August 10, 2009
Clawbacks, outrage, and interpretation
Posted by Usha Rodrigues

I read a WSJ op-ed last week, and it's still bothering me.  The SEC vs. CEO Pay bubbles with outrage from its opening sentence: "A lawsuit filed on July 22 by the Securities and Exchange Commission (SEC) should send a mid-summer chill down the spine of every chief executive and chief financial officer of a U.S. public company."

What's amiss in corporate America, you ask?  Well, the problem is a change in the SEC's enforcement of Sarbanes-Oxley Section 304, the clawback provision.  Section 304 provides that if a company issues an accounting restatement "as a result of misconduct", and the CEO or CFO received bonuses or made money on stock sales based on numbers that were later proved to be inflated (thus necessitating the restatement), then those bonuses or stock sales could be "clawed back," i.e., paid back to the company.

Until recently the SEC only went after CEOs that perpetuated or were aware of the "misconduct" under 304, but a few weeks ago the agency sued a CEO without alleging that he himself engaged in the fraud.  Russell Ryan, author of the op-ed, is outraged, asserting that the SEC has "stretched the law".  But elsewhere he acknowledges that

in its haste to “do something” about the scandal of the day, Congress muddied the question of whether the “misconduct” required for such a clawback had to be committed by the executive himself (or at least known to him), or could be that of a subordinate, completely unbeknownst to the executive. 

Because of these "muddy waters," it wasn't entirely clear what 304 meant, and "[m]any executives and legal advisers have cautiously assumed that bonuses and stock proceeds were at risk only for executives who actually engaged in misconduct themselves—or at least were aware of it and acquiesced."  An all-too-familiar story these days: hasty legislation that leaves executives walking on eggshells, unsure of exactly what the law requires.

Ryan concludes: "On a visceral level, it seems shocking that a U.S. law enforcement agency could take more than $4 million from any citizen without so much as an accusation of personal misconduct, or at least knowing acquiescence in someone else’s misconduct." 

Are my viscera out of step with everyone else's?  I'm just not all that fussed.  I mean you could interpret SOX 304 to say to executives, "If you get a bonus because you meet a goal, and it later turns out that the goal wasn't really met because someone messed with the numbers, then you need to give the money back.  Even if you didn't do anything wrong, you didn't really earn that money."  As I read them, this is how the newer vintage TARP clawback provisions work: financial institutions can recover any bonus or incentive compensation paid to senior executives based on statements of earnings or gains later proven to be materially inaccurate--no misconduct needed.

What's troubling to me is that the SEC suddenly changed its interpretation.  After 5 years, expectations become settled, and changing course seems arbitrary.  This point underlines the amount of discretion the agency has over enforcement, which might be the biggest lesson to come out of my recent work with Mike Stegemoller: there's the law on the books and then there's the law as enforced.  But Ryan seems to me to be barking up the wrong tree by attacking the SEC's interpretation of 304.  Or is my gut wrong?

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