"Clawbacks" of Executive Compensation

from Gibson Dunn & Crutcher LLP

Following
the Enron- and WorldCom-era corporate scandals and enactment of the
Sarbanes-Oxley Act of 2002, attention increased on the extent to which
companies had the ability to recoup -- or "clawback" -- incentive
compensation awarded to senior executives if it was later determined
that their activities significantly contributed to a financial
statement restatement, which resulted in a determination that the
executives had received unearned incentive compensation as a direct
result of their own misconduct.

The Sarbanes-Oxley Act of 2002
includes a clawback provision, Section 304, which generally requires
public company chief executive officers (CEOs) and chief financial
officers (CFOs) to disgorge bonuses, other incentive- or equity-based
compensation, and profits on sales of company stock that they receive
within the 12-month period following the public release of financial
information if there is a restatement because of material
noncompliance, due to misconduct, with financial reporting requirements
under the federal securities laws. However, Section 304 has a number of
limitations. Specifically:

* it governs recoupment of compensation paid only to the CEO and CFO and does not extend to other senior officers;


*
it does not define "misconduct," creating an ambiguity about whether
the CEO or CFO had to have participated in the misconduct in order to
be subject to liability, and it does not otherwise specify whose
misconduct is sufficient to trigger recoupment; and


* to
date, courts have held that Section 304 is enforceable only by the SEC
and does not provide private plaintiffs (such as a company or its
shareholders) standing to bring a claim against a CEO or CFO.[1]

In
December 2007, the SEC reached its first settlement with an individual
under Section 304. In a settled enforcement action, the former Chairman
and CEO of UnitedHealth Group Inc. agreed to reimburse the company for
all incentive- and equity-based compensation that he received from 2003
through 2006, totaling approximately $448 million in cash bonuses,
profits from the exercise and sale of UnitedHealth stock, and
unexercised options.[2]

Clawback provisions can be implemented
in a number of ways: through policies, compensation plans, award
agreements and employment agreements. Some of these approaches provide
a contractual basis for enforcing the provisions, while others do not.
In the absence of a contractual right, there nevertheless is some
ability to pursue
recoupment of unjustly paid compensation through
state-law claims, as shown by the 2006 Alabama Supreme Court ruling
that former HealthSouth Corporation CEO Richard Scrushy was obligated
to repay $47.8 million in bonuses that he received improperly.[3]

Company and Shareholder Initiatives
There
is no requirement under the Sarbanes-Oxley Act, other SEC rules or
securities market listing standards that companies take steps to
provide for the clawback of executive compensation. However, the SEC's
executive compensation disclosure rules adopted in 2006 provide that it
may be appropriate for the Compensation Discussion & Analysis in a
company's proxy statement to discuss any company "policies and
decisions regarding the adjustment or recovery of awards or payments if
the
relevant registrant performance measures upon which they are
based are restated or otherwise adjusted in a manner that would reduce
the size of an award or payment."[4]

In the wake of the SEC's
rule changes, there is now more information available about which
companies have adopted clawback provisions and the substance of these
provisions. A fall 2007 survey by Equilar, Inc. indicates that among
Fortune 100 companies, the prevalence of disclosed clawback policies
increased from 17.6% in 2005 to 42.1% in 2006. A survey of
approximately 2,100 companies released in June 2008 by The Corporate
Library found that 300 companies had clawback provisions, compared to
only 14 companies that had disclosed the existence of these provisions
four years ago. As of March 2008, 28 of the Dow 30 companies had
implemented clawback provisions, including 23 companies that had
adopted formal clawback policies aimed at recouping the incentive
compensation paid or granted to executive officers and certain other
employees. These policies most often provide for recoupment in the
event of a restatement or a significant/material restatement of
financial results due to misconduct on the part of the executive
officer or other employee. The remaining five companies had incentive
compensation plans that contain clawback provisions.

Clawback
provisions also have been a focus of shareholder proposals in recent
years. Between January 2004 and June 2008, shareholders submitted a
total of 32 proposals requesting that companies adopt clawback
provisions, including six proposals submitted for the 2008 proxy
season. The 32 shareholder proposals were submitted to 22 different
companies, with some companies receiving the proposal in more than one
year. Of these 22 companies, nine previously had restated their
financial results in the one to five years before receiving the
proposal. The popularity of clawback shareholder proposals peaked in
2006 and 2007, when shareholders submitted ten and 11 proposals,
respectively. In 2008, the proposals have averaged 10.7% of votes cast
at five meetings, according to preliminary results compiled by
RiskMetrics Group, Inc./ISS Governance Services (ISS), compared to 23.7% of votes cast in 2006 and 28.4% of votes cast in 2007.

Some
companies have taken steps to address clawbacks in response to a
shareholder proposal, and some have done so as a general governance
reform or following a high-profile restatement of financial results.
Other companies have argued in response to shareholder proposals that
formal clawback policies unnecessarily restrict a board's discretion to
determine how best to respond to accounting improprieties.

A
number of companies have sought to exclude clawback shareholder
proposals from their proxy statements by pointing to existing clawback
provisions and arguing that these provisions "substantially
implemented" a shareholder proposal under Rule 14a-8(i)(10). The SEC
staff generally has taken a narrow view of the actions that are
sufficient to "substantially implement" a clawback proposal and has
permitted companies to exclude a proposal only in circumstances where
the form and substance of a company's clawback provisions correspond
closely to those sought in the proposal.[5] ISS takes a case-by-case
approach in formulating voting recommendations on shareholder proposals
seeking the adoption of clawback policies. It considers whether a
company has adopted a "formal" clawback policy, and whether there is an
absence of chronic restatement history or material financial problems.
In applying these criteria, ISS generally has been supportive of
companies that adopt clawback policies, and has recommended votes
"against" shareholder proposals at these companies, as long as the
clawback policies do not afford too much discretion to the board. As an
example, during the 2008 proxy season, the SEC staff took the position
that Exxon Mobil Corp.[6] could not omit a clawback shareholder
proposal as substantially implemented, but ISS recommended votes
"against" the proposal.

Issues for Companies to Consider in Addressing Clawbacks
There
are a number of issues for boards to consider with respect to
clawbacks. The primary question is whether to address clawbacks in the
first place. Doing so sends a message to shareholders that the board is
committed to sound executive compensation practices and effective
corporate governance, and voluntary implementation of clawback
provisions will reduce the likelihood that a company will receive a
shareholder proposal. On the other hand, companies need to consider
whether the adoption of a clawback will adversely affect their ability
to attract and retain executives.

Once a board decides to
adopt a clawback provision, there are a number of issues that need to
be addressed in formulating the provision.

1. To whom should the clawback provisions apply?

Clawback
provisions can cover the CEO and CFO, or they can apply more broadly to
all executive officers or even all employees. Covering the CEO and CFO
is consistent with the approach taken in Section 304 of the
Sarbanes-Oxley Act. However, a clawback provision that is limited in
this respect does not reach other executive officers whose compensation
may be performance-based or whose job functions may impact a company's
financial reporting. Proxy voting advisors ISS and Glass, Lewis &
Co.
generally favor clawback shareholder proposals covering
executive officers and recommend that shareholders vote "for" proposals
seeking recoupment both from senior executives and from employees who
are potentially responsible for accounting improprieties.

2. To which awards should clawback provisions apply?

Base
salary is not generally linked to specific performance targets and,
therefore, is not typically covered by clawback provisions. With
respect to performance-based awards, the single most popular approach
that companies have taken is to adopt clawback provisions that include
all performance-based awards, both short-term (i.e., with a performance
period of one year or less) and long-term (i.e., with a performance
period of more than one year, and typically two to four years).
Covering only long-term incentives may be viewed as too narrow to serve
as a deterrent for misconduct if executives are continuing to receive
short-term incentives (usually in the form of annual cash bonuses)
based on specific performance targets that were not actually achieved.
Consistent with Section 304 of the Sarbanes-Oxley Act, some companies
also have adopted provisions that apply to the recoupment of gains
derived from selling stock when the price of the stock was affected by
improper accounting, although these provisions are relatively rare.

3. What circumstances should trigger clawback provisions?

Companies
with clawback provisions take a variety of approaches to the standards
for determining the circumstances that trigger these provisions.
Clawback provisions can apply in the event of a "significant" or
"material" restatement, in the event of all restatements (other than
those due to changes in accounting policy) or in the event that
financial data turns out to be incorrect. Many companies have limited
the application of their clawback provisions to "significant" or
"material" restatements. It should be noted, however, that under
applicable accounting standards, a materiality standard applies when a
company determines whether accounting errors require a restatement of
financial statements. A clawback provision that applies in the event of
all restatements, other than those due to changes in accounting policy,
addresses the argument that it is unfair to shareholders if executives
are permitted to retain incentive compensation based upon performance
targets that were not actually achieved. However, such a provision also
would apply in circumstances where a restatement is required due to an
error that was not the result  of fraud or misconduct or where a
restatement does not result in a significant change to a company's
overall financial results. For this reason, such a provision may impact
a company's ability to attract or retain executives. Finally, a
"no-fault" clawback provision would require recoupment following a
determination that the prior achievement of performance goals was based
on incorrect data. Like clawback provisions triggered by any
restatement, a "no-fault" provision addresses the argument about the
unfairness to shareholders that results from allowing executives to
keep compensation awarded on the basis of performance targets that were
not actually met. However, a "no-fault" provision would require
recoupment in circumstances where incorrect data result from an
innocent mistake, not fraud or misconduct or where applicable
accounting standards would not require a restatement of financial
statements. Accordingly, this type of provision could have negative
ramifications for a company's ability to attract and retain executives.


4. To what type of conduct should the clawback provisions apply?

Related
to the issue of when clawback provisions should apply (question 3
above) is the type of conduct that triggers application of the
provisions. Alternatives include requiring recoupment in the event of
misconduct by the executive officer from whom recoupment is sought, in
the event of misconduct by any employee, or in the event of any conduct
that results in incorrect financial data. Limiting clawback provisions
to misconduct by the individual executive officers from whom a company
seeks recoupment is the most common alternative and provides a targeted
approach that incorporates a deterrent effect. Broader provisions that
rely on misconduct by any employee could be viewed as consistent with
the oversight function performed by senior executives. Finally, a
"no-fault" clawback provision would not require any misconduct;
instead, it would mandate recoupment simply upon a restatement of
financial statements or the discovery of incorrect financial data. As
discussed above, a "no-fault" provision addresses the argument about
the unfairness to shareholders that results from allowing executives to
keep compensation awarded on the basis of performance targets that were
not actually achieved. However, a clawback provision with no reference
to misconduct would apply in circumstances where the incorrect data
resulted from an innocent mistake, and thus may impact a company's
ability to attract and retain executive officers.

5. Should the clawback provisions grant discretion to the board?

Clawback
provisions may grant discretion to the board of directors to determine
whether misconduct occurred and whether to recoup compensation.
Provisions that grant discretion to the board offer the advantage of
flexibility because the board can decide whether, and to what extent,
recoupment is appropriate based on the specific facts and circumstances
involved. However, if the board has too much discretion, the SEC staff
is unlikely to concur that a company may exclude a clawback shareholder
proposal on "substantial implementation" grounds. In addition, ISS may
recommend a vote in favor of a clawback shareholder proposal where a
company's clawback provisions grant what ISS views as too much
discretion to the board.

6. To what extent should the clawback provisions modify employment agreements, compensation plans and award agreements?

Companies
that intend to adopt clawback provisions can do so by adopting a
clawback policy. However, the adoption of a policy, without more, may
raise questions as to the policy's enforceability and could lead to
criticism for failing to implement the provisions fully. Accordingly,
companies should consider the additional step of amending existing
employment agreements, compensation plans and/or award agreements to
include specific reference to clawback provisions, either by adding
language that provides for recoupment in specified circumstances or by
incorporating an external clawback policy by reference. Unlike with a
stand-alone clawback policy, this would provide a contractual basis for
enforcing the clawback provisions. In cases where a company enters into
individual award agreements pursuant to an incentive compensation plan,
clawback provisions can be implemented by amending or revising the form
of award agreement used for executives covered by the provisions;
changing
the plan itself may not be necessary. As a legal matter, it may not be
possible to apply clawback provisions retroactively to outstanding or
previously paid awards without the consent of the covered executives.
Retroactive application may contravene existing employment agreements
and award agreements, which generally contain language prohibiting
changes that are adverse to an executive without the executive's
consent. These provisions also may not be enforceable because the
executive is not receiving any reciprocal rights or benefits. In
addition, retroactive implementation may have a negative effect on
employee morale.

7. How far back should the clawback provisions reach?

Section
304 of the Sarbanes-Oxley Act provides for recoupment of compensation
received within the 12-month period following the public release of
financial information that subsequently has to be restated. Consistent
with this, some companies have adopted clawback provisions that reach
back 12 months prior to the filing of restated financial results.
However, more companies have adopted provisions that reach back for
longer periods. In some cases, the relevant period covers 36 months,
representing the period of time for which companies must include
financial statements in their SEC filings, while other companies'
provisions reach back for longer periods, such as five years, or
correspond to the length of performance cycles (often three years)
under compensation plans. Another, less common approach is for the
policy to have unlimited reach, although executives are likely to view
this as inequitable and it may impact the company's ability to attract
and retain executives.

_____________________

[1] See,
e.g., Neer v. Pelino, 389 F. Supp.2d 648 (E.D. Pa. 2005), In re BISYS
Group Inc., 396 F. Supp. 2d 463 (S.D.N.Y. 2005), Kogan v. Robinson, 432
F. Supp. 2d 1075 (S.D. Calif. 2006).

[2] See Securities and Exchange Commission v. William W. McGuire, M.D., Litigation Release No. 20387 (Dec. 6, 2007).

[3] See Scrushy v. Tucker, 955 So. 2d 988 (Ala. 2006) (involving state law claim for unjust enrichment).

[4] See Item 402(b)(2)(viii) of Regulation S-K.

[5] See, e.g., Exxon Mobil Corp. (avail. Mar. 24, 2008, recon. denied).

[6] See id.

About Gibson Dunn & Crutcher LLP
Gibson, Dunn & Crutcher's Securities Regulation and Corporate Governance Practice Group and its Executive Compensation and Employee Benefits Practice Group are available to assist in addressing any questions you may have regarding these issues.

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