Larry Ribstein —  23 June 2010

Dennis Berman, writing in yesterday’s WSJ, discussed the SEC’s case against Maynard Jenkins, former ceo of CSK, to return $4.1 million in stock option grants because accounting fraud, in which
Jenkins was not involved, allegedly inflated the returns the grants were based on.

This is the SEC’s first attempt to enforce SOX Section 304 against an innocent executive. That section provides for return of incentive-based compensation and profits from stock sales following accounting restatements resulting from “the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws.”

Berman notes that Jenkins is protesting that he

must pay (literally and figuratively) for [accounting] misconduct because he was literally the “captain of the ship,” despite the fact that under its own view of the evidence the crew was mutinous—deceiving him and secretly circumventing the ship’s controls.”

Also, an outside audit of the company “found that his bonus payments were tied to other financial goals—such as refinancing company debt—and had virtually no link to CSK’s earnings statements.” But the SEC argues that board members now say they wouldn’t have awarded Jenkins the compensation had they known that the company had a loss rather than the reported profit.

Berman rightly refers to this as a new frontier in SEC enforcement efforts. He notes that this case’s importance is increased by the fact that the current version of the financial reform bill has a three-year claw-back provision which does not require any misconduct at all. Specifically, Section 954 requires the SEC to order national securities exchanges and associations to prohibit the listing of a security whose issuer does not adopt the following rule:

(b)(2) [I]n the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentive-based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.

Both the SOX and financial reform clawback provisions are terribly misguided.

To be sure, firms may reasonably decide that clawback provisions in employment contracts make sense on a prospective basis, as argued here. A retrospective clawback provision like the one proposed in the wake of the AIG bonuses obviously cannot be justified on incentive grounds.

A mandatory provision that operates prospectively is at least better than one inserted ex post. But firms might rationally decide against including such provisions in employment agreements. While the accounting restatement might be said to have undercut the basis for the bonus, any incentive pay based on short-term financial results might similarly seem unfounded in the fullness of time. For example, a business strategy or product that seemed great at the time could misfire. Moreover, a clawback is essentially the same thing as holding the executive strictly liable for the restatement up to the amount of the executive’s incentive compensation. If strict liability is not warranted on incentive grounds, it is not clear why the fact of incentive compensation should make it so.

The real question concerns the appropriate allocation of the risk of accounting mistakes or fraud between the company and the executive. This is and should be left to firm-specific contracts. Firms might or might not decide to subject executives’ compensation to this risk to motivate them to monitor for misconduct. But even if the firm decides this is a good idea in general, it also needs to decide such questions as (1) which types of compensation should be subject to clawback; (2) whether the clawback should be triggered by any restatement, or only a restatement resulting from misconduct; and (3) whether the trigger be of a type that the executive might have been expected to guard against.

Indeed, contracts will continue to apply in this setting whatever the law says. If the law subjects “incentive-based” compensation to a potential penalty for bad accounting, the parties can always contract for non-incentive-based pay, or increase the non-incentive component of pay to reflect the risk. It is not clear how shareholders or society benefit from messing with incentive compensation in this way.

Finally, writing this provision into a federal law sets in stone a novel approach to disclosure penalties and executive pay despite the lack of a clear idea what its consequences will be. The need for flexibility and experimentation is a good reason for leaving compensation arrangements to contracts and the market for state law.

The clawback provision is just one little aspect of the mammoth federalization of corporate law. Watch this space for further updates as the morass of financial reform takes shape and effect.

Larry Ribstein


Professor of Law, University of Illinois College of Law