By Robin M. Bergen and Shawn J. Chen 

Under Sarbanes-Oxley Act (“SOX”) § 304, chief executive officers (“CEOs”) and chief financial officers (“CFOs”) must reimburse incentive compensation and stock sale profits they received in the twelve month period following a restatement due to their companies being in material non-compliance with financial reporting requirements due to misconduct.  For years the Securities Exchange Commission (“SEC”) used this “clawback” authority to seek reimbursement of compensation and profits from stock sales only in cases when the CEO or CFO personally engaged in the misconduct.  Starting in 2009, the SEC began using SOX § 304 to seek “no-fault” clawback of compensation in cases where there was a misstatement even in the absence of misconduct by the CEO or CFO.  In this post we will discuss this trend and a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) that has not gotten as much attention as other controversial provisions, but which gives the SEC even more ammunition to aggressively pursue clawbacks.

In the July 2009 Jenkins case, the SEC sought the return of more than $4 million from Maynard Jenkins, former CEO of CSK Auto Corp while acknowledging that Mr. Jenkins was not involved in the wrongdoings which other officials in fact concealed from him.  The Court in that case denied Mr. Jenkins’ motion to dismiss, holding that “the text and structure of SOX § 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer’s CEO or CFO.”  The SEC has since settled cases under similar circumstances in an action against the former CEO of Diebold Inc. (SEC v. O’Dell), and the former CEO and CFO of Beazer Homes USA (SEC v. McCarthy and SEC v. O’Leary, respectively).

Under Dodd-Frank § 954, this trend towards no-fault clawbacks will continue, as the new provision greatly expands the situations where reimbursement of executive compensation will be required following a restatement.  § 954 requires the SEC to issue rules prohibiting the listing on any national securities exchange of any company that does not adopt a policy which provides for among other things, recovery of any amount of incentive-based compensation paid to any current or former executive officer that exceeds the amount that would have been paid under an accounting restatement in the three years prior to the date on which the company was required to prepare the restatement.  Under the SEC’s current timeline, the relevant rules will be proposed some time before the end of the year.

This new provision differs in important ways from SOX § 304: (i) SOX § 304 only applies to the CEO and CFO; Dodd-Frank § 954 applies to any current and former executive officer; (ii) SOX § 304 only applies to a twelve month period following first public issuance or filing with SEC of document requiring restatement; Dodd-Frank § 954 covers a three year time period preceding the date the company is required to prepare a restatement; (iii) SOX § 304 applies only to restatements due to misconduct; Dodd-Frank § 954 does not require misconduct; and (iv) SOX § 304 requires reimbursement of incentive-based compensation as well as any profits realized from the sale of stock; Dodd-Frank § 954 only requires repayment of incentive-based compensation, including stock options, which exceeds what would have been paid under the restatement.

This growing focus on no-fault clawbacks raises several issues.  First and foremost is whether such clawbacks are fundamentally fair.  Obviously executives should not be able to retain benefits acquired while the investing public was being misled by false financial statements, and that the threat of clawback will help to ensure they implement strong financial controls.  In cases such as Jenkins, however, where there is no allegation of personal misconduct, and in fact the CEO was also misled by others who hid the misconduct, it is not clear how seeking clawback is an appropriate response or will serve as a deterrent.  Furthermore, it is still an open question whether the amount and methods of calculating such recoveries may violate the Due Process Clause prohibition against “excessive punitive damage awards.”

There are also several open questions in the current clawback regime that executives will need to consider going forward.  It appears the only sure way to avoid a clawback prosecution under SOX § 304 is for CEOs and CFOs to pay back any relevant incentive-based compensation before the SEC begins an enforcement action, as the SEC has provided no guidance on what criteria is used in determining which executives will be subject to an action.  It is also unclear how executives are supposed to do this as a practical matter, if the company does not have a clawback policy addressing such situations, as the SEC also has not provided any guidance on how it calculates the amounts recoverable under SOX § 304.  In McCarthy, the SEC alleged approximately $7.3 million in profits from stock sales, but the settlement included less than $1 million from those sales.  Finally, it is still an open question whether, and to what extent, the individual’s compensation must be traceable to the misstatement for purposes of clawback, as the Court in Jenkins did not address that question in ruling on the motion to dismiss.

Although Dodd-Frank § 954 provides greater clarity as to when clawback will be required – any time there is a restatement – it still leaves several open questions that will need to be addressed as part of the rulemaking process.  Dodd-Frank § 954 does not define the terms “executive officer” or “incentive-based compensation.”  Under Dodd-Frank § 954 clawback is mandatory if a company is “required” to prepare an accounting restatement due to its “material noncompliance” with any financial reporting requirement under the law.  There are many cases where it will not be readily apparent whether a restatement was “required” or due to “material noncompliance.”  Moreover, in many cases it will be difficult to determine what portion, if any, of an incentive-based award is attributable to a false financial statement.

Regardless of these open questions, we believe that the SEC will continue to vigorously pursue clawbacks of executive compensation.¹  In light of this growing emphasis, companies and executives should be rigorous in their creation and certification of internal controls.  Companies should also begin looking more closely at their clawback policies, to the extent they have any, to see if they comply with Dodd-Frank § 954. 

¹ We note, though, that the Washington Post has reported that the SEC rejected a proposed settlement agreed to by the Staff and Mr. Jenkins for less than half of the $4 million being sought.  Sources indicated that the rejection reflects tension within the SEC over no-fault clawbacks, with some commissioners rejecting the proposed settlement because it was too lenient, while other commissioners rejected the settlement because they thought the staff should not have pursued the case, given the lack of misconduct by Mr. Jenkins.