The Clawback Conundrum
November 4 2010 by Richard A. Epstein
Under corporate law, the board of directors sets compensation packages for the key officers of the corporation, especially the CEO. No one thinks that this task is easy. The higher that people move up, the more complex—and pricey— the benefit package needed to attract and retain them. But in today’s populist times, the public and the press tend to view generous compensation packages with extreme suspicion, or even downright ire. Finding ways to clamp down on executive compensation, and that of CEOs in particular, has become something close to a national obsession.
here is, thanks to the First Amendment, nothing that CEOs can or should be able to do to stifle journalistic and popular calls to rein in executive compensation. No group should be immune from public criticism, even when it smarts. Today’s corporate critics, however, typically aren’t satisfied just with expressing their disapproval. They want legal muscle. One of the most potent examples is clawback provisions that require the CEOs and other high executives to return compensation previously received because some shortcoming in firm performance led to restatement of earnings. Two related provisions call for special attention: the 2002 Sarbanes-Oxley Act, and the Dodd-Frank law enacted in July 2010.
SOX on Restatements
Section 304 of the Sarbanes-Oxley Act, or SOX, contains a provision designed to strike at executive abuse in the manipulation of securities markets. In principle, it is difficult to object to any requirement that CEOs and other key corporate officers who are guilty of some form of misfeasance should return to the corporate coffers their ill-begotten gains. After all, standard state fiduciary rules governing both directors and officers impose a duty of loyalty that clearly covers these forms of manipulation.
The new frontier in this area involves the recent efforts by the Securities and Exchange Commission to force executives who were personally innocent to cough up their corporate bonuses and gains on stock options. Right now the action centers on the SEC suit brought in the early days of the Obama Administration against Maynard Jenkins, the former chief executive of CSK Auto, a retailer of auto parts, demanding that he return $4.1 million in additional compensation that he received during his decade of service. Other executives, without his knowledge or approval, cooked the books in ways that allowed the firm to overstate profits from 2002 through 2004. CSK was forced to restate its earnings twice, once in 2004 and again in 2007.
The individual officers responsible for these reporting errors were subject to fraud charges by the SEC. More controversially, CSK Auto settled the case, with the usual perverse consequence. Statutory rules intended to protect shareholders against corporate looting are enforced by taking money out of the corporation that would otherwise go into the shareholders’ pockets.
The most controversial leap is the SEC’s unprecedented effort to use Section 304 of Sarbanes-Oxley on the CEO who was, by its own admission, innocent of all wrongdoing. The statutory language states that “as a result of misconduct with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for” bonuses and stock options. Textually, it looks as though Judge G. Murray Snow got it right when he said that misconduct by the CEO or CFO was not needed to trigger the statutory obligation. Misconduct by any corporate employee could trigger the duty.
Section 304(b) also allows the SEC to exempt anyone from that requirement “as it deems necessary and appropriate.” In general, these provisions give the SEC the kind of unreviewable discretion that should leave every CEO uneasy. There are no criteria for determining whether this dispensation should be granted or withheld. This ability to play favorites should leave everyone uneasy. But in the absence of any firm statutory guidance, it seems best that the general principles of civil responsibility should take over, and those strongly discourage the imposition of fines on parties known to be innocent, which seemed to be the unstated policy in the Bush Administration.
Deter, Not Defame
As a matter of basic legal theory, the best deterrence is obtained by punishing the people who did the wrongdoing. The effort to hit the innocent CEO puts him to the futile task of overseeing any and all aspects of a far-flung operation when he is heavily dependent for information on the very parties who deceive him. The net effect of this SOX reading could be to force higher CEO pay to offset these uncertain losses, assuming that the threat of a high-profile civil action is itself not reason enough to turn down these jobs. Figuring out the size of any clawback is far from obvious, because complex compensation agreements could well have targets that are related to the long-term stability of the company, such as by reducing debt/equity ratios, and not this year’s quarterly profits.
By allowing these actions to continue, CEOs can look forward to prolonged depositions and endless distractions in doing business. In addition, the entire operation exposes the conscientious CEO to a double whammy. To incentivize CEOs, a larger fraction of their compensation is tied to future benefits, contingent on performance. That compensation structure thus exposes the CEO to the loss of a huge part of the overall compensation. Yet SOX offers no clear direction as to how short a haircut the CEO will have to face.
In the aftermath of Judge Snow’s first decision, we can expect extensive depositions as the parties joust over how much of that $4 million Jenkins can keep. One possible approach is to take back only those portions of the additional compensation during the 2002-2004 period if the accounting statement inaccurately reflected corporate earnings, which involves complex after-the-fact reconstruction of the policies and intentions of the CSK board. Another approach is to inquire whether there may been some want of due diligence on Jenkins’ part that could justify a higher penalty. Still a third approach would be to engage in conscious overkill as an indirect mode of deterrence. Once again, the gaps in SOX only increase the regulatory uncertainty for CEOs. It is highly likely that compensation packages after the Jenkins case will be drafted in ways that make them less dependent on particular earnings targets.
Dodd-Frank on Disclosure
The Jenkins issue under SOX is likely to be only the opening round in a series of extensive conflicts between the government and CEOs and other executives. Dodd-Frank is the most comprehensive financial reform statute ever, with the possible exception of the securities and exchange legislation in the 1930s. Section 954 of Dodd-Frank deals with clawback regulations. The less onerous portion of the legislation requires all companies to disclose their clawback policies with incentive-based compensation to the public, which might have some modest effect on the willingness of shareholders to press hard on these questions.
The more controversial provision by far is the adoption of mandatory recoupment policies that remove all doubt. Today any restatement of the financial results that is attributable to “material noncompliance” with the SEC reporting requirements triggers an obligation on all companies to seek repayment from both present and former executives, not just the CEO or CFO, as under SOX. That obligation extends to any incentive-based compensation paid in the immediate three years before the “date that the company was required to prepare the accounting restatement.” The statement of material noncompliance is broader than the SOX requirement of actual misconduct. Added teeth are put into this provision by its requirement that corporations not complying with Section 954 are not eligible for listing on national securities exchanges or for membership in national securities associations.
Under Dodd-Frank, it is no longer the SEC that takes the enforcement action. That task now falls to the corporate issuers, which could lead to some very dicey management problems if the restatement places the entire management team on the hot-seat. It is not clear what internal readjustments have to be made to accommodate these suits, and whether the SEC can or will intervene if it thinks that the company’s effort in this direction is misguided.
Dodd-Frank also does not indicate whether its sanctions to CEOs and CFOs are cumulative with those imposed under SOX. Nor does it give any clue when delisting is required for a corporation that “does not comply with the requirements of this section.” Can late or incomplete publication of a disclosure statement trigger the withdrawal from the exchanges and associations of a Fortune 500 company? What about the insufficient prosecution of the recoupment actions? If a company is delisted, is there anything that it can do to regain listing?
These sanctions are so disproportionate that it is hard to believe that the inevitable set of regulations will not soften the blow to some narrow subset of these cases. Otherwise the punishment will not fit the crime, for it makes no sense to punish the shareholders, who of course bear the brunt of any corporate delisting.
One common feature of both SOX and Dodd-Frank is that each generates dozens of knotty problem for which there are no statutory solutions. Without question, these laws create a hostile business climate, not only for CEOs but for the corporations they lead. Congress seems congenitally unable to realize that over-deterrence is as great a sin as under-deterrence. It does not perceive the real risk that these laws will induce foreign capital to flee our shores and foreign corporations to leave our exchanges before they suffer the cost and humiliation of these statutory sanctions. Nor does Congress seem to grasp that more able people may forswear roles in public corporations, and more domestic public corporations may choose to go private. Whether these grim prophecies prove true can only be learned, alas, as the implications of the new legislative and enforcement policies become painfully clear.