Bringing a New Ethics to the Market Place: Sox 304, Dodd-Frank 954

Bringing a New Ethics to the Market Place: Sox 304, Dodd-Frank 954

SOX Section 304 and Dodd-Frank Section 954 present the SEC with a critical test. Each Section provides for the claw back of certain executive incentive executive compensation when there is a restatement. The challenge for the Commission is to use its authority under each Section to encourage the new ethics in the marketplace each is designed to foster.

Section 304 was passed as part of the Sarbanes Oxley Act in August 2002. It gives the Commission the authority to seek the repayment of certain CEO and CFO incentive-based compensation and stock trading profits when the executive's company must restate its financial statements because of misconduct. The Section does not specify that the misconduct be that of the CEO or CFO.

The Commission has adopted essentially a "strict liability" approach to Section 304. Under that approach, the CEO or CFO is held responsible despite the fact that he or she was not involved in the misconduct. This position is currently being litigated in SEC v. Jenkins (here) and is the predicate for the settlement in SEC v. O'Dell (here). The Second Circuit recently bolstered the Commission's position by holding that it has the sole authority to exempt a CEO and CFO from this liability - the company can not indemnify the executive. Cohen v. Viray, No. 08-3860-cv (2nd Cir. Sept. 30, 2010) (here).

Dodd-Frank Section 954, now Exchange Act Section 10D, is similar. It expands the class of executives whose incentive compensation may have to be repaid from the CEO and CFO to executive officers, an undefined term. It also expands the time period for which repayment is required from the one year in Section 304 to three years, while dropping the requirement that wrongful conduct cause the restatement. The claw back is, however, limited to what appears to be disgorgement, rather than the entire bonus.

Unlike Section 304, the SEC is not specifically given the authority to exempt persons from liability in Dodd-Frank Section 954. The Commission is, however, required to write rules directing that the exchanges, as part of their listing standards, require issuers to adopt and disclose such a claw back policy. How these policies will be enforced is not specified.

The challenge for the Commission is how to use these tools. Clawing back executive compensation is of course popular in many quarters. No doubt it will generate headlines in the press and at lest some support on Capital Hill if executives are required to line up and pay back big bonuses. The SEC can clearly use some good press. The more important question, however, is whether this is consistent with the goals of the statutes and agency's statutory mandate. Stated differently, does it help halt wrongful conduct and bring a new ethics to the marketplace?

Neither SOX 304 nor Dodd-Frank 954 specifies precisely how the Commission should exercise its authority. Since each is part of a larger statute this suggests that the Commission should interpret each Section and its authority in the context of the overall statute. Section 304 is part Sarbanes Oxley, the goal of which is to prevent a reoccurrence of the corporate scandals that spawned it while bringing a new ethics to the marketplace. One of its key mechanisms is executive accountability, illustrated by the CEO and CFO certification requirements. These sections, along with others, ensure proper corporate conduct by requiring senior officials to fully and effectively implement what had previously been viewed as their corporate law Caremark obligations as directors and officers.

The massive Dodd-Frank bill is similar. It was written in the wake of the worst market crisis in decades. Central to the disparate sections of the legislation are the notions of transparency and accountability. Sections requiring hedge fund registration and record keeping and derivative trading on exchanges for example are intended to bring sunlight to players and transactions in the marketplace that have a significant impact, but about which little was previously known. Other sections, such as those regarding rating agencies and increasing the reach of the SEC and DOJ, are designed to add accountability.

Viewing Sections 304 and 954 in this context means that the SEC should utilize its authority under each to bring accountability and transparency to the marketplace. Since incentive-based executive compensation is generally tied to performance metrics, the Sections should be administered in a manner which encourages corporate executives to take whatever steps are necessary to ensure that corporate performance metrics are correct. Accordingly, executives should be encouraged not just to fulfill the minimum of their monitoring duties, but to seek out and adopt best practices. Propelling corporate executives toward this goal is fully consistent the purpose of Sarbanes Oxley as well Dodd-Frank. It is also helps implement the Commission's statutory mandate.

In contrast, continuing with the SEC's current "strict liability" approach undermines its statutory obligations and is quite possibly outside the scope of its Section 304 authority. A "strict liability" approach holds an executive liable regardless of whether he or she did a good, superior or even excellent job in carrying out their duties. Under this approach even when the company adopts "best practices," if wrongful conduct occurs - and that can happen under the best of circumstances as the auditing literature has long recognized - the CEO and CFO are penalized under Section 304 and possibly 954. It may also encourage issuers to avoid restatements since they are the triggering mechanism under each statute. This would undermine transparency, the efficiency of the markets and be a disservice to investors. Likewise, arbitrary punishment does not encourage a new ethics in the marketplace. Rather, it creates disrespect for the law as punitive, arbitrary and unfair.

Finally, such an interpretation may well exceed the SEC's authority under Sections 304 and 954. Section 304 gives the SEC the authority to exempt persons from liability, but does not define the standards. Section 954 directs the SEC to write rules, but also does not specify the standards. Under these circumstances, it is incumbent on the Commission to use its authority in a manner which is consistent with the goals of the two statutes from which its authority emanates as well as its overall statutory mandate. Employing policies which encourage executives to adopt best policies is fully consistent with those provisions. Strict liability is not. This means that compensation should be clawed back not on an arbitrary basis, but only when the executive fails in his or her obligations to strive for the implementation of best practices in carrying out their duties. The adoption of this standard will encourage corporate executives not just to do the minimum, but to strive for a new ethics in the corporate culture, the essence of the reform legislation in 2002 and 2010. The question is whether the SEC is up to the challenge of fully implementing the goals of each piece of legislation.

For more cutting edge commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.