Unprecedented Challenges for Executive Compensation Require Immediate Planning

November 14, 2008

In the past few months, executive compensation practices have received unprecedented attention. In the recent "bailout" legislation for the financial services industry, for the first time Congress has imposed substantive limitations on executive compensation. In this case, the restrictions are imposed on executives of financial institutions that accept federal assistance under the Troubled Assets Relief Program ("TARP"). It is widely anticipated that Congress will expand some of the limitations under TARP to cover other publicly-traded companies. In addition, Congress may enact "say on pay" legislation in the next Congress. Even if it does not, it can be expected that compensation-related shareholder proposals, perhaps modeled on TARP, will be forthcoming in the 2009 proxy season. Finally, many expect a significant increase in marginal tax rates applicable to highly-paid employees, most likely effective in 2009. Separate and apart from legislative issues is the problem of how to retain and properly incentivize employees in the face of recent stock market declines, which have caused many stock option awards to become "underwater" and of limited retention or incentive value.

These and other challenges must be faced by executives, compensation committee members, and other interested parties. We outline below some of the most pressing current challenges and some possible approaches to mitigate their impact.

The TARP Program

To date, the Treasury Department has announced three programs to implement TARP: The Capital Purchase Program (the "CPP"), the Troubled Asset Auction Program (the "TAAP") and the Programs for Systemically Significant Failing Institutions (the "PSSFI"). Treasury has issued interim final rules and notices for each program. Currently, the CPP is the only active program, with approximately 20 institutions participating. Treasury Secretary Henry Paulson recently announced that the Treasury does not plan to use any bailout funds to purchase troubled assets from banks. Therefore, it is unlikely that either the TAAP or the PSSFI will be launched.

Any institutions participating in the CPP are subject to the following executive compensation standards applicable to their senior executive officers ("SEOs"), which generally include the chief executive officer, the chief financial officer and the three other most highly compensated executive officers (generally the same officers whose compensation is disclosed in the company’s annual proxy statement if the institution is publicly traded):

The elimination of incentive compensation arrangements for SEOs that encourage unnecessary and excessive risks. Within 90 days of participating in the CPP, the institution’s compensation committee (or similar committee) must review all SEO compensation arrangements with the institution’s senior risk officer to ensure that such arrangements do not encourage "unnecessary and excessive" risks. If an arrangement does, then it must be amended. Each year thereafter; the committee must meet with the institution’s senior risk officer to discuss and review the relationship between the institution’s risk management policies and the SEOs’ incentive arrangements. The committee must certify that it has completed these reviews, either in the institution’s Compensation Discussion and Analysis section of its proxy statement or, if it is a private company, in a filing with its primary regulatory agency.
The prohibition of certain golden parachute severance payments. For this purpose, the cap on severance payments generally is three times the SEO’s average taxable compensation during the preceding five years. Severance is defined broadly to include any payment in the nature of compensation to an SEO on account of an "applicable severance from employment," including amounts that otherwise would have been forfeited and payments that are accelerated upon termination. An "applicable severance from employment" is defined as any SEO severance from employment with the institution (1) by reason of involuntary termination of employment (including termination by the SEO for "good reason") or (2) in connection with any bankruptcy filing, insolvency or receivership of the institution.
The addition of "clawback" arrangements. Bonus and incentive compensation payments to SEOs must be subject to "clawback" if the payment was based on materially inaccurate financial statements or performance achievement. The CPP’s clawback provisions are far broader than Section 304 of the Sarbanes-Oxley Act: the clawback is applicable to all SEOs (rather than just the CEO and CFO); it is applicable to both public and private companies; it is not triggered exclusively by an accounting restatement; it does not limit the recovery period; and it covers not only material inaccuracies relating to financial reporting but also material inaccuracies related to performance objectives. Further, there is no requirement that misconduct has been involved.
Limits on annual compensation deduction. No more than $500,000 of annual compensation payable to an SEO is deductible. There is no "performance-based compensation" exemption to this limit, unlike the general rules applicable under section 162(m) of the Internal Revenue Code (the "Code"), and any compensation earned, but deferred, to a future year, will be counted toward the $500,000 limitation even if it is not paid until after the CPP’s coverage period has ended.

Institutions that are subject to these rules will need to put appropriate procedures in place to ensure compliance. Prior to participating in the CPP, each participating institution will need to modify employee benefit plans and employment agreements to the extent necessary, certify that such modifications have been made and obtain a waiver of any claims an SEO may have against the United States or his or her employer as a result of these modifications.

Many members of Congress have expressed a desire to limit executive compensation more generally. It can be expected that these proposals will receive a serious hearing in the next Congress, and the TARP rules may serve as the basis for more broadly-applicable limitations.

Due to these threatened changes, many public companies are considering alternatives to their current arrangements. For example, some companies have considered terminating potential future golden parachute obligations in exchange for a current cash payment. Of course, how this will affect next year’s proxy disclosures should be kept in mind. In addition, if amounts at issue are considered "deferred compensation" subject to Section 409A of the Code, there may not be any ability to accelerate such payments into 2008 without triggering highly adverse tax consequences for the executive.

Say on Pay/Shareholder Proposals

Several Democratic members of Congress, most prominently Representative Barney Frank (D-MA), have long advocated providing shareholders with the right to non-binding annual votes on executive pay packages. President-Elect Obama has indicated his support for these measures. If this proposal is enacted, which appears likely, most public corporations probably will want to follow their shareholders’ vote even if the vote technically is nonbinding. This will place a premium on designing pay packages that are easy to describe and are in-line with market practices.

In addition, many expect that shareholder advocates will push proposals to provide TARP-like limits on executive compensation. Public companies should think about how they will respond to these proposals, as well as alternative compensation structures in the event such proposals pass.

Potential Tax Increases

The marginal tax rate applicable to high-income earners is expected to be raised, possibly in 2009 (although there is some skepticism that Congress will raise rates if the economy is in recession, so it is possible that the increases will be delayed). President-Elect Obama proposed raising the top rate from 35% to 39.6% (where it stood while President Clinton was in office), but more recently there has been talk of an additional 5% surtax on the wealthy, resulting in a possible top rate of 44.6%.

As a result of these changes, there may be a desire by many executives to accelerate income into 2008 (or possibly 2009). For example, it may make sense for executives to exercise stock options and take other actions that voluntarily move taxable income into 2008. Companies also have some flexibility in this regard. For example, vesting of restricted stock could be accelerated into 2008 (although public companies would want to take into consideration the impact of such decisions on their proxy disclosure).

However, as discussed above with respect to TARP-type rules, if amounts are considered "deferred compensation" subject to Section 409A of the Code, it generally is not permissible to accelerate payments into 2008, because if there were such an acceleration, a 20% additional tax would apply in addition to ordinary income tax, and there may be state income tax consequences as well. Thus, there is little flexibility to pay out deferred compensation in 2008 unless the compensation was previously scheduled to be paid this year. Alternatively, executives may want to consider accelerating payments of deferred compensation into 2009 if they believe tax rates will be lower in 2009 than in later years. However, the ability of deferred compensation to be credited with investment returns on a "pre-tax" basis may counsel against acceleration in many cases, and executives should consult with their financial advisors and attorneys to discuss the best course of action.

Underwater Stock Options

Stock options that are significantly out of the money have limited retention and incentive value. As a result of the stock market declines over the past few months, many options, especially those granted recently, may be significantly out of the money. Many companies have considered repricing options or cancelling the options and replacing them with other awards (such as restricted stock).

Such actions raise many issues, some of which include the potential requirement for shareholder approval; whether SEC tender offer rules must be followed; adverse accounting impact; and tax treatment of the optionees. We prepared a client alert in September 2008 that addresses the key issues:
http://www.gibsondunn.com/Publications/Pages/DealingwithUnderwaterStockOptions.aspx.

Conclusion

These are challenging times for planning executive compensation. However, proactive companies and executives are less likely to be disappointed by future events. We are pleased to assist companies and executives in addressing these important issues.

Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or

To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.

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