SOX Clawback Provision Takes Another Bite

| Graeme W. Bush

Section 304 of the Sarbanes-Oxley Act of 2002 requires the CEO and CFO of an issuer that has restated its financial statements to reimburse the company for any incentive or equity-based compensation, and for the profits on any stock sales of the company’s stock, during the 12-month period following the first issuance of the offending financial statements.   Although this provision has been used sparingly by the SEC, the recent settlement of SEC investigatory charges by Saba Software, in which executives who were not charged with any wrongdoing agreed to repay bonuses and stock profits, is a cautionary tale for CEOs and CFOs of publicly traded companies.  

Saba Software became the subject of an SEC investigation and enforcement action arising out of an alleged scheme to overstate revenues by overbooking and pre-booking time statements of international consultants in order to meet pre-arranged time estimates.  As part of the settlement of the SEC charges in the fall of 2014, Saba was required to restate its financial records for the years 2009 through part of 2012.  In a contemporaneous settlement, Saba’s CEO agreed to reimburse the company for over $2.5 million in incentive and equity compensation and profits from stock sales earned following the issuance of the financial statements the company restated.

On February 10, 2015, the SEC announced that it had reached settlements with two former CFOs of Saba under which they would reimburse the company for over $500,000 in bonuses and profits from stock sales realized following the issuance of the false financial statements.  What is interesting in the settlements with the CFOs is that there is no indication that either had any involvement in or knowledge of the scheme that led to the overstatement of revenues.  The SEC has for some time taken the position that there is no requirement that the officers have culpability in order to trigger the reimbursement requirement of section 304.  In this settlement the SEC obtained reimbursement from a non-culpable officer.  The SEC has done this on previous occasions, but from time to time has not required repayment by a non-culpable CEO or CFO.  

Whether and in what circumstances this provision may come into play for CEOs and CFOs of public issuers is uncertain.  Section 304 does not create a private action by a shareholder to require repayment, and research has turned up no indication of a shareholder derivative action to force a company that has restated its financial statements to require reimbursement.  So whether repayment is demanded may be a function of whether the company affirmatively requires it, or whether the SEC has initiated an enforcement action that requires it.

There is, however, reason to expect that clawback actions will become more common.  Section 954 of the Dodd-Frank Act mandates that the SEC promulgate rules directing the national securities exchanges to require each company listed on an exchange to adopt procedures for the recovery of any amount of incentive-based compensation paid to any current or former executive that exceeds the amount that would have been paid under an accounting restatement in the three years prior to the restatement.  This provision is significantly broader than the clawback provision of Section 304 because it applies to all executives (not just the CEO and CFO), covers three years prior to the restatement (not simply 12 months), extends to all incentive-based compensation, and does not require that the restatement is a result of “misconduct.”  It is narrower in the sense that reimbursement is limited to the amount by which the executive was overcompensated as a result of the misstatement.   Although the rules contemplated by Dodd-Frank have yet to be promulgated, the SEC has expressed interest in moving the project forward and many companies have already adopted the procedures in advance of the anticipated rules. 

Interesting issues are presented by clawback liability and the prospect that clawback litigation may increase.  It may makes sense for companies and their executives to structure incentive compensation packages in ways that minimize reliance on reported financial statement metrics, and make clear exactly what performance metrics are relevant to each part of an incentive compensation plan. 

Listed companies and their executives may want to consider how indemnification provisions in company by-laws or certificates of incorporation would apply.  Will the company end up funding the executive’s litigation costs in any clawback action?   Will a non-culpable executive’s ultimate liability be indemnified under by-law provisions?  Companies and their executives may want to review the company’s D&O insurance policy to make sure that at least innocent executives who become subject to clawback liability are protected.  In the course of any such evaluation, one should keep in mind that the SEC has frequently made it a condition of settlements that fines, penalties and disgorgements may not be paid by insurance or under indemnification provisions. 

Finally, a departing executive may want to make sure that any potential exposure to clawback claims following departure is released, since Dodd-Frank requires issuers to pursue clawback claims against former executives. 

Information provided on InsightZS should not be considered legal advice and expressed views are those of the authors alone. Readers should seek specific legal guidance before acting in any particular circumstance.

As the regulatory and business environments in which our clients operate grow increasingly complex, we identify and offer perspectives on significant legal developments affecting businesses, organizations, and individuals. Each post aims to address timely issues and trends by evaluating impactful decisions, sharing observations of key enforcement changes, or distilling best practices drawn from experience. InsightZS also features personal interest pieces about the impact of our legal work in our communities and about associate life at Zuckerman Spaeder.

Information provided on InsightZS should not be considered legal advice and expressed views are those of the authors alone. Readers should seek specific legal guidance before acting in any particular circumstance.