Guilty Though Proven Innocent: The Rise of No-Fault Executive Claw-Backs

By Matthew M. McDonald and Eric C. Kassab

Claw-Backs under SOX 304

In 2002, Congress passed the Sarbanes-Oxley Act (SOX) in an effort to increase the accuracy of financial reporting and to restore investor confidence in the truthfulness and dependability of public disclosures made by issuers. Section 304 is one of the key enforcement provisions included in SOX and allows the SEC to claw-back executive compensation when an issuer files documents that materially misstate its financials. Specifically, SOX 304 provides that if, as a result of misconduct, it is necessary for an issuer to file an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, the chief executive officer and the chief financial officer shall reimburse the issuer for any bonus or other incentive or equity based compensation received within the 12-month period after a misstated financial statement had been filed, as well as any profits realized from the sales of securities of the issuer during that 12-month period.

From 2002 until 2009, claw-back actions brought by the SEC under SOX 304 only involved CEOs and CFOs who were charged with violating securities laws and alleged to have been primary actors in the misconduct that led to the filing of misstated financials. In 2009, however, the SEC began broadening its interpretation of the scope of SOX 304 and started seeking to claw-back compensation from CEOs and CFOs who were not accused of participating in the underlying misconduct. The SEC asserted that even though innocent of any wrongdoing, these executives were liable under SOX 304 because of their position with the issuer when the fraudulent accounting occurred.

CSK Auto Corporation

In early 2009, the SEC initiated its first enforcement action in which it sought a clawback from an executive who, by the SEC's own admission, had not participated in the underlying misconduct. The case involved CSK Auto Corporation (CSK) and its CEO, Maynard Jenkins. In 2004, CSK twice restated its financial statements for fiscal years 2002 through 2004. These restatements were prompted by CSK's treatment of a practice known as vendor allowances. Under this practice, in exchange for CSK marketing vendors' products, vendors would pay CSK allowances at fixed amounts or as a percentage of the goods CSK purchased from the vendor. These allowances were used to lower the cost of the products sold at CSK's stores and generally lowered CSK's cost of goods sold, thereby increasing pre-tax income. Under GAAP, uncollected vendor allowances are written off as an unpaid receivable, but CSK applied later paid vendor allowances to prior years and failed to correctly account for vendor allowances paid back to vendors. This practice, which CSK referred to as "filling the bucket," resulted in CSK overstating its pre-tax income in fiscal 2002 by $11 million, or 47 percent, in fiscal year 2003 by $34 million, resulting in the reporting of pre-tax income instead of loss, and in fiscal 2004 by $21 million, or 65 percent.

In response to these financial misstatements, CSK terminated its CFO, COO and controller, as well as the director of its vendor allowance program. In addition, the SEC initiated charges against all four of these individuals, alleging in its March 5, 2009, complaint that the defendants had "orchestrated a multi-million dollar accounting scheme to inflate the company's financial results and overstate its net income in 2002 through 2004." Although Jenkins was neither terminated by CSK nor personally charged by the SEC with respect to any of CSK's misconduct, the SEC filed a complaint asserting that he had violated the claw-back provision of SOX 304 because he had failed to reimburse CSK for the incentive based compensation and profits he received from selling CSK stock in the 12 months after the filing of the misstated financials.

Beazer Homes USA, Inc.

A similar case involving Beazer Homes USA, Inc. (Beazer) was brought in August 2011, when the SEC filed a complaint against Beazer's former CFO, James O'Leary, for failure to reimburse Beazer for incentive compensation and stock sale profits he received after it was discovered that the company had committed accounting fraud. Beazer had, on multiple occasions, misstated its net income in its quarterly and annual earnings reports from 2002 through 2006. Specifically, Beazer's senior vice president and chief accounting officer, Michael T. Rand, supervised a reserve accounting scheme under which reserves for certain future homebuilding expenses were improperly established, inflated and/or maintained in order to artificially increase the income and earnings reported for fiscal year 2006. Additionally, Rand instituted a scheme through which Beazer recognized millions of dollars in revenues and operating income that would not have been recognized under GAAP.

These practices resulted in Beazer having to restate its financial statements for various years including 2006. In connection with this accounting fraud, the SEC charged Rand with conducting a multi-year fraudulent earnings management scheme but did not personally charge O'Leary with the underlying misconduct. Nevertheless, because O'Leary was CFO of Beazer when the financial fraud had taken place, the SEC, utilizing SOX 304, sought reimbursement of all incentive and equity-based compensation and stock sale profits that O'Leary realized during the year following the filing of the misstated financials.

The Court Weighs In

In 2010, while the enforcement actions against Jenkins and O'Leary were active, Jenkins filed a motion to dismiss the SEC's claim with the United States District Court for the District of Arizona. Jenkins argued that the SEC could only use SOX 304 to claw back executive compensation if a CEO or CFO was involved in the underlying misconduct that forced a company to restate its financials. In denying Jenkins's motion to dismiss, the Court held that SOX 304 "require[s] only the misconduct of the issuer, but do[es] not necessarily require the specific misconduct of the issuer's CEO or CFO... [T]he plain language of the statute indicates that misconduct of corporate officers, agents or employees acting within the scope of their agency or employment is sufficient misconduct to meet this element of the statute."

Discord at the SEC?

Following the denial of his motion to dismiss, Jenkins and the SEC staff entered into settlement discussions. In March 2011, the SEC advised the Court that, subject to the approval of the SEC Commissioners, a settlement had been reached between Jenkins and the SEC staff for approximately $4.1 million. This represented the full amount of bonus compensation and stock sale profits that Jenkins had received during the relevant period. The SEC Commissioners, however, rejected this settlement. Many commentators believe that this rejection was due to internal conflict within the SEC over whether SOX 304 should be used as a no-fault enforcement mechanism against CEOs and CFOs and, if so, to what degree their compensation should be clawed-back. On Nov. 15, 2011, the SEC announced that the SEC Commissioners had approved a settlement with Jenkins in which he agreed to return only $2.8 million in bonus compensation and stock sale profits he received in the 12 months following CSK's filing of misstated financials.

In contrast, O'Leary's settlement agreement was approved by the SEC Commissioners on Aug. 30, 2011, with O'Leary agreeing to return approximately $1.4 million to Beazer. This settlement represented the entire amount that the SEC could have required O'Leary to reimburse Beazer under SOX 304. The relative timing of and inconsistent approaches taken in these two cases suggest that there may be continuing disagreement within the SEC over the appropriate scope of reimbursements sought under SOX 304 in no-fault cases.

Increasing Concerns Under Dodd-Frank

The use of SOX 304 as a no-fault enforcement mechanism against CEOs and CFOs has received significant attention both within and outside of the SEC. While the enforceability of such an action may have initially been in doubt, the decision of the District Court in Arizona to deny Jenkins' motion to dismiss and the successful settlements ultimately reached with Jenkins and O'Leary have established a firm basis for no-fault claw-backs under SOX 304. This increase in the scope of the SEC's enforcement power under SOX 304 and soon-to-be enacted Dodd-Frank Act provisions indicate that the trend towards no-fault claw-backs is likely to continue.

Under Section 954 of the Dodd-Frank Act, issuers must adopt policies that require any current or former executive to reimburse the company for incentive-based compensation (including stock options awarded as compensation) received during a three-year period preceding the date that restated financials were required to be filed as a result of the issuer's material noncompliance with any financial reporting requirement under the securities laws. The executive is required to return any excess of the incentive compensation actually received over what would have been received under the accounting restatement.

There are four key features that distinguish Section 954 of Dodd-Frank from SOX 304:

  1. Liability under Section 954 of Dodd-Frank applies to any current or former executive officer of the issuer, not just the CEO or CFO;
  2. Section 954 of Dodd-Frank allows an issuer to be reimbursed for the three-year period preceding the financial restatement, whereas SOX 304 only applies to the 12-month period after the filing of misstated financials;
  3. Section 954 of Dodd-Frank does not require that misconduct occur in order to impose liability; and
  4. Section 954 of Dodd-Frank only requires repayment of incentive based compensation and not profits realized from the sale of the issuer stock as is the case with SOX 304.

Section 954 of Dodd-Frank, explicitly, and SOX 304, through SEC and judicial interpretation, both allow for no-fault claw-backs of executive compensation. While they differ in the types of compensation that can be recovered and the time period for which an issuer will be entitled to reimbursement, together they represent a significant increase in the potential exposure for executives of issuers that restate their financial statements. In light of the SEC's growing tendency to seek executive claw-backs under SOX 304 and given the expansion of this power under Section 954 of Dodd-Frank, executives should be increasingly dedicated to developing, maintaining and monitoring effective internal controls in order to avoid restatement of financials and the resulting severe monetary penalties.

ISS 2012 Policy Updates

By William H. Clark, Jr. and Ena Marwaha Lebel

Institutional Shareholder Services (ISS) released its 2012 policy updates on Nov. 17, 2011. These updates apply to shareholder meetings that will be held on or after Feb. 1, 2012.

ISS is the largest and most influential of the proxy advisory firms and it currently exercises a broad influence over institutional investors. While studies present varied conclusions, one study found that a negative ISS recommendation in uncontested director elections correlates to a 20.3 percent drop in favorable votes by shareholders. Other studies have found that ISS is able to influence shareholder votes by 6 percent to 19 percent. More recently, one study found that many institutional investors do not blindly follow ISS recommendations but do evaluate and consider them, and, according to this study, ISS swings only 6 percent to 10 percent of the vote in uncontested director elections. Nevertheless, ISS is still a powerful voice and companies should consider its policy updates when preparing for the upcoming proxy season. If there is a possibility of any "Against" recommendations, particularly as a result of ISS's more holistic review of problematic executive compensation practices, companies should start a dialogue with ISS to determine how to avoid an "Against" recommendation. Also, immediately after ISS issues its report on a company's proposals, the company should review it for factual errors and request any necessary corrections.

Policies on Executive Compensation

Executive compensation remains a hot button issue for many shareholders for the 2012 proxy season.

Board Response to Frequency of Advisory Vote on Pay Results

Under this new policy, ISS will recommend a vote of "Against" or "Withhold" from directors if the board implements a say-on-pay schedule that is less frequent than the frequency most recently preferred by shareholders. New director nominees will be evaluated on a "case-by-case" basis. Under the Dodd-Frank, the SEC not only required U.S. corporate issuers to present shareholders with an advisory say-on-pay vote (which ISS refers to as the Management Say-on-Pay proposal or MSOP) but also required them to provide shareholders with an advisory vote to select the preferred frequency of MSOP votes at the first annual shareholder meeting occurring on or after Jan. 21, 2011, and at least every six years thereafter. The resolution allowed shareholders to vote for a frequency of every year, every two years or every three years, or to abstain.

While the MSOP frequency vote is non-binding on the board, it is a means for shareholders to express their preference. ISS believes majority support for a particular frequency should be viewed as a mandate to a board and that boards should be responsive and implement the option preferred by shareholders, regardless of whether it is the same option recommended by the board. Where no particular frequency received a majority of votes cast, ISS will take a "case-by-case" approach to evaluating the issuer's say-on-pay schedule and recommending votes on director candidates.

Pay-for-Performance Evaluation

ISS refined their methodology for determining pay-for-performance alignment after a survey of institutional investors found that those investors consider pay relative to peers and pay increases in light of company performance as very relevant to the evaluation. This methodology has quantitative and qualitative aspects. Since this methodology is very detailed, ISS provided additional guidance on the 2012 Pay-for-Performance methodology in a white paper published on Dec. 20, 2011. Under the new methodology, companies in the Russell 3000 index will be analyzed as follows:

1. Peer Group/Relative Alignment:

  • The degree of alignment between the company's total shareholder returns (TSR) rank and the CEO's total pay rank within a peer group, as measured over one-year and three-year periods ending on the last day of the month closest to the company's fiscal-year end (weighted 40 percent/60 percent); and
  • The multiple of the CEO's total pay relative to the peer group median, calculated by dividing the company's one-year CEO pay by the median pay for the peer group.

2. Absolute alignment: The absolute alignment between the trend in CEO pay and company TSR over the prior five fiscal years — i.e., the difference between the trend in annual pay changes and the trend in annualized TSR during the period.

If ISS believes that the above quantitative analysis demonstrates significant unsatisfactory long-term pay-for-performance alignment or, in the case of non-Russell 3000 index companies, ISS believes misaligned pay and performance are otherwise suggested, it will analyze the following qualitative factors to determine how various pay elements may work to encourage or to undermine long-term value creation and alignment with shareholder interests:

  • The ratio of performance-based to time-based equity awards;
  • The ratio of performance-based compensation to overall compensation;
  • The completeness of disclosure and rigor of performance goals;
  • The company's peer group benchmarking practices;
  • Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc., both absolute and relative to peers;
  • Special circumstances related to, for example, a new CEO in the prior fiscal year or anomalous equity grant practices (e.g., biennial awards); and
  • Any other factors ISS deems relevant.

ISS has said that the peer group it will use is generally comprised of 14-24 companies that are selected using market cap, revenue (or assets for financial firms) and Global Industry Classification Standard (GICS) industry group, via a process designed to select peers that are closest to the subject company, and where the subject company is close to median in revenue/asset size. Peer groups for all Russell 3000 companies are constructed twice per year, based on data provided by an independent source as of Dec. 1 and June 1 for annual revenues, assets and market capitalization. ISS chooses companies in the same two-digit GICS universe as the subject company, each with between 0.45x and 2.1x the subject's company annual revenues and with market capitalizations of between 0.2x and 5x the subject company. Then ISS chooses companies from the above comparison universe that are in the subject company's six-digit GICS category (or four- or two-digit category if fewer than 14 companies exist in the six-digit category) to select the industryclose peer group. The goal is achieve a comparison group of at least 14 companies. If the methodology fails to identify at least 14 comparison companies, ISS will relax the revenue (but not market capitalization) parameters in the peer group selection process. Additionally, "super-mega" non-financial companies (about 25 non-financial companies within the Russell 3000 index) that are unique in being among the largest public companies and have very few industry peers close to their size will be compared to one another and any industry-specific performance will be considered in the qualitative review.

For more detailed information about this methodology, please refer to the ISS white paper entitled "Evaluating Pay for Performance Alignment" as it includes an explanation of how the above measures were back-tested and technical information on how the regressions for the absolute alignment test are calculated. The white paper can be found at: http://www.issgovernance.com/sites/default/files/EvaluatingPayForPerformance_20111219.pdf .

Board Response to High Levels of MSOP Opposition

ISS has updated its policy towards the Compensation Committee and the MSOP proposal to take a "case-by-case" approach to making a voting recommendation if the company's previous MSOP proposal received the support of less than 70 percent of the votes cast. ISS will consider the following in making its recommendation:

  • The company's response, including:
    • Disclosure of engagement efforts with major institutional investors regarding the issues that contributed to the low level of support;
    • Specific actions taken to address the issues that contributed to the low level of support; and
    • Other recent compensation actions taken by the company;
  • Whether the issues raised are recurring or isolated;
  • The company's ownership structure; and
  • Whether the support level was less than 50 percent, which would warrant the highest degree of responsiveness.

ISS's rationale for the update is the overwhelming desire of shareholders to receive substantive and meaningful disclosure in determining whether the company has taken sufficient actions to address the compensation issues that contributed to the low level of support for the MSOP proposal.

Other Policy Updates

Proxy Access

ISS updated its current "case-by-case" approach to recommending a vote on shareholder proposals asking for open or proxy access by expanding the factors examined in the evaluation. Now, ISS will not only look at the ownership threshold proposed in the resolution, but also the maximum proportion of directors that shareholders may nominate each year and the method of determining which nominations should appear on the ballot if multiple shareholders submit nominations. In addition, ISS will evaluate company-specific factors. This policy has also been expanded to cover management proposals on proxy access as well.

Board Accountability – Governance Failures

ISS has updated its current policy to recommend a vote of "Against" or "Withhold" from directors who fail on material governance issues by explicitly including a reference to risk oversight as a factor considered by ISS. This new factor is meant to highlight the boards that have had a material breakdown in risk oversight. ISS cites the recent well-publicized failures of board risk oversight, such as the BP Deepwater Horizon oil spill of 2010 and the scandals surrounding News Corporation's U.K. operations in 2011, as a rationale for including this new factor.

Equity Plans

ISS has updated its policy on equity plans submitted for 162(m) shareholder approval. Now, the first time a company presents such a plan, it will be given the full equity plan evaluation. The purpose of this change is to provide shareholders with the opportunity to identify whether any problematic features exist under the proposed plan such that approval solely for Section 162(m) would not benefit shareholders.

Dual-Class Structure

ISS has decided to put its long-held policy of "one share-one vote" in writing through a recommendation to vote "Against" proposals to create a new class of common stock unless:

  • The company discloses a compelling rationale for the dual-class capital structure, such as:
    • The company's auditor has concluded that there is substantial doubt about the company's ability to continue as a going concern; or
    • The new class of shares will be transitory;
  • The new class is intended for financing purposes with minimal or no dilution to current shareholders in both the short term and long term; and
  • The new class is not designed to preserve or increase the voting power of an insider or significant shareholder.

Political Spending

ISS has changed its policy on proposals requesting greater disclosure of a company's political contributions and trade association spending policies and activities from a "caseby- case" approach to recommending a vote "For" such proposals. ISS cites shareholder interest in greater transparency on this issue especially in light of the Citizens United decision by the U.S. Supreme Court.

Lobbying Activities

ISS has expanded and updated its policy on proposals seeking information on a company's lobbying initiatives to include proposals seeking information on a company's lobbying activities generally and to clarify that its policy applies to proposals addressing broader efforts to inform or sway public opinion as well as to formalize political lobbying activities.

Exclusive Venue Management Proposals

ISS will take a "case-by-case" approach to recommending a vote on exclusive venue management proposals. These proposals for shareholder approval of exclusive venue charter provisions were new in 2011 after a court opinion suggested that exclusive venue bylaw provisions adopted solely by action of the board might not be enforceable.

Environmental Issues

ISS has created new and updated policies on the following environmental issues: hydraulic fracturing, recycling and water issues. ISS believes specific policies are warranted on each of these issues as environmental issues continue to gain attention by shareholders, the SEC and the public at large.

Workplace Safety

ISS adopted a new policy under which it would take a "case-by-case" approach to recommending a vote on requests for workplace safety reports, including reports on accident risk reduction efforts. This policy was motivated by recent requests by shareholders to have greater transparency and accountability regarding workplace safety after near fatal accidents at oil refineries and the BP Deepwater Horizon incident.

A copy of the 2012 ISS Policy Updates can be found at: http://www.issgovernance.com/files/ISS_2012US_Updates20111117.pdf .

SEC Staff Issues Cybersecurity Disclosure Guidance

By Troy M. Calkins

The SEC staff issued CF Disclosure Guidance: Topic No. 2 – Cybersecurity on Oct. 13, 2011. This guidance is intended to provide the views of the SEC's Division of Corporation Finance regarding disclosure obligations relating to cybersecurity risks and cyber incidents. While the statements in this CF Disclosure Guidance represent the views of the staff of the Division of Corporation Finance, this guidance is not a rule, regulation, or statement of the Securities and Exchange Commission. Nonetheless, given the role of the staff of the Division of Corporation Finance in reviewing public company disclosure, the Guidance provides helpful insight into what the staff will be looking for when reviewing filings.

The Guidance observes that a public company that depends on digital technologies to conduct some or all of its business may be exposed to risks or liabilities arising out of what it terms "cyber incidents". Therefore, the staff believes that it may be necessary for such a company to consider adding disclosure to its periodic filings regarding its experience with respect to cyber incidents and with respect to cybersecurity in general.

The Guidance suggests that cybersecurity disclosure may be relevant in a number of places in an affected issuer's filings, including:

  • Risk Factors;
  • Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A);
  • Description of Business;
  • Legal Proceedings;
  • Financial Statements; and
  • Disclosure Controls and Procedures.

The Guidance, which is relatively brief, is available on the SEC's website at: http://www.sec.gov/divisions/corpfin/guidance/cfguidance-topic2.htm .

Recent SEC Enforcement of Regulation FD: Fifth Third Bancorp

By Robert C. Juelke and Laura M. Hemm

On Nov. 22, 2011, the SEC announced a settlement with Fifth Third Bancorp (Fifth Third) over allegations that it selectively communicated to certain investors information regarding the redemption of its trust preferred securities. The settlement marked the first Regulation FD enforcement action brought by the SEC in over a year.

In May 2011, Fifth Third elected to redeem its trust preferred securities on the basis that a "capital treatment event" had occurred by virtue of certain provisions of the Dodd-Frank Act. To redeem the securities, Fifth Third was required first to obtain approval from the Federal Reserve Bank of Cleveland, and then to instruct the trustee to issue notice to the holders of the securities at least 30 days in advance of the redemption date. The governing trust documents required that the trustee give notice only to the Depository Trust Company (DTC), which was the sole registered holder of the securities.

On May 16, Fifth Third instructed the trustee to redeem the securities and to "send all appropriate notices to the holders." The trustee sent a notice of redemption to DTC, and DTC informed the beneficial owners of the securities of the redemption by posting the redemption notice early the following morning to its Legal Notification System, an online library available to subscribers and DTC member banks and brokers. The redemption notice indicated that Fifth Third would be redeeming the securities for about $25.00 per share.

At the time, the securities were trading on the New York Stock Exchange at about $26.50 per share. After certain investors learned that the securities would be redeemed at a discount to the market price, they began selling the securities to buyers who were apparently unaware of the redemption. On May 18, the securities opened at $26.66 and closed at $25.20. Within the first two hours of trading, volume increased from a daily average of 38,000 shares to over two million shares. Fifth Third filed a Form 8-K disclosing the redemption just before 11:30 a.m. on May 18, after it had noticed the unusually heavy trading volume and realized the impact that the selective disclosure regarding the redemption had on the market.

Fifth Third submitted an Offer of Settlement, which the SEC accepted, and consented to the entry of a cease-and-desist order. The SEC did not impose a civil penalty, based in part on Fifth Third's cooperation with the SEC staff. In addition, the SEC's order noted the remedial acts promptly undertaken by Fifth Third, including its compensation of investors harmed by the timing of its disclosure and its adoption and implementation of additional policies and procedures relating to the redemption of securities.

Regulation FD applies only to communications made by an issuer or any person acting on its behalf. The enforcement action against Fifth Third is noteworthy because the SEC necessarily took the position that, at least for Regulation FD purposes, DTC was an agent of the issuer. It was therefore Fifth Third's responsibility to ensure that communications made by DTC were Regulation FD compliant.

SEC Speeds Up Release of Comment Letters

By Troy M. Calkins

The SEC staff announced on Dec. 1, 2011, that it would speed up the public release of staff comment letters and issuer responses to those comment letters. From 2005 through 2011, the SEC staff has released these letters to the public "no earlier than 45 days" following the conclusion of the staff's review of the issuer's filings. Beginning in January 2012, the staff will be making these letters available to the public "no earlier than 20 business days" following the completion of the review. This change in practice may result in more issuers seeking confidential treatment of portions of their response letters.

SEC Adopts Final Rules on Accredited Investor Net Worth and Mine Safety Disclosure

By Troy M. Calkins

The SEC, without an open meeting, adopted on Dec. 21, 2011, final rules regarding accredited investor net worth and mine safety disclosure. Both of these rulemakings were mandated by the Dodd-Frank Act. The accredited investor net worth rule change is effective on Feb. 27, 2012, and a copy of the adopting release can be found at: http://www.sec.gov/rules/final/2011/33-9287.pdf . The new mine safety disclosure rule change is effective on Jan. 27, 2012, and a copy of the adopting release can be found at: http://www.sec.gov/rules/final/2011/33-9286.pdf .

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.