Treasury Rules for TARP Firms Give Central Role to Compensation Committees and Certifications

The Treasury has issued special executive compensation and corporate governance rules for firms receiving funds under the troubled assets relief program (TARP). Please note that these special rules apply in addition to the SEC’s executive compensation regulations. The Treasury executive compensation TARP rules were adopted under the authority of the Emergency Economic Stabilization Act of 2008 (EESA), as amended by the American Recovery and Reinvestment Act of 2009 (ARRA), and supersede all earlier Treasury guidance and rules. Section 111 of EESA requires entities receiving financial assistance (TARP recipients) from the Department of the Treasury to meet appropriate standards for executive compensation and corporate governance.

Generally, the Treasury rules exclude compensation incentives for senior executive officers that influence them to take unnecessary and excessive risks that threaten the value of the TARP company. Also, the rules outright prohibit making any golden parachute payment to a senior executive officer or any of the next five most highly compensated employees.

The Treasury rules also prohibit the payment or accrual of bonus, retention award, or incentive compensation to senior executive officers or certain highly compensated employees, subject to exceptions for payments made in the form of restricted stock. Similarly, the rules prohibit compensation plans that would encourage manipulation of earnings reported by the TARP recipient to enhance an employee’s compensation.

At the heart of the sound governance for TARP firms is an independent compensation committee with enhanced duties. The Treasury rules require the TARP recipient to establish a compensation committee composed of independent directors. Since each TARP company faces different material risks given the unique nature of its business and the markets in which it operates, the rules require the compensation committee to discuss, evaluate, and review at least every six months with senior risk officers all senior officer compensation plans and employee compensation plans and the risks these plans pose to the TARP company.

The committee must also identify and limit the features in the senior executive officer compensation plans that could lead them to take unnecessary and excessive risks that could threaten the value of the TARP recipient. Similarly, the compensation committee must identify and limit any features in the employee compensation plans that pose risks to the TARP companies to ensure that the companies are not unnecessarily exposed to risks, including any features in these senior officer or employee compensation plans that would encourage behavior focused on short-term results rather than long-term value creation.

In addition, the rules require the compensation committee to review at least every six months the terms of each employee compensation plan and identify and eliminate the features in the plan that could encourage the manipulation of reported earnings of the TARP recipient to enhance the compensation of an employee.

The compensation committee must also provide annually a narrative description of how it limited the features in senior executive officer plans that could encourage them to take unnecessary and excessive risks that could threaten the value of the TARP company, including how these compensation plans do not encourage behavior focused on short-term results rather than long-term value creation. The annual disclosure must also describe how the committee limited employee compensation plans to ensure that the TARP recipient is not unnecessarily exposed to risks, including how these compensation plans do not encourage behavior focused on short-term results rather than long-term value creation. Similarly, the narrative must relate how the committee limited features of the employee compensation plans that could encourage the manipulation of reported earnings of the TARP recipient to enhance the compensation of an employee.

The rules also require the compensation committee to annually certify that it has completed the reviews of the senior officer and employee compensation plans and the employee compensation plans in the manner required by the regulations. TARP companies with securities registered with the SEC must provide these disclosures and certifications in the Compensation Committee Report required pursuant to Item 407 of Regulation S-K. The disclosures and certifications must also be provided to the Treasury Department.

The rules create a Compensation Czar, officially known as the Office of the Special Master for TARP Executive Compensation, to review and approve the compensation payments and structures of TARP firms receiving exceptional financial assistance. TARP recipients that are not receiving exceptional assistance may apply to the Special Master for an advisory opinion with respect to compensation payments and structures.

The Special Master is appointed by, and serves at the pleasure of, the Secretary of the Treasury. The Secretary may remove the Special Master without notice, without cause, and before the naming of a successor. The scope of the Special Master’s authority and responsibility is limited to compensation and corporate governance matters under section 111 of EESA with respect to TARP recipients The Special Master has no authority to provide guidance or review any submissions with respect to matters other than compensation and corporate governance matters under section 111, or to provide guidance or review any submissions with respect to compensation or corporate governance matters of employers that are not TARP recipients.

Broadly, the Treasury rules establish a compliance reporting regime relating to executive compensation based on certifications provided by the principal executive and financial officers of a TARP company. The rules require an extensive series of certifications within ninety days of the completion of each fiscal year any part of which is a TARP period.

TARP companies with securities registered with the SEC must provide the certifications on Exhibit 99.1 in their annual report on Form 10-K. They must also provide them to the Treasury. TARP companies that do not have securities registered with the SEC must provide the certifications to their primary regulator and to Treasury.

TARP companies must preserve appropriate documentation and records to substantiate each certification for no less than six years after the date of the certification, with the first two years in an easily accessible place. They must also furnish promptly to Treasury any requested documentation and records. Any individual or entity making or providing false information or certifications to Treasury may be subject to the criminal penalties under title 18 of the U.S. Code or other provision of federal law.

Among other things, the principal executive and financial officers must certify that the compensation committee has met at least every six months during the prior fiscal year with the senior risk officers of the TARP company to discuss and evaluate senior executive officer compensation plans and employee compensation plans and the risks these plans pose to the TARP firm. They must also certify that the compensation committee has identified and limited the features in the senior officer compensation plans that could lead such officers to take unnecessary or excessive risks that could threaten the value of the TARP company; and, similarly, that they have identified any features in the employee compensation plans that pose risks to the company, and have limited those features to ensure that the TARP firm is not unnecessarily exposed to risks.