Dodd-Frank: What the New Law Means for CEOs and Shareholders

Section 954 of the new financial reform bill indicates growing influence of shareholders in corporate matters. Legal experts believe the Dodd-Frank legislation which came into force recently has put the CEOs and the corporations at the receiver’s end, while giving an upper hand to shareholder groups.

October 1 2010 by Fayazuddin A. Shirazi


CSK Auto Corp’s former CEO Maynard Jenkin’s tryst with SEC’s clawback lawsuit in an Arizona Federal Court might have escalated the debate on whether CEOs who committed no offence should also be liable for bonus clawback under section 304 of SOX, the recent financial reform enactment however, has all the more complicated things for CEOs and other executives held for accounting restatements.

Legal experts believe the Dodd-Frank legislation which came into force recently has put the CEOs and the corporations at the receiver’s end, while giving an upper hand to shareholder groups.

Legal pundits say that while shareholder groups are apparently the biggest beneficiaries of this law, the latest enactment will have far-reaching repercussions for CEOs and other executives arraigned for accounting restatements.

Making matters worse for executives, the current version of Senator Christopher Dodd’s financial reform bill – Section 954 – requires companies that filed a restatement to recover incentive-based compensation from executive officers, even if none of the executives were found to be engaged in any misconduct.

This means executives such as Jenkins who are pleading innocence will end up having a raw deal.

Growing Shareholder Influence:

Robert Reder, Co-Practice Group Leader of Milbank’s Global Corporate Group, a NY based international financial services law firm, believes the new legislation may shift the corporate decision making from the director/management control model, to a federally-mandated, shareholder-centered legislative regime.

In an interview to CE Online Bob Reder opined: “In particular, once the SEC’s rules on proxy access are in place, it will be interesting to see the impact that directors who are nominated and elected via the shareholder access rules have on the functioning of boards. As with any legislation that is as far- reaching, the unintended consequences could be profound.”

Additionally, unlike Section304 of SOX, which did not require the SEC to adopt any rules to implement the statute, with the new legislation, the SEC and the national securities exchanges are required by Section 954 of the Dodd-Frank Act to adopt rules that in turn will call upon listed companies to “implement a policy” for reimbursement of incentive-based compensation following a restatement of their financials.

“As we have seen from various federal court cases, only the SEC is entitled to enforce SOX Section 304 – individual shareholders cannot seek reimbursement from corporate heads. It will be interesting to see if the SEC rules under Section 954 explicitly grant shareholders a private right of action to seek executive reimbursement or if the courts grant such a right of action to shareholders to enforce a reimbursement policy that the companies themselves will have implemented,” Reder noted.

Similarly, another bill approved by the House Financial Services Committee – if enacted – would require public companies to allow their shareholders to vote on political campaign expenditures at their annual meetings.

“This is a legislative response to the recent U.S. Supreme Court decision in the Citizens United case that struck down federal campaign finance laws applicable to corporations,” claims Reder.

Although the opponents of this proposed bill have already raised hue and cry saying this enactment might entail further undue intrusion by the federal government into an area heretofore reserved for the state corporation laws, the move, however, clearly signifies that the shareholders will have a greater say in corporate matters hereafter, legal experts point out.

“Without commenting on the merits of this legislation, or even predicting whether it will ever become a law, it clearly indicates potential shifting of corporate decision-making from the board of directors to shareholders,” Reder reiterated his resolve.

However, Fredric D. Firestone, a partner in the Washington, D.C., law firm of McDermott Will & Emery (MWE) believes lack of clarity on whether Section 954 gives a private right of action for shareholders against faltering CEOs, is a potential problem in the new enactment.

“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,” he says.

Firestone believes 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.

Impact on Corporations:

The new act will further require companies to pay even greater attention to the compensation disclosures in their proxy statements. Legal experts are of the opinion that besides keeping a watchful eye, corporate boards, and their audit committees, now have greater responsibility of supervising the financial statement process.

“This represents another step along a continuum of enhanced disclosures that began with Sarbanes-Oxley and were reflected in last year’s round of SEC amendments to the proxy statement disclosure rules,” says Reder.

“They (boards) should be sensitive to this ruling because it’s in their interest to shield their top officers from this type of liability so that they can discharge their duties without fear or favor,” feels Reder.

While ensuring that the internal accounting team is decently staffed with adequate resources and expertise to efficiently discharge their duties, boards will also feel the need to have an increased direct communication with external auditors. “The new law might trigger boards to engage in an increased direct communications with the outside auditors,” opines Reder.

While proponents of the new law believe the new requirements will prosper better proxy disclosures and ensure greater transparency, experts point out that there is also a possibility that the new rules might in fact complicate matters for shareholders.

Section 954, has complicated provisions which requires public companies to develop and implement compensation recovery policies as a condition of having securities listed on national securities exchanges and associations. This will mean additional workload and challenging conditions for boards, warn legal analysts.

Firestone who believes the new law would raise complex issues for companies says the element of uncertainty whether an executive who was awarded compensation would have to return those benefits to the company or to any other body, if the clawback provision was subsequently triggered as a result of a restatement is very tricky and unclear.

“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 be granted to executives,” feels Firestone.

To mitigate these uncertainties, Firestone points out that, 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,” Firestone told CE Online.

Prior to these regulatory developments, as many as 212 companies in the S&P 500 had so far adopted a variety of clawback policies, but hundreds of other public companies still don’t have such compensation recovery policies as required by Dodd-Frank.

What Should Companies Do:

Besides the above discussed points corporate governance experts prescribe few tenets for companies to follow while drafting policies as per the new requirements.

In a recent article with BusinessWeek, Ben W. Heineman Jr. a senior fellow at Harvard Law School and Harvard’s Kennedy School of Government feels for public companies that must design, or redesign, a program: many questions still persist, such as who is covered, what is the triggering event of corporate malfeasance or nonperformance, whether the period during which recovery can be sought is limited or not?

“As companies revise or adopt clawback policies—whether voluntarily or because they are required to do so—these questions and others will be reexamined and policies reformulated. More basic questions, however, must first be addressed: What is the mission of the corporation, how is corporate action evaluated according to that mission, and in that context, what is the philosophy of executive compensation,” Heineman, who was also GE’s former senior vice-president for law and public affairs noted in his opinion piece.

Impact on Executives:

While the SOX 304 impacts only the CEO’s and CFO’s, the Dodd-Frank’s 954 section impacts all current and former executive officers, not just CEOs and CFOs.

“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,” Firestone warns.

Firestone, an associate director of the SEC’s Division of Enforcement prior to joining MWE, says 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, while SOX 304 seeks reimbursement for only one-year period following publication of the incorrect financials.

“Any CEO or CFO who hears about this decision will likely want to make extra sure that the internal accounting is properly staffed and functioning,” says Reder.

When asked will this anyway affect the cases already in trial (SEC vs Jenkins, Diebold), Reder gave an emphatic no, saying: “Neither Jenkins nor Diebold involved individual wrongdoing on the part of the CEO, but reimbursement was nevertheless required because the corporations themselves were found to have engaged in “misconduct.”

However, Reder points out that most of the outcome of this new enactment will depend on the actual language of the SEC/stock exchange rules implementing Dodd-Frank Section 954.

“The failed argument used by the CEO in Jenkins to try to avoid reimbursement under SOX Section 304 will not be available to executives who face reimbursement under company policies implemented pursuant to Dodd-Frank Section 954,”he says.

Deborah Meshulam, an expert on securities enforcement practices and a partner with DLA Piper, NY based global law firm suggests one clear way to avoid a clawback prosecution is to simply pay back any relevant incentive-based compensation before the SEC initiates an enforcement action, thereby eliminating the SEC’s cause of action.

She is of the opinion that while there are other arguments which the accused executives can use as defenses, they are yet to be tried and tested.

“The Jenkins case also suggests possible defenses to a SOX 304 claim, arguing that the SEC must prove causation, i.e., that the reimbursement it seeks is traceable to the company’s misstatement of financial results, or arguing that the reimbursement sought by the SEC violates the Due Process Clause prohibition against excessive punitive damage awards. While these defenses are untested, legislators’ and regulators’ interest in pressing for more no-fault clawbacks suggests that they may be tested soon, Meshulam opines.

According to her, CEOs and CFOs who, pursuant to SOX, must certify that they are responsible for the design and operation of effective financial controls and the accuracy of a company’s financial statements should heed the warning of the court in Jenkins that “Section 304 provides an incentive…to be rigorous in their creation and certification of internal controls,” Meshulam observed in her article with DLA Piper.

Public Sentiment amp; Lack of Political Will

Experts are of the opinion that there seems to be no reprieve for executives facing accounting fraud and restatement charges, as they feel there’s absolutely no political will and inclination for the authorities to be lenient with executives.

Given the state of the economy, the financial meltdown and the ongoing recession, there’s absolutely no political appetite to make things easier for CEOs or CFOs, experts point out.

“Section 304 of SOX is probably here to stay, so it’s something that CEOs and CFOs must understand “goes with the territory,” quips Reder.

Additionally Reder feels that the way SEC’s enforcement division is pursuing cases against companies and their heads (for example, the lawsuit against Goldman), looks like the trend will continue and SEC will aggressively prosecute CEOs and CFOs accused of accounting fraud.

“No matter what one may think about the “fairness” of this provision, it is here to stay. One must remember that the genesis of this provision is some of the biggest accounting frauds — the Enron, Worldcom, Tyco, etc. of 2002,” Reder recalls.