Corporate Governance

The Dodd-Frank Wall Street Reform Act and the Preemption of Delaware Law (Compensation Clawbacks)

By J Robert Brown Jr.

Another place where preemption occurred was in connection with clawbacks.  Could there be any other place that demonstrates more clearly the weakness in Delaware law than the need for a federal provision that requires clawbacks of compensation based upon erroneous financial statements?  Nonetheless, no such requirement or practice has emerged under Delaware law.  As a result, the matter has become federalized.  Moreover, the approach shows that Congress will return to an area and deepen the preemptive effect if state law does not fill the breach. 

Congress stepped into the area of clawbacks in a mild and tentative way under SOX.  Section 304 of SOX provided for the forfeiture of bonuses but only in very narrow circumstances.  The provision applied to the CEO and CFO and only extended to bonuses paid within 12 months of the faulty financial statements. 

The forfeiture was triggered by a restatement "due to the material noncompliance of the issuer, as a result of misconduct."  The provision does not require the forefeiting officer to have actually engaged in the misconduct.  As one court has described:

• it was Congress's purpose to recapture the additional compensation paid to a CEO during any period in which the corporate issuer was not in compliance with financial reporting requirements. A CEO need not be personally aware of financial misconduct to have received additional compensation during the period of that misconduct, and to have unfairly benefitted therefrom. When a CEO either sells stock or receives a bonus in the period of financial noncompliance, the CEO may unfairly benefit from a misperception of the financial position  of the issuer that results from those misstated financials, even if the CEO was unaware of the misconduct leading to misstated financials. It is not irrational for Congress to require that such additional compensation amounts be repaid to the issuer.
  

SEC v. Jenkins, 2010 US Dist. Lexis 57023 (D. Arizona June 9, 2010).

Section 954 of the Dodd-Frank Wall Street Reform Act, however, substantially broadened the reach of the clawback provision.  The need for restatements due to misconduct was eliminated.  Instead, clawbacks are required where a restatement occurs due to "material noncompliance."  Moreover, Dodd-Frank expanded the reach from the CEO and CFO to "any current or former executive officer."  Finally, the look back period has been extended from one to three years.   The provision does provide, however, that the clawback will only apply to the amount paid "in excess of what would have been paid to the executive officer under the accounting restatement."

The provision addresses performance based compensation based upon mistaken financial statements.  It does not address performance based compensation that encourages short term earnings.  Thus, officers who receive substantial performance based compensation because of a good year (think 2007) only to see matters collapse the following year (think 2008) will not have to pay back the compensation.  The approach, therefore, puts a premium on financial accuracy rather than prudent management.

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.  We've attached the provision below.  

SEC. 954. RECOVERY OF ERRONEOUSLY AWARDED COMPENSATION.

The Securities Exchange Act of 1934 is amended by inserting after section 10C, as added by section 952, the following:

SEC. 10D. RECOVERY OF ERRONEOUSLY AWARDED COMPENSATION POLICY.

(a) LISTING STANDARDS.—The Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that does not comply with the requirements of this section.

(b) RECOVERY OF FUNDS.—The rules of the Commission under subsection (a) shall require each issuer to develop and implement a policy providing—

(1) for disclosure of the policy of the issuer on incentive-based compensation that is based on financial information required to be reported under the securities laws; and

(2) that, in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentive-based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.

Full post as published by The Race to the Bottom on July 23, 2010 (boomark / email).