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
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
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
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.