FinCriAdvisor

The chief risk officer at Sterling Bancshares in Houston doesn’t usually attend the bank’s compensation committee meetings. But that changed once the holding company received a $125.2 million capital infusion from Treasury’s TARP program.

The reason is simple: During the time Treasury holds a bank’s preferred stock, the risk officer must ensure there are no incentives in any of the bank’s executive compensation plans for its top five senior officers that would lead to “unnecessary and excessive risks that threaten the value of the financial institution.”

So from now on, says James W. Goolsby, Sterling’s executive VP and general counsel, the risk officer will make an annual presentation to the compensation committee exploring the relationship between the bank’s risk management policies and practices and its executive compensation plans. Goolsby expects the report to take place in the fourth quarter of each year.

The American Recovery and Reinvestment Act of 2009 (ARRA), signed by President Obama in February, made the compensation restrictions for financial institutions getting TARP money even tougher than the original TARP regulation. And it will be up to the risk officer – and the bank board of directors, in some cases – to make sure the rules are followed.

Three examples:

• Financial institutions can’t deduct any executive compensation in excess of $500,000 – even though the tax law allows you to deduct up to $1 million.

• You also can’t pay any bonus, retention or incentive compensation award (except for long-term restricted stock) to covered employees.

• You must have clawback provisions to recover bonuses, retention awards or incentive compensation that are based on earnings later found to be materially inaccurate.

And there’s more:

Thinking of sprucing up your bank offices? Think again. The ARRA mandates that the board of directors of TARP-funded institutions come up with a policy for “excessive or luxury expenditures,” limiting expensive entertainment, events, transportation and yes, even office or facility renovations.

Severance payments? Those get complicated, too. The new rules say that TARP recipients can’t pay any severance to its top compensated employees, other than for work they have already performed or benefits they’d already accrued.

If you’re a public institution, you also must have a so-called “say on pay,” a non-binding stockholder vote on your executive compensation plans.

The new rules don’t include a specified salary limit paid to top Street Smart Profits executives, but they do expand the number of highly-compensated executives whose plans will be restricted. Depending on how much money your institution received,as many as 20 extra executives will have new salary compensation restrictions. For TARP recipients of $25 million or more, Treasury has the right to increase the number of employees affected.

Here’s how the compensation restrictions break down:

Banks will need to reassess annually which executives belong on the list, warns Jeffrey Martin, manager of accounting firm Grant Thornton’s national tax office in Washington, D.C. Because of rules banning bonuses, retention awards or incentive compensation, for instance, a highly-paid officer in 2009 might not qualify as one in 2010. So someone else could make the list.

“This is an analysis they are going to have to do every year,” Martin says of any institution receiving TARP money.

Some parts of ARRA are also unclear, Martin notes:

• The legislation allows TARP recipients to pay long-term restricted stock to SEOs, as long as the stock does not “fully vest” during the TARP period. But the legislation does not define “fully vest,” raising some important tax issues. Could the stock become partially vested, Martin asks, or could it become vested (and taxable to the employee under IRS Code Section 83) but not sold until the TARP period ends?

• The fair market value of the restricted stock can’t exceed one-third of the executive’s total annual compensation, but the legislation doesn’t explain what the total compensation package should include. Martin says it could be a big difference if the one-third limit on the restricted stock is measured based on compensation in the year the stock is granted, or if it is based on the previous year’s compensation.

Attorney Claudia V. Swhier, a partner in Barnes & Thornburg Affiliate Investigator group in Indianapolis, advises her clients to have a separate contract with the senior executive officers, stipulating that they agree to be subject to the compensation restrictions. Since so many compensation contracts violate the Treasury terms, she also says it’s a good idea to formally amend existing contracts, stipulating that the terms in violation (usually golden parachute clauses) will not be paid while Treasury holds the bank’s preferred stock.

“If you know there is a non-complying agreement, it makes sense to get a formal amendment,” she says.

Swhier, co-chair of her firm’s Financial Institutions Practice Group, represents 10 financial institutions that are participating in the Treasury program. She tells her clients to “agree in advance” to any compensation adjustments that the program requires.

Treasury also requires the compensation committee to certify that it has reviewed its executive compensation arrangements with its risk officers, making “reasonable efforts” to ensure that the plans don’t encourage unnecessary and excessive risk-taking. The new rules require the CEO and CFO to certify in writing that the TARP recipient has complied with all the law’s requirements, including making sure that incentive plans don’t encourage manipulation of reported earnings. Public institutions should file those certifications with the SEC, while private banks should file them with Treasury.

When Treasury first introduced the CPP last October, it issued compensation guidelines to help banks comply with the rules. It modified those rules again last January. But it hasn’t issued any clarification on the new legislation, leaving many TARP-funded institutions with questions.

“I find it surprising that Treasury hasn’t moved to publish guidance on this,” Martin says.

The ARRA applies retroactively, though it allows Treasury to approve written employment contracts with incentive packages that were executed before Feb. 11, 2009.

Under the original TARP rules, SEOs signed waivers, releasing the government from claims against it as a result of changes to their compensation plans. Attorneys for Fried Frank in Washington, D.C. say bank executives impacted by the new legislation may have some recourse, however, “under the takings clause of the Fifth Amendment.”

Lawmakers had another idea. They made it easier for institutions to repay TARP money if they don’t like the new rules of the game.