Treasury and Limitations on Executive Compensation: The Board's Responsibility

Treasury (before Geithner's arrival) recently issued an updated "interim final rule" updating a similar provision that had been issued in October.  The rule contains technical amendments and imposes specific time periods on certain certification obligations.  It presents an opportunity to comment on the broader approach used by Treasury.

TARP applied the limits on compensation to any financial institutions selling troubled assets to Treasury.  See section 111(b) of the Emergency Economic Stabilization Act of 2008, Div. A of Pub. Law No. 110-343.  Of course, the idea of acquiring troubled assets was quickly abandoned, displaced by a strategy of making capital contributions to healthy financial institutions through the purchase of preferred stock.  The October interium rule (as does this one) extended the compensation limitations to these companies as well, going beyond the language in the statute.

Section 111(b)(2)(A) of EESA requires:

• “limits on compensation that exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution.”

EESA also provided for clawbacks and limits on golden parachutes. 

The responsibility for execution falls on the compensation committee.  The October Rule imposed on the compensation committee the obligation to identify compensation arrangements that could result in exessive risk taking.  The committee also must review the incentive compensation arrangements with top officers. Finally, the committee must meet at least annually with senior risk officers to review the relationship between risk management policies and the incentive compensation arrangements.The entire set of rules adopted by Treasurey are here.

Nonetheless, Treasury has essentially imposed on the CEO the obligation to see that these compliance steps are taken.  Within 120 days of a capital infusion under TARP, the CEO must certify that the compensation committee has reviewed the incentive compensation arrangements with the senior risk officers to ensure that there are no arrangements that encourage unnecessary and excessive risk taking.  Within 135 days of the completion of each fiscal year while the company is participating in the bailout, the CEO must certify:

• that the compensation committee has met at least once during the prior fiscal year with the senior risk officers of the financial institution to discuss and review the relationship between the risk management policies and practices of the financial institution and the SEO incentive compensation arrangements; the compensation committee has certified to this review; the financial institution has required that SEO bonus and incentive compensation be subject to recovery or “clawback” by the financial institution if the payments were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria; the financial institution has prohibited any golden parachute payment to a SEO; the financial institution has instituted procedures to limit the deduction for remuneration for federal income tax purposes to $500,000 for each SEO for the most recently ended fiscal year as if section 162(m)(5) of the Internal Revenue Code applied to the financial institution; and certain named individuals are the SEOs for the current fiscal year based on the compensation of such individuals during the prior fiscal year.

Finally, within 135 days of the completion of the the fiscal year, the CEO must certify that the company limited the deduction for compensation to the $500,000 limits set out in 162(m)(5) of the Internal Revenue Code.  

There are two issues that arise from these requirements.  First, why did it take TARP and participation in the bailout to make consideration by the compensation committee of the possibility of excessive risk taking mandatory? It reflects the fact that under Delaware law (mostly interpretations by the Delaware courts) there is almost no affirmative obligation by directors to take any specific steps or perform any specific analysis with respect to executive compensation. 

The Disney case illustrates how little the Delaware courts require.  In that case, the compensation committee received an incomplete term sheet, had no outside advisors present, and met for a short period of time, and ultimately approved a contract that resulted in the payment of somewhere around $160 million to an officer who worked at the company for slightly more than one year.  The Delaware Supreme Court held that this behavior was consistent with the directorys' fiduciary obligations to the company.  In other words, Delaware imposes no meaningful standards when considering compensation issues.  Could any case better illustrate why standards for determining executive compensation need to be federalized (the appropriate standards are discussed in my paper here)?

We will consider the other issues in the next post.