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The public markets are known to punish the stock prices of companies that announce the need to restate their past financial results. The stock price decline tends to morph into devastation when a financial restatement arises from executive fraud or misconduct. From a governance perspective, shareholder groups and boards of directors have been embracing a deterrent policy that could be called a “restatement clawback,” because it enables companies to claw back cash bonuses and stock awards from executives whose fraud or misconduct leads to a financial restatement. Within the past year, major companies such as Bristol-Myers Squibb Co., Citigroup Inc., Eastman Kodak Co., General Motors Corp., the Interpublic Group of Cos. and Monsanto Co. have established policies of this kind. The policies of Citigroup and General Motors are some of the most stringent in terms of the forms of compensation subject to the clawback and other punitive effects the clawback policy will have on executives subject to that policy, while the Monsanto policy is one of the most stringent in terms of the number of subject executives. In the marketplace, institutional investors are pressing mightily for restatement clawbacks. The U.S. Securities and Exchange Commission (SEC) has specifically identified them as an item requiring special proxy statement disclosure, and board members (and executive officers) are seeing that there simply is no reason not to put some form of this clawback into effect. Congress responded to the Enron scandal by passing the Sarbanes-Oxley Act of 2002, imposing stricter internal controls and more stringent accounting standards that prompted public companies to critically examine and disclose internal problems related to their financial statements. The year 2005 saw a record number of financial restatements. Greg Farrell, “Restatements of Earnings in 2005 to Break Records,” USA Today, Dec. 19, 2005. In 2006, a new scandal-involving the backdating or misdating of stock options-instigated another round of financial restatements. Whether a financial restatement arises voluntarily, in response to an SEC investigation or from another source, there is no assurance to shareholders that those who are responsible will be held accountable. At first blush, 304 of Sarbanes-Oxley appeared to offer a remedy, because its language provides for the recoupment of certain bonuses, or incentive-based or equity-based compensation, paid to either the chief executive officer (CEO) or chief financial officer (CFO) if a public company is required to restate its accounts due to a material noncompliance as a result of misconduct. The SEC has yet to pursue an action to enforce the provisions of 304, which in any case applies only to CEOs and CFOs and does not provide shareholders with a private cause of action. See, e.g., Kogan v. Robinson, 432 F. Supp. 2d 1075 (S.D. Calif. 2006); In re BISYS Group Inc. Derivative Action, 396 F. Supp. 2d 463 (S.D.N.Y. 2005); Neer v. Pelino, 389 F. Supp. 2d 648 (E.D. Pa. 2005). The absence of a specific statutory remedy has forced companies to consider self-help, which is entirely consistent with established principles of enterprise risk management. The governance principle known as enterprise risk management directs policy-makers to identify and address the greatest risks to the company’s overall value; attempt to contain the risks within acceptable levels; design methods to deter their occurrence; and provide reasonable assurances to corporate investors regarding the company’s achievement of its financial objectives. When these principles are applied to the risk that executive fraud or misconduct will prompt a financial restatement, there is no doubting the appeal of a carefully focused deterrent. The adoption of some form of restatement clawback policy is practically a no-brainer, because there is simply no defending the retention of bonuses or stock awards by executives whose fraud or misconduct causes a financial restatement. Forms of clawback The designing of a restatement clawback generally begins with a company’s board of directors or compensation committee considering the terms of a general policy implemented through subsequent award agreements. The board of directors or compensation committee should consider which events should trigger the restatement clawback; which employees or executives will be subject to the clawback; what forms of compensation are vulnerable to being clawed back; and whether the clawback will extend to past awards or be limited to future ones. It is critical for directors to consider the enforceability of any restatement clawback in the company’s operating jurisdictions, as well as other disclosure and reporting requirements that may result from its implementation. (See below for a discussion regarding SEC disclosure considerations.) Similar to the triggering mechanisms set forth in 304 of Sarbanes-Oxley, many of the newly proposed or implemented clawback policies are triggered by the fraud and/or misconduct of the executives subject to the policy. The clawback policies mentioned above do not define either term. This places a premium on careful documentation and decision-making (e.g., award agreements may include definitions of such terms or require deference to company decisions). That is because in litigation, courts will generally apply principles of good faith and fair dealing, interpreting the terms “fraud” and “misconduct” in ordinarily understood ways (absent special definitions). Although 304 limits the application of its forfeiture provisions to required restatements, restatements may arise voluntarily out of settlement negotiations with the SEC. As a result, it makes sense for clawback policies to maintain the flexibility to be triggered any time a company restates its financials, regardless of whether such restatement was voluntary or required. Another important consideration is determining which of the company’s executives will be subject to the policy. As noted above, while � 304 limits its application to a public company’s CEO and CFO, companies may give their restatement clawbacks broader reach. For instance, it would seem sensible to design a clawback to encompass those individuals who are charged (either by statute or corporate practice) with ensuring the accuracy of the company’s financial statements and who receive incentive compensation based on the information included in such financial statements. Many companies are considering more deeply drawn policies-on the premise that anyone whose fraud or misconduct could conceivably trigger a financial restatement should be at risk of a clawback. Existing examples of restatement clawback policies demonstrate that public companies tend to rely on their boards of directors to make all relevant determinations pertaining to clawbacks. This reflects the gravity of a financial restatement and the desire to have a full board determine who should be subject to the clawback policy. Nevertheless, a delegation of clawback responsibilities to a board’s compensation committee may be appropriate and justifiable, based on the established governance principles of both the New York Stock Exchange and Nasdaq. These principles recognize that the compensation committee’s purpose is “to discharge the board’s responsibilities relating to compensation of the company’s executives.” Report of New York Stock Exchange Corporate Accountability and Listing Standards Committee (June 6, 2002). Additionally, a company’s compensation committee could reasonably delegate clawback responsibilities relating to nonexecutive employees to one or more executives. Whether a board or compensation committee delegates its authority to claw back executive compensation, the establishment of a process for claim procedures could secure greater judicial deference to any effort to do so. For instance, a company may secure a highly deferential standard of judicial review for company decisions by having the executive expressly agree to such review either in a contract or pursuant to a plan provision. Enforcing clawback agreements The introduction of a clawback policy tied to financial restatements should be enforceable when limited to future stock awards, cash bonuses or both. In fact, there is widespread precedent for the enforcement of the clawback (also called “recovery,” “recapture,” “recoupment,” “disgorgement” or “forfeiture”) of stock-based awards in the event that an award recipient violates a loyalty-related covenant, such as a nonsolicitation, confidentiality or noncompetition agreement. In any instance, the issue becomes a matter of contract: Has the company documented its reservation of rights fairly? Has the executive consented knowingly and voluntarily? Is the clawback policy conscionable? Additionally, companies should include language in the relevant award agreement or contract providing that if the clawback is deemed unenforceable, then the award agreement or contract granting such award, bonus or other incentive or equity-based compensation is unenforceable due to failure of consideration. Regardless, in any dispute concerning actual enforcement of a clawback policy, a company would have to prove the requisite triggering mechanism required to sustain the clawback (i.e., fraud or misconduct leading to a restatement), subject to possible deferential review, as discussed above. When the clawback policy merely applies to future cash bonuses or stock awards, a company generally may impose it unilaterally-as a condition for the award. These clawbacks generally are the least objectionable to implement, because those affected must either accept the clawback risk or lose the award. The calculus for a restatement clawback policy gets more complex when companies seek to apply the clawback to past periods, through extending an executive’s clawback risk to cash bonuses and stock awards that were made or that vested during a past period. Any effort to introduce a retroactive clawback is almost certain to require the informed, written consent of the executive who is placing past compensation at risk. This should be feasible, by requiring the executive’s consent to such retroactive application as a condition for receipt of future incentive compensation. It would seem impolitic for an executive to refuse new awards in order to avoid having a restatement clawback apply to past awards. Nevertheless, some executives may consider this approach to be a form of employer hardball. Overall, any clawback program with a retroactive reach should be carefully designed and communicated, to assure that executives find it sufficiently fair and appropriate to garner their consent. The SEC’s role The SEC issued final rules last summer overhauling the disclosure requirements for executive compensation and related-person transactions. See Executive Compensation and Related Person Disclosure, Securities and Exchange Commission release nos. 33-8732A, 34-54302A and IC-27444A (Aug. 29, 2006). Conspicuously singled out for disclosure in those rules are the types of clawback policies described above. Because of the SEC’s newly released disclosure requirement and the inherent appeal of clawback policies tied to financial restatements, corporate directors and institutional investors are likely to further push public companies to implement such policies, causing such policies to become commonplace. There is no doubting the corporate disaster that comes from financial restatements, nor the sensibleness of discouraging any executive fraud or misconduct that could give rise to them. Boards of directors consequently should be adopting policies by which to claw back bonuses and incentive- and equity-based compensation when executive fraud or misconduct causes financial restatements. Companies uncertain about how to design a restatement clawback policy should consider establishing a basic policy now, and refining it over time as needed. The failure to take any action in early 2007 most likely will lead to fiduciary regret-and to possible recriminations, because the SEC’s new disclosure requirements will highlight the absence of such action. Those regrets and recriminations will certainly be heightened if the absence of a restatement clawback policy permits executives to retain incentive awards despite their own fraud or misconduct causing a financial restatement. J. Mark Poerio is an employment partner in the Washington office of Paul, Hastings, Janofsky & Walker. He is co-chairman of the global benefits practice group, which focuses extensively on executive compensation and employee benefits. Crescent A. Moran is an associate in the firm’s employment department in Washington. They can be reached, respectively, at [email protected] and [email protected]. Patrick W. Shea, a partner at the firm, contributed to the article.

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