits & 162(m) tax deductions as well as the requirements for certain claw-back provisions and to have a board Compensation Committee to oversee compensation strategies that should include measures to curb inappropriate risk-taking.
Companies that participate in the TARP are also now subject to additional restrictions through new Treasury statements in 2009 and the American Recovery and Reinvestment Act of 2009 (ARRA), which I blogged about in April of this year. This legislation focuses on executive compensation, moving to provide greater transparency and control to shareholders through certification requirements, executive compensation disclosure, say on pay, and limited bans on parachute payments and luxury expenditures. The ARRA also makes an important distinction between regular participants in the TARP, and those who receive exceptional assistance. It also provides a way for participating companies to release themselves from these restrictions by repaying TARP funds, which some companies have already done – see Ten Major Banks Repay $68 Billion in TARP Funds (CNBC June 17, 2009).
Interim Final Rule
The various regulations governing TARP recipients were consolidated by the Treasury on June 10, 2009 when it issued the Interim Final Rule (IFR). TARP recipients are subject to different levels of restrictions based on which program they are participating in and the size of the assistance they receive. Fortunately, the Interim Final Rule appoints a Special Master to help companies determine the applicable regulations and review executive compensation for participating companies. As it stands now, participating companies may be subject to the certain restrictions for senior executive officers (SEOs) or the next most highly compensated employees (HCEs). The IFR:
Prohibits
“golden parachute” payments to SEOs and the next five HCEs
bonus payments to SEOs and certain other HCEs, with the exception of certain restricted stock awards that meet the qualifications for the exception or other qualifying bonus payments that were legally binding through a contract on or before February 11, 2009
compensation plans that encourage “unnecessary and excessive risk” by SEOs
tax gross-ups to SEOs and the next 20 HCEs, except for payments under tax equalization agreements
Requires:
clawback provisions for bonuses paid to SEOs and the next 20 HCEs that are found to have been based on materially inaccurate performance criteria
“say on pay” non-binding shareholder vote applicable to proxy statements filed with the SEC after February 17, 2009
implementation of a corporate policy on excessive or luxury expenses;
disclosure of the use of any compensation consultant including the specific services provided and methods employed by the compensation consultant
disclosure of any perquisite with a total value exceeding $25,000;
certification by the CEO and CFO that the company is in compliance with all compensation and corporate governance requirements
Additional Ramifications
In addition to the IFR, the Treasury also expressed support for the SEC in its pursuit to impose similar executive compensation and corporate governance reforms for all companies, not just for TARP recipients.
On July 1, 2009, the SEC voted to move forward (see the SEC Press Release) with plans to improve corporate executive compensation disclosures (as outlined in the June 10th Press Release), in addition to modifying proxy disclosure to be in line with the IFR requirements for TARP recipients.
I think that all companies should be paying attention to the requirements made on TARP recipients. Congress and the current Administration appear to be moving towards implementing reforms for all companies to guide corporate governance and align executive compensation with company performance. Now is the time to review your company’s compensation philosophy and equity compensation programs and begin implementing changes that keep personal performance goals in line with company performance. Additionally, it is time to take a look at “say on pay” to determine if it’s right for your company now.
Financial institutions that have been participating in the Troubled Asset Relief Program’s (TARP) Capital Purchase Program (CPP) since its creation under the Emergency Economic Stabilization Act of 2008 (EESA)–which I blogged about back in November–find themselves subject to tighter rules in 2009. We’ve recently seen new rules from the Treasury along with the finalization of the American Recovery and Reinvestment Act of 2009 (ARRA). In this entry, I will break down the top changes from 2009 legislation to-date.
First, there have been two new statements from the U.S. Department of the Treasury:
The first, on January 16, 2008, expands the executive compensation standards of the CPP to additionally require the participating company CEO to:
provide annual certification that the participating company has complied with the executive compensation standards of the CPP; and
certify, within 120 days of the closing date of the Securities Purchase Agreement, that the senior executives’ incentive compensation arrangements do not encourage unnecessary and excessive risks that could threaten the value of the financial institution.
It also requires the company to keep records to substantiate these certifications for at least six years following each certification and provide these records to the TARP Chief Compliance Officer upon request.
The second statement from the Treasury came on February 4, 2009. In this statement, the Treasury distinguishes between banks participating in any generally available capital access program (like the CPP) and banks needing “exceptional assistance.” Companies that receive exceptional assistance (like AIG) will be required to:
limit senior executives to $500,000 in total annual compensation other than restricted stock that may not fully vest until the government has been repaid with interest;
fully disclose the company’s executive compensation structure and strategy and institute a “say on pay” shareholder resolution;
ban golden parachute payments for the top 10 senior executives; and
adopt a policy banning “luxury expenditures”.
Those participating in generally available programs:
have the same limit to total comensation for senior executives, but allows for that limit to be waived by shareholder vote and with a full public disclosure;
require clawback provisions for bonuses paid to top executives who are found to have engaged in deceptive practices;
ban golden parachutes for senior executives that are greater than the value of one year’s compensation (previously, payments of no greater than three years’ compensation were permitted); and
The ARRA standards apply not only to institutions that participate in the TARP going forward, but also retroactively to those who are currently receiving TARP funds. In addition to the provisions of EESA and the recent Treasury rules, the ARRA includes the following additional requirements:
The Treasury Secretary must review all compensation and bonuses paid to the top 25 highest paid individuals to confirm that such payments were neither inconsistent with the executive compensation provisions of the ARRA nor contrary to public interest.
The ARRA limits bonus, retention, and incentive pay for covered employees to the form of restricted stock that does not exceed 1/3 of the individual’s annual compensation and may not fully vest until after the TARP funds have been repaid. The number of employees covered by this limit depends on the amount of TARP funds received by the company.
Participating companies must establish a Board Compensation Committee of independent directors tasked with reviewing employee compensation plans.
The annual certification required by the February 4th Treasury Rule must be included in the company’s annual filing with the SEC.
The claw-back provisions originally under the TARP are expanded under the ARRA to include the top 25 highest paid individuals, requiring the recoupment of any incentive awards that were based on materially inaccurate financial statements or erroneous performance metrics.
However, the ARRA does provide a way for currently participating institutions to exit the TARP. Companies may, with permission from the Treasury Secretary, repay the funds and no longer be subject to the executive compensation standards.
In light of these new rules and the new Act, we have updated our EESA portal. The new and updated Economic Stabilization Legislation portal includes the legislation from the original Emergency Economic Recovery Act of 2008, the new Treasury rules for TARP, and the American Recovery and Reinvestment Act of 2009. Additionally, you will find many helpful memos from top professionals to clarify the latest rules. All of this new legislation is part of the government’s Financial Stability Plan. We have yet to see what the impact will ultimately be to all companies, not just financial institutions or banks participating in the TARP.
The recently passed Emergency Economic Stabilization Act of 2008 (EESA) includes several programs that will change executive compensation and taxation for participating companies as well as changes to offshore non-qualified deferred compensation, and AMT on ISO exercises.
Troubled Asset Relief Program (TARP)
This program allows financial institutions to sell “troubled assets” to the Treasury by either direct purchase or by auction. The direct purchase program is called Capital Purchase Program (CPP), which includes $250 billion of the bailout fund, and the auction process is called Trouble Asset Auction Program (TAAP). Companies who participate in any of the TARP programs will be subject to certain pre-conditions once the company exceeds $300 million received through one or both (cumulatively) of the programs.
Companies who sell troubled assets to the Treasury directly through the CPP will be subject to the following restrictions as a condition of participation:
•IRC 280G(e): Senior executives’ severance benefits must be limited to less than three times the executive’s trailing five-year average annual taxable compensation.
•162(m): Participating companies must limit the federal income tax deduction for annual compensation paid to each of its senior executives to $500,000 and may not claim an exemption for performance-based compensation during the covered period (as long as the Treasury holds equity or debt in the participating company).
•Incentive compensation: Participating companies must adopt measures to avoid incentive compensation that might encourage senior executives to take risks that could negatively impact the value of the company.
•Clawback: Participating companies must include clawback provisions for any bonus or incentive compensation paid out on the basis of financial statements or performance metrics later determined to be materially inaccurate during the covered period.
Companies participating in the TAAP will be subject to the CCP provisions plus:
•Severance benefits: New arrangements with senior executives will also be limited to less than three times the executive’s trailing five-year average annual taxable compensation. If an existing arrangement allows the executive to receive more than this amount, any amount that is in excess of the executive’s average annual income will be non-deductible by the company and subject to a 20% excise tax payable by the executive.
IRC 457A: Taxation of Offshore Deferred Compensation
In addition to the pre-conditions for companies participating in the TARP, the EESA adds section 457A to the IRC. Section 457A applies to non-qualified deferred compensation plans for any foreign corporation that has little or no taxable income in the United States and it not subject to a comprehensive foreign income tax as well as any partnership where less than “substantially all” of its income goes to persons not subject to U.S. income tax nor a comprehensive foreign income tax. Under 547A, non-qualified deferred compensation will be taxable when it vests (or when the income amount can be determined) rather than when it is paid. So, this change may impact only a small number of companies and compensation structures, but will certainly complicate taxation for situations that are covered.
There has been an effort to help alleviate the burden of AMT for many taxpayers (see the NASPP Legislative update “IRS to Suspend Collection Action for AMT on ISO Exercises). Well, the EESA slipped in a little light at the end of the tunnel for individuals struggling with AMT consequences, as Barbara brought to our attention in Tuesday’s blog entry. Division C of the EESA does the following for AMT:
•Allowable AMT exemption increased to $46,200 for individuals and to $69,950 for married individuals filing jointly.
•Personal credits can be credited against AMT Income for the 2008 tax year. •Accelerates (reduces) the AMT tax credit recovery period depending on the individual’s particular situation
•Eliminates the phase-out provision of AMT, which reduced the amount of the taxpayer’s AMT refundable credit by a percentage commiserate with the individual’s excess adjusted gross income.
•Abates any underpayment of tax outstanding as of 10/3/2008 related to AMT from ISO exercises, including interest and penalties.
For full details, see our newly created Economic Stimulus Legislation portal where you can find the actual legislation, memos detailing the impact of the EESA, and sample documents for companies participating in the TARP Capital Purchase Program.