Corporate Governance

The SEC, Enforcement Actions, and Substantive Regulation of Executive Compensation

By J. Robert Brown

We have noted often on this Blog that executive compensation is a matter of state law.  That means Delaware.  The amount of compensation is a discretionary decision by the board of directors and is tested under the board's fiduciary obligations.  The Delaware courts have made this approach largely meaningless, reducing the matter down to a number of weakly enforced and often meaningless procedures. 

Thus, while compensation is tested under the duty of loyalty (at least for any one on the board) and theoretically subject to a fairness analysis, the Delaware courts have allowed approval by "independent" directors to shift the standard of review to the largely formalistic duty of care.  The result has been compensation without limits.  For more on this, take a look at Returning Fairness to Executive Compensation. 

Of course, the consequences of the system have become all too clear with the excessive payments of compensation, particularly to companies involved in the financial bailout.  Yet while the Delaware courts have grudgingly allowed some cases to go forward in the compensation area that reflect the growing public pressure, it is clear from cases like In re Citigroup that they have not gotten the message that the standards need to be made more meaningful.

As it turns out, the SEC has, increasingly, stepped in this regulatory vacuum.  The agency has already proposed a number of corporate governance reforms that seek to undo the lax regulatory environment in Delaware.  The proposals include allowing shareholders access to the company's proxy statement and imposing disclosure requirements that encourage the board to separate the position of chairman and CEO and to take a greater role in risk review. 

Equally interesting, however, has been the growing use of the Agency's enforcement authority to reign in compensation practices.  The Commission has brought actions for inaccurate disclosure of executive compensation but the cases have been few and far between, with most of the regulatory effort used to adopt more complex and specific rules governing compensation disclosure.

That approach, however, may be undergoing a shift.  The SEC brought a very high profile enforcement action agains BofA for the bonuses paid by Merrill Lynch shortly before the merger, exacting a $33 million fine.  While it was a disclosure case, consistent with the Agency's jurisdiction, it was in fact an excessive compensation case.  Had the bonuses not been viewed so negatively by the public (in part because they were paid to a company that incurred extraordinary losses), the action likely would not have been brought.  The message is clear.  BofA had the ability to exercise greater control over the payments.  The agreement (actually the exhibit) merely required Merrill to award the compensation "in consultation with" BofA.  See Paragraph 12 of the Complaint.  Had the Bank received veto authority and then exercised it, the case would never have surfaced.

But one cannot draw a line with only a single point.  The other case of considerable interest was SEC v. Jenkings.  In effect, the SEC is seeking to require the former CEO to pay back compensation in a "clawback" action under SOX.  The litigation release alleges that the CEO received $4 million in bonuses and trading profits (according to the complaint:  $2,091,020 in bonuses and $2,018,893 in stock sales) during the clawback period. 

Section 304 of SOX is an odd provision.  It requires the CEO and CFO to reimburse the company for bonuses and trading profits following an accounting restatement that resulted from misconduct.  The Section is essentially a strict liability offense; the CEO and CFO do not have to have had any role in the misconduct.  Nonetheless, it would not seem like a provision that the SEC would generally want to enforce, at least in the absence of misconduct by the top officers.  In most instances, there is likely to be a private remedy.  The company presumably can enforce the provision and shareholders can presumably sue the board if directors refuse. 

Not in this climate.  Although the Commission has used the authority before, the release noted that it was the first case "seeking reimbursement under Section 304 from an individual who is not alleged to have otherwise violated the securities laws."  In other words, the Commission used the provision against a non-wrong doer. 

Certainly, the case (which is apparently in litigation) has some public appeal.  Bonuses and other types of incentive payments made when a company has been engaging in false disclosure are not popular. 

The implications, however, are likely to have broad implications inside the board room and offices of the CEO/CFO.  Every CEO and CFO will know that if they preside over a company that later restates as a result of wrongdoing by others, they will potentially lose their bonuses and trading profits.  The collective shiver from that thought will likely induce top officers to supervise more intently the financial disclosure process.

It is highly unlikely that the SEC would be this deeply involved in litigation against companies for compensation practices were it not for the excessive practices allowed under Delaware law.  It should not have taken a provision in SOX and enforcement by the SEC to get boards to seek repayment from top officers when the requisite misstatement occurred.  It should not have taken the SEC to encourage companies to watch more carefully compensation practices during acquisitions.  The Agency has plenty of things to do but in this case it is filling a vacuum left by the Delaware courts. 

Full post as published by The Race to the Bottom on August 11, 2009 (boomark / email).