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13 Oct. 2016 | Comments (0)

By Gary Larkin, Research Associate, The Conference Board Governance Center

Maybe— just maybe— SEC Chair Mary Jo White might be able to follow through on reaching her goal of finalizing the long-awaited Dodd-Frank Act clawback rules (AKA Listing Standards for Recovery of Erroneously Awarded Compensation) before a new administration comes into office.

I believe the SEC will finally go ahead with finalizing the executive compensation clawback rules after the U.S. Court of Appeals for the Ninth Circuit laid the groundwork in a recent decision involving top executives (former CEO Peter Jensen and former CFO Thomas Tekulve) at the now defunct Basin Water Inc. On August 31, the court affirmed the SEC’s interpretation of Section 304 of the Sarbanes-Oxley Act, which allows the commission to claw back performance-based compensation from CEOs and CFOs in cases where a company has restated its financial statements due to misconduct. The decision overturned a 2013 lower California-based federal court ruling.

According to a National Law Review article by Proskauer Rose LLP Partner Jonathan E. Richman, the Ninth Circuit Court decision to disgorge certain CEO and CFO compensation when an issuer restates its financial statements “as a result of misconduct” applies even if those executives were not personally involved in the misconduct. Although several district courts had previously reached that conclusion, the Ninth Circuit’s decision in SEC v. Jensen appears to be the first appellate ruling on the issue. That decision tends to give the Sarbanes-Oxley clawback rule more teeth than when it was originally drafted.

In fact, the proposed Dodd-Frank rules were written to be tougher and broader than the Sarbox rule. As proposed, the clawback rules and amendments would require the national securities exchanges to establish listing standards requiring companies to adopt and disclose policies to recover incentive-based compensation that was awarded erroneously from current and former executives. The proposed rules would pertain to compensation based on financial results that were restated due to the issuer’s material noncompliance with financial reporting requirements.

In a recent client memo, Wachtell, Lipton, Rosen & Katz stated the significance of this decision on SEC clawback rule enforcement: “A key issue in the interpretation of this provision has been the question of whether the ‘misconduct’ must be committed by the person whose compensation the SEC is seeking to recover.

The SEC has argued that personal misconduct is not required, but that any misconduct within the corporation—committed by any employee—is a sufficient predicate to claw back compensation from the CEO and CFO.”

The law firm believes this victory will mean that the SEC may “seek this relief with greater frequency.” If that’s not a signal that the SEC should act now to finally put the more stringent clawback rules in place, I don’t when there would be. Especially, when you consider that there are only three members of the commission due to the Senate’s inability to confirm two nominees. So what can this mean for companies that have compensation clawback policies already in place or even those without such policies? According to ISS Corporate Solutions, 86.4 percent of S&P 500 companies and 70.5 percent of S&P Midcap 400 companies have clawback provisions. Conversely, only 34.6 percent of the smaller Russell 3000 companies have such requirements. However, many of these policies are based on the Sarbox financial restatement trigger, which means many will have to make changes when the SEC rules are finalized. [Read Bloomberg BNA October 6 article, Will Wells Fargo Scandal Lead to Changes in Pay Plans?]

Consider what Wells Fargo’s board did following the report that 5,000 of its employees had opened fake bank and credit accounts for existing customers. In that case, the bank’s board decided to rescind a total of $60 million in unvested equity awards from its Chair and CEO John Stumpf, who retired just days after testifying before a Senate committee hearing, and its former retail head Carrie Tolstedt.

Until his October 10 retirement announcement, Stumpf was not collecting a salary during the fraud investigation. The precedent here is that the clawbacks were made based on allegations about employee actions, not that of the two executives, and those actions didn’t lead to a restatement. Essentially, that is what the proposed SEC clawback rules would do. And that is why I think the SEC will act sooner than later. I’m not saying it will happen before Election Day, but public company boards should prepare for revisiting those clawback policies.

If you are interested in learning more about this topic and other key developments in executive compensation and governance, The Conference Board is hosting its 2016 Executive Compensation Conference on November 1-2. York University Professor Richard LeBlanc will lead a discussion on those topics. Also Conference Board Executive Compensation Council II Program Director Lisa Hunter will review the Conference Board’s 2016 CEO and Executive Compensation Practices Report.

The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board of the Governance Center.  

  • About the Author:Gary Larkin

    Gary Larkin

    Gary Larkin is a research associate in the corporate leadership department at The Conference Board in New York. His research focuses on corporate governance, including succession planning, board compo…

    Full Bio | More from Gary Larkin


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