The current version of U.S. Senator Christopher Dodd’s financial reform bill contains a provision (Section 954) that would require companies that filed a restatement to recover incentive-based compensation from executive officers, even if no one engaged in any misconduct (S. 3217, Title 9, Section 954). Please note that the U.S. House of Representative’s financial reform bill does not contain a similar provision, and thus the final adoption of Section 954 is not ensured. However, if enacted, Section 954 would have adverse consequences for public companies, their officers and their shareholders.
By way of background, Section 304 of the Sarbanes-Oxley Act of 2002 (SOX) requires the chief executive officer (CEO) and chief financial officer (CFO) to reimburse a company for amounts received as incentive-based compensation and profits realized from stock sales during the 12-month period following the issuance of a financial statement that requires an accounting restatement due to material non-compliance with securities laws. This requirement does not apply to other executive officers, and is only triggered “as a result of misconduct.”
Although Section 304 came into effect in 2002, the U.S. Securities and Exchange Commission (SEC) did not utilize this enforcement tool until 2007. Even then, the SEC limited the use of Section 304 to those CEOs or CFOs who were alleged to have engaged in securities violations. In July 2009, the SEC filed the first action, under Section 304, against a CEO, who was not charged with any violations of the securities laws (SEC v. Jenkins, case 2:09-cv-01510-JWS). The defendant has moved to dismiss the SEC action on numerous grounds, including that the defendant’s lack of involvement in the misconduct renders the SEC’s claim under Section 304 unconstitutional. The constitutional arguments raised by the defendant would be equally applicable to the framework proposed by Section 954, which as discussed below, does not require misconduct by any person at the company.
Section 954, if enacted, would require public companies to develop and implement compensation recovery policies as a condition of having securities listed on national securities exchanges and associations (S. 3217, Title 9, Section 954 and S. 3217, Title 9, Section 954). Unlike Section 304, Section 954 would require public companies to recover from all current or former executive officers—not just CEOs and CFOs—incentive-based compensation in “excess” of the amount that the executives would have received had there been no error in the financial reports. Section 954 would force companies to seek reimbursement of these amounts received by executives during the three years prior to the date on which the company was required to prepare a restatement. As a practical matter, the proposed legislation would force public companies to file legal actions against current or former executives who refused to return amounts claimed as excess compensation.
Importantly, Section 954 would not require, as Section 304 does, that the error in the financial report be as a result of any misconduct. Also, Section 954 does not provide an exception if the board of directors determines that the amount that the company could reasonably expect to recover in any litigation would be less than the anticipated cost of pursuing the action.
Another potential problem with Section 954 is that it does not address whether it would create a private right of action for shareholders. As a result, shareholders may be able to file successfully derivative actions on behalf of companies that do not take any action to recover excess compensation. Dealing with any shareholder lawsuits could become quite complicated due to disagreements over what can be recovered under the policy (i.e., what is the “excess” compensation), particularly with respect to incentive compensation plans that allow the compensation committee to exercise discretion in awarding amounts or that use performance goals that are based on non-GAAP financial criteria.
Finally, Section 954, if enacted, would raise complex issues for companies. For example, it would create uncertainty as to whether an executive who was awarded compensation would have to return those benefits to the company, if the clawback provision was subsequently triggered as a result of a restatement. Given the constant uncertainty that would exist, companies and their boards of directors would face challenging decisions in trying to negotiate new compensation packages with executives, or in determining the appropriate amount of incentive-based compensation to award to executives. These issues would be further compounded by the lack of any misconduct requirement in the proposal. To mitigate these uncertainties, executives may insist upon receiving significant increases in base compensation. This would result in reducing one of the benefits of performance-based compensation—alignment of the interests of executives with the interests of shareholders.
The enactment of Section 954 seems premature. Many public companies have recently established, on a voluntary basis, compensation recovery policies that have a scope much broader than Section 304. These policies often include all executive officers (as opposed to just the CEO and CFO), and frequently cover conduct, including unethical behavior by the executive.
In conclusion, while the proposed legislation appears to be aimed at protecting shareholders, it may actually harm shareholders in several ways, including by forcing them to bear the costs of unnecessary, excessive and potentially unsuccessful litigation.