NOVEMBER 2010
EXECUTIVE SUMMARY
BUSINESS LAW AND GOVERNANCE
PRACTICE GROUP
Clawback of Executive Compensation Under Financial Reform Laws
Patricia Kane Williams, Esquire
Law Office of Patricia Kane Williams LLC
Haddonfield, NJ
The last decade has seen the adoption of three sweeping financial reform laws. Those enactments are: the Dodd-Frank Wall Street Reform and Consumer Protect Act (the
Dodd-Frank Act),
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Emergency Economic Stabilization Act of 2008, as amended
(EESA),
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and Sarbanes-Oxley Act of 2002 (SOX).
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Each was enacted in response to devastating economic crises, and each dealt with governance and executive compensation. This Executive Summary will focus on the provisions dealing with clawback of excessive compensation under these laws.
Designed to avoid future “fire sales” like that of Wachovia and major collapses like that of Lehman Brothers, the Dodd-Frank Act was signed into law by President Barack
Obama on July 21, 2010. Its express purpose is to “promote the financial stability of the
United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayers by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” Its provisions are wide ranging and include numerous changes to executive compensation and corporate governance rules.
Section 954 of the Dodd-Frank Act amends the Securities Exchange Act of 1934 by adding Section 10D, dealing with policies to recover erroneously awarded compensation. The U.S. Securities and Exchange Commission (SEC) is required to adopt rules directing the national securities exchanges and national securities associations to prohibit the listing of any security of a company that does not comply with Section 10D. SEC must require each issuer to implement and disclose its policy

regarding incentive-based compensation. In the event that the company is required to prepare an accounting restatement because of material noncompliance with any financial reporting requirements, the company must have a policy to recover from any current or former executive officer a portion of the incentive-based compensation paid or accrued during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement. The amount to be recovered is the amount in excess of what would have been paid to the executive officer under the accounting restatement. Thus, if material noncompliance with financial reporting requirements causes net income to be overstated and an officer receives stock options awarded as compensation based on the amount of net income, the excess amount must be reimbursed to the company. The excess amount is the difference between what would have been awarded under the proper accounting statements over what was actually paid based on the non-complying financial reporting.
On September 8, 2010, the Municipal Securities Rulemaking Board filed with SEC its proposed Amendments to Rule A-3, on Membership on the Board to Comply with the
Dodd-Frank Wall Street Reform and Consumer Protection Act. In July 2010, SEC posted a request for comments on the standard of care that brokers, dealers, and investment advisors should use; the comment period ended on August 30, 2010.
Otherwise, no regulatory action has yet occurred under the Dodd-Frank Act. However, a review of the previous reform laws may shed some light on how Dodd-Frank will be applied.
The previous federal financial reform bill was EESA, enacted to restore liquidity and stability to the nation’s financial system following collapse of the credit markets. Section
101(a) established the Troubled Asset Relief Program (TARP) to purchase troubled assets from financial institutions. Section 111 provided that entities that receive financial assistance from the U.S. Department of the Treasury (Treasury) under TARP would be subject to specified executive compensation and corporate governance standards. In particular, Section 111(b)(2)(B) required recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer (any one of the top five highly paid executives of a public company) based on statements of earnings, gains, or other criteria that are later proved to be materially inaccurate.
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On October 20, 2008, Treasury published an interim final rule in 31 CFR Part 30
(October Interim Final Rule) that established executive compensation standards for financial institutions participating in the Capital Purchase Program (CPP). CPP was a
TARP program under which the Treasury purchased shares in financial institutions.
The October Interim Final Rule required the bonus and incentive compensation of each senior executive officer (SEO) paid while Treasury held an equity or debt position to be subject to clawback by the financial institution if the payments were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria. A similar provision was included in the new February 2009 Treasury Guidance for all entities participating in TARP programs. The February 2009 Treasury Guidance also required clawback of bonuses and incentive compensation awarded to the next twenty executive officers if based on materially inaccurate financial statements or performance metrics, which the executive officers had knowingly engaged in providing.
The 2008 credit crunch and subprime mortgage crisis evolved into the deep 2009 recession. President Obama signed into law the American Recovery and Reinvestment
Act of 2009 (ARRA) on February 17, 2009. Title VII of Division D of ARRA amended, in its entirety, Section 111 of EESA. Section 111(f) required the Secretary to review compensation paid before the enactment of ARRA to SEOs and the next twenty most highly compensated employees of each TARP recipient to determine whether any such payments were inconsistent with the purposes of Section 111 or were otherwise contrary to the public interest. If such a determination was made, the Secretary was required to seek to negotiate appropriate reimbursement with the TARP recipient and the subject employees.
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On June 10, 2009, Treasury appointed Kenneth R. Feinberg as the special master for TARP Executive Compensation. As special master, he was charged to review payments and compensation plans for the executives and the 100 most highly compensated employees of TARP recipients that received exceptional assistance to ensure that compensation was structured in a way that gave those employees incentives to maximize long-term shareholder value and protect taxpayer interests. Companies that received exceptional financial assistance included those that received assistance under the Programs for Systemically Significant Failing Institutions,
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Targeted Investment Program, and Automotive Industry Financing Program, including
AIG, Citigroup, Bank of America, Chrysler, GM, GMAC, and Chrysler Financial.
Both the October 2008 and February 2009 Treasury Guidance were revised in their entirety by the Treasury’s Interim Final Rule published on June 15, 2009 (Interim Final
Rule). The Interim Final Rule is set forth in the form of questions and answers. Section
30.8 (Q-8) of the Interim Final Rule requires the TARP recipient to ensure that any bonus, retention award, or incentive compensation paid or accrued during a TARP period to an SEO or one of the twenty most highly compensated employees is subject to recovery by the company if the payments or accruals were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria. Q-8 states that financial statements include but are not limited to statements of earnings, revenues, or gains. For this purpose, a financial statement or performance metric criteria must be treated as materially inaccurate with respect to any employee who knowingly engaged in providing inaccurate information, including knowingly failing to timely correct inaccurate information. Otherwise, with respect to performance criteria, materiality depends on whether the actual performance is materially different from the performance that was required under the performance criteria or whether the application of the actual performance to the performance criteria was inaccurate. The TARP recipient must exercise its clawback rights except to the extent that it demonstrates that it is unreasonable to do so, such as, for example, if the enforcement expense would exceed the amount recovered.
According to the Final Report of the Special Master, issued on September 10, 2010, determinations for the top twenty-five executives in each TARP recipient resulted in
“substantial reductions in cash and overall compensation” for 2009 and 2010. The cash and overall compensation for executives who were in the top twenty-five group in 2010 but not in 2009 were “reduced substantially from historical levels.”
SOX was the first major financial reform law of this century, enacted in 2002 following a number of major corporate and accounting scandals, including Enron, Tyco, and
WorldCom. Under SOX Section 304, if an issuer is required to prepare an accounting restatement due to material noncompliance as the result of misconduct with any
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financial reporting requirements, the chief executive officer (CEO) and chief financial officer (CFO) must reimburse the company for any incentive or equity-based compensation received during the twelve-month period following the first public issuance of the misleading financial documents. In addition, they must reimburse the issuer for profits realized from the sale of its securities during that twelve-month period.
The Appendix attached hereto contains a table summarizing the differences among these laws.
Under the authority granted to it in Section 304, SEC has settled several cases against
CEOs and CFOs of companies allegedly required to restate financial statements because of misconduct and is proceeding with similar actions against others:

Securities and Exchange Commission v. William W. McGuire, M.D.
, Press Rel.
2007—255 (Dec. 6, 2007)—first settlement under Section 304; reimbursement of $461 million;

Securities and Exchange Commission v. Michael J. Byrd , Litigation Release 21412
(Feb. 12, 2010)—disgorgement plus prejudgment interest, totaling $249,843.

Securities and Exchange Commission v. Brad A. Morrice, Patti M. Dodge et al.
,
Litigation Release 21609 (July 30, 2010)—former CEO Morrice: disgorgement of
$464,354 with $76,991 in prejudgment interest thereon; former CFO Dodge: disgorgement of $379,808 with $70,192 in prejudgment interest thereon,

Securities and Exchange Commission v. Douglas Bartek and Nancy Richardson ,
Case No. 3:08cv1105-B (N.D. Tex., filed June 30, 2008).
There have been some judicial and administrative actions involving issues arising under
Section 304:

Does the CEO or the CFO have to be involved in the misconduct? On June 9,
2010, the United States District Court for the District of Arizona denied the defendant’s motion to dismiss in an action brought by SEC to compel reimbursement by the CFO of bonuses and other compensation. SEC did not allege that the CFO personally was aware of the fraudulent concealment of accounts receivable, but the CFO did certify the company’s financial statements. The court held that Section 304 requires only the
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misconduct of the issuer; it does not necessarily require the specific misconduct of the issuer’s CEO or CFO.
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
May the issuer indemnify the CEO and CFO for Section 304 liability? In the first case considering this issue, the Second Circuit, on September 30, 2010, held that it may not.
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The factual background of this case is instructive. On August 24, 2005, the
National Institute of Justice of the U.S. Department of Justice (DOJ) reported that bullet-resistant body armor models containing the fiber Zylon
® were non-compliant with its requirements. Shortly thereafter, DHB Industries, now known as Point Blank
Solutions Inc. (referred to herein as DHB), a manufacturer and distributor of body armor, announced that it was discontinuing use of Zylon
®
in its products. Its market capitalization dropped 24%. The following month, various class and derivative actions were filed on behalf of persons who purchased DHB shares, alleging that senior officers were aware of flaws in the company’s products but caused or allowed DHB to make false public statements affirming the strong condition of the company and anticipated increased revenue. In addition, the complaints alleged insider trading of more than $200 million of stock when the stock price was allegedly artificially high.
That same month, DHB withdrew its interim and annual financial statements for the years ending December 31, 2003, and 2004. On December 15, 2006, the parties filed
Stipulations of Settlement for both the class and the derivative actions, which provided that DHB would indemnify former CEO David Brooks and former CFO Dawn Schlegel against any liability under Section 304. In September 2007, a committee of DHB shareholders raised various exceptions to the settlement. On October 25, 2007, SEC filed securities fraud charges against Brooks, seeking reimbursement under Section
304 by Brooks to the company of bonuses and profit from stock sales. DOJ also filed a superseding criminal indictment against him for securities fraud, conspiracy to commit securities fraud, insider trading, obstructing SEC’s investigation, and conspiracy to commit tax fraud.
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The Settlement Hearing on the class and derivative actions was held on June 25, 2008. The U.S. Attorney General objected to the Section 304 indemnification, arguing that it would undermine SEC’s ability to pursue its civil actions against Brooks and Schlegel and was contrary to public policy. The district court rejected that argument and on July 8, 2008, entered final judgment approving the
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Settlement. The objecting shareholders filed an appeal with the Second Circuit. In an amicus brief, SEC argued that the indemnification provision would take from the company all of the Section 304 award in SEC’s civil action and return it to Brooks.
SEC referred to this as a “get out of Section 304 free” card for Brooks. DHB filed a voluntary petition for Chapter 11 reorganization on April 4, 2010, which filing delayed resolution of the appeal. On September 30, 2010, the Second Circuit agreed with the
SEC’s arguments and objecting shareholders, vacated the district court judgment, and remanded the case to the district court:
. . . [O]nly the SEC has authority to enforce § 304 and to ‘exempt’ CEOs and
CFOs from liability under § 304. The Settlement’s release and indemnification provisions attempt an end-run around § 304 that vitiates the SEC’s role and is inconsistent with the law. If allowed to stand, it would effectively bar the relief the
SEC is authorized to seek.
[Internal citations omitted.]

Must SEC prove that the issuer was “required to prepare an accounting restatement”? In July 2007, SEC filed a complaint against the CEO and CFO of
Engineered Support Systems Inc., alleging that the company issued back-dated stock options to officers, key employees, and non-employee directors and seeking various types of relief, including repayment of bonuses and other incentive- or equity-based compensation, and profits realized from the sale of securities. In the action, SEC sought an injunction against violation of the securities laws, disgorgement of all illgotten compensation, plus pre-judgment interest, civil monetary penalties, an order barring former CEO Michael Shanahan from serving as an officer or director of any public company, and repayment of bonuses or other incentive-based or equity-based compensation and profits realized from the sale of the company’s securities. The CEO moved for partial summary judgment, contending that the complaint did not state a claim under Section 304 because the company never restated its financial statements.
In a case of first impression, the court held that “the ordinary, contemporary, common meaning of Section 304 is that, before penalties may be imposed, an issuer must be compelled or ordered to prepare a financial restatement, and must actually file the restatement.”
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
May shareholders enforce the company’s right to recovery under Section 304?
It is now settled that only SEC can enforce Section 304. Most courts have expressed this conclusion, as “Section 304 does not explicitly create a private remedy.”
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One court held that the shareholder-plaintiff did not have standing, “Because [plaintiff
Stichting Pensionenfonda ABP (ABP)] is not entitled to the relief authorized by
[Section 304 of SOX], I conclude that ABP does not have standing to assert a claim against [former CFO] Szeliga.”
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Conclusion
The judicial and administrative history of executive compensation clawbacks under
TARP and SOX should serve as a lesson to senior executives of listed companies.
They are personally at risk if the issuer does not comply with financial reporting requirements.
1
Pub. L. No. 111-203, 124 Stat. 1376 (2010).
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12 U.S.C. 5021 et seq.
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Pub. L. No. 107-204, 116 Stat. 746.
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On July 23, 2010, the special master reported that, for a variety of reasons, he did not determine that
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6 such payments were contrary to the public interest.
SEC v. Jenkins , D. Ariz., No. 2:09-cv-1510-GMS, June 9, 2010.
Cohen v. Viray , 08-3860-cv, slip op. (2 nd
Cir. Sep. 30, 2010).
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On September 14, 2010 Brooks was convicted of seventeen counts.
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Securities and Exchange Commission v. Michael F. Shanahan, Sr.
et al ., 624 F. Supp. 2d 1072 (E.D.
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Miss. 2008).
Kogan v. Robinson et al.
, 432 F. Supp. 2d 1075 (S.D. Cal. 2005). Also, see In re Brocade
Communications Systems, Inc. Derivative Litigation , 615 F. Supp. 2d 1018 (N.D. Cal. 2009), In re
Digimarc Corporation Derivative Litigation , No. 06-35838 (9 th
Cir. 2008), Pedroli ex rel. Microtune, Inc. v.
Bartek et al ., 564 F. Supp. 2d (E.D. Tex. 2008), In re iBasis, Inc. Derivative Litigation , 532 F. Supp. 2d
214 (D. Mass. 2007), In re Bisys Group Inc. Derivative Litigation , 396 F. Supp. 2d 463 (S.D. N.Y. 2005).
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In re Qwest Communications International, Inc. Securities Litigation , No. 04-cv-00238-REB-CBS (D.
Col. 2005).
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Clawback of Executive Compensation Under Financial Reform Laws © 2010 is published by the
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Listing on national securities exchange or association.
Receipt of TARP funding.
Receipt of TARP funding.
Receipt of inaccurately calculated incentive-based compensation from publicly held company.
No No Yes, must be instituted and implemented.
Yes, must be adopted, implemented, and disclosed.
Material noncompliance with any financial reporting requirements.
Materially inaccurate financial statements or any other materially
Materially inaccurate financial statements or any other materially inaccurate performance metric
Material noncompliance, as the result of misconduct, with any financial reporting

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Any current or former executive officer of a company whose stock is listed on a national securities exchange or association.
Three-year period preceding the date on which the issuer is required to prepare restatement.
Excess over amount that would have been paid absent material inaccuracies. inaccurate performance metric criteria.
Top five most highly paid executives and the next twenty most highly compensated employees of each TARP recipient.
Period during which any obligation arising from financial assistance under the TARP remains outstanding.
Entire bonus, retention award or incentive compensation paid. criteria. requirement.
CEO, CFO, and other top three highly paid executives of each
TARP recipient.
Period during which
Treasury holds a position in the company.
Entire bonus or incentive compensation paid.
CEO and CFO of public company.
Twelve-month period following first public issuance of misleading financial documents.
Entire incentive or equity-based compensation paid and profits realized from sale of securities.