The current crisis on Wall Street has brought to the surface a bubbling populist anger over perceived pay excesses and stirred a debate in Washington on executive compensation. This anger was manifest in the recent bailout or “rescue” legislation, in which Congress imposed a number of executive compensation provisions.
Most of the executive compensation provisions of the final legislation only apply to troubled firms that sell assets to the Department of Treasury and only while the Department of Treasury holds a significant equity or debt position in a firm. However, Congress at the last minute in the final legislation added new limits on deferred compensation paid by certain foreign entities and partnerships owned by tax-exempt investors.
In the current environment, these limits on executive remuneration may signify just the beginning of a new era in executive-compensation regulation.
The approved bailout legislation (entitled the Emergency Economic Stabilization Act of 2008) applies different standards to firms whose assets are directly acquired by the Department of Treasury and those whose assets are acquired at auction. For firms acquired directly by the Department of Treasury, the secretary of treasury shall establish appropriate executive compensation standards that:
• Preclude limits that exclude incentives for “senior executive officers” to take unnecessary and excessive risks that threaten the value of the institution.
• Permit “claw-backs” – i.e., the recovery of any bonus or incentive compensation paid to a senior executive officer based on materially inaccurate statements of earnings, gains, or other criteria later proven inaccurate.
• Prevent any golden parachute payment to any senior executive officer.
For companies that sell more than $300 million in assets to the Department of Treasury at auction, the secretary of treasury is required to adopt rules that: prohibit any new employment contract with a “senior executive officer” that provides a golden parachute upon an involuntary termination, bankruptcy filing, insolvency, or receivership. In addition, the final legislation amends the Internal Revenue Code so that a company acquired by the Department of Treasury at auction cannot deduct more than $500,000 in current executive remuneration (i.e. salary, incentive compensation, and benefits) for any tax year. The legislation also in effect limits the deduction of deferred compensation to $500,000 in the aggregate per covered executive.
Notably, the standards for limits on taking unnecessary and excessive risks, “claw-backs” and golden parachute payments only apply to “senior executive officers.” The legislation defines a “senior executive officer” as one of the top five executives in a public company whose compensation must be disclosed under Securities Exchange Act of 1934 and nonpublic company counterparts. On the other hand, the deduction limits on executive remuneration apply to “covered executives,” who include the chief executive officer, chief financial officer, and the other top three highest-compensated employees. Once a person becomes a “covered executive,” he or she will remain a covered executive.
But the new Emergency Economic Stabilization Act did not stop with regulating executive compensation of firms that are being bailed out or rescued. Congress at the end added provisions that in effect prohibit deferred compensation being paid to U.S. individuals or firms by certain tax haven corporations or partnerships. These provisions may affect management fee deferral agreements with an offshore private investment fund or a fund substantially all of which is owned by tax-exempt investors.
This new Internal Revenue Code provision focuses on certain entities that are indifferent with respect to whether a tax deduction is available for deferred compensation or not. These “tax indifferent” entities are typically entities that are structured so as to escape both U.S. and foreign income tax. Under the legislation, effective January 1, 2009 nonqualified deferred compensation from a “nonqualified entity” will be taxed when there is no substantial risk of forfeiture. In other words, the tax becomes due when the right to payment vests even if it is an unfunded and unsecured promise to pay. A “nonqualified entity” subject to these new restrictions generally includes any foreign corporation or any partnership unless the corporation is (or in the case of a partnership, substantially all of the partners are) subject either to U.S. taxation or comprehensive foreign taxation (such as taxes from a country with which the U.S. has a tax treaty).
These rules can impact individuals or firms subject to U.S. tax that have deferred fee or other deferred compensation agreements with entities that are organized in tax havens exempt from U.S. and foreign income tax or with partnerships substantially all of which are owned by tax-exempt investors. Such individuals and firms may need to restructure these agreements in order to make them currently taxable in the U.S.
However, you should not relax just because your company is not being bailed out by the federal government, or because you do not do have compensation agreements with Cayman Island corporations. In particular, company executives, boards of directors, and compensation committees should not think that this current legislation is the end of the story. There is, after all, an election coming up. Even regardless of the outcome of the election, if the economy slows further, or if more crisis involving Wall Street firms and their executives become public, Congress is likely to be under increased pressure to enact even more significant compensation guidelines.
In fact, there have already been proposals to expand the scope of regulation of executive compensation to cover companies other than those impacted by the bailout legislation. These proposals include limiting tax deductions for excessive compensation, requiring shareholder review and/or approval of compensation arrangements, and further limits on severance benefits. Entities organized as partnerships have been targeted for their “carried interest” deferred compensation techniques. Moreover, the new rules in the bailout legislation effectively eliminating deferred compensation from certain foreign entities is a model that could be expanded to domestic businesses.
In anticipation of future legislation and/or regulation, companies should review now their compensation practices and procedures for executives. In particular, boards of directors and compensation committees should examine closely existing arrangements for incentive forms of compensation, caps on total compensation and levels of severance and change of control benefits. The goal of this review process is to be fully prepared to quickly and effectively enact any changes made necessary by new legislation or regulation. At the same time, this review provides an opportunity to ensure compliance with all current legal requirements. •
Thomas J. McCord is a partner in the Employee Benefits Group of Nixon Peabody LLP. He can be reached at
tmccord@nixonpeabody.com.
