Executive Compensation

by Joseph E. Bachelder

This article is reprinted with permission from the
May 27, 2011
edition of the
New York Law Journal.
© 2011 NLP IP Company.

Clawbacks Under Dodd-Frank and Other Federal Statutes

As used in this column, "clawback" means a repayment of previously received compensation required to be made by an executive to his or her employer. Three federal statutes that provide for clawbacks are discussed in today's column. They are:

1. Sarbanes-Oxley Act of 2002 (SOA) §304; 15 U.S.C. §7243(a);

2. Emergency Economic Stabilization Act of 2008 (EESA) §111(b)(3)(B), as added by Section 7001 of the American Recovery and Reinvestment Act of 2009 (ARRA); 12 U.S.C. §5221(b)(3)(B) (applicable only to recipients of assistance under the Troubled Asset Relief Program (TARP) that have not repaid the Treasury); and

3. Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) §954, 15 U.S.C. §78j-4(b).

A summary comparison of the three statutory clawback rules is provided in the chart below.

A Summary of "Clawbacks" Under Three Federal Statutes1
  Sarbanes-Oxley Act §304 Emergency Economic Stabilization Act §111(b)(3)(B) Dodd-Frank Act §954
1. Trigger Event "[M]isconduct" resulting in required restatement of any financial reporting required under securities laws "[S]tatements of earnings, revenues, gains, or other criteria … found to be materially inaccurate." Accounting restatement due to material noncompliance with reporting requirements under securities laws
2. Executives Covered CEO and CFO only "[A] senior executive officer and any of the next 20 most highly compensated employees"2 "Executive officers"3
3. Compensation Clawed Back:      
(a) Type Bonus or other incentive-based or equity-based compensation; in addition to compensation clawback, recovery of profits of certain sales of securities is required4 "[B]onus, retention award, or incentive compensation" Incentive-based compensation (including stock options) in excess of what would have been paid under the accounting restatement
(b) Period Covered "[T]he 12-month period following the first public issuance or filing with the [SEC] (whichever occurs first) of the financial document" giving rise to the required restatement No reference to time period Three-year period preceding the date the company is required to prepare the accounting restatement

1. Because the chart provides only summary descriptions of statutory provisions, readers should check any terms summarized against the language of the respective statutes and regulations under them (including forthcoming regulations under DFA §954).

2. "Senior executive officer" is defined in EESA §111(a)(1) as "1 of the top 5 most highly paid executives of a public company, whose compensation is required to be disclosed pursuant to the Securities Exchange Act of 1934…and nonpublic company counterparts."

3. "Executive officer" presumably means as defined in Rule 3b-7 under the Securities Exchange Act of 1934. DFA §954 explicitly covers "any current or former executive officer." Unlike DFA §954, neither SOA §304 nor EESA §111(b)(3)(B) states specifically that it applies to "former" executives. Presumably, each of the SOA and DFA provisions would apply to someone who was employed in the applicable category at the time of the misstatement whether or not that executive ceased to be employed at the time of the applicable payment (that is, the payment subject to clawback).

4. Under SOA, in addition to clawback of compensation, recovery is required of "any profits realized from the sale of securities of the issuer" during the same 12-month period. While not a "clawback" of compensation, the effect, like a clawback, is to require the executive to pay over to the employer amounts that he or she had realized (and paid tax on).

After discussing the statutory clawbacks, the column will discuss corporate clawback policies and practices that exist without regard to the provisions of these three federal acts. Finally, note is made of tax differences between clawbacks and the forfeiture of "holdbacks." (For purposes of today's column, "holdback" refers to compensation that requires one or more conditions to be met before it is paid out.)

Sarbanes-Oxley Act §304

Section 304 of SOA was enacted as part of legislation intended to provide higher standards and better processes in the overseeing of financial reporting by public companies. This legislation resulted from corporate scandals that came about, in part, because of lax management of financial reporting by public companies.

Clawbacks under SOA §304 are limited to clawbacks from the CEO and the CFO and apply only to cases in which there is "misconduct" resulting in "material noncompliance of the issuer…with any financial reporting requirement under the securities laws.…" In SEC v. Jenkins, 718 F.Supp.2d 1070 (D. Ariz. 2010), a federal district court held that the misconduct referred to is that of the issuer itself and does not require misconduct by the CEO or CFO. The court stated that "the plain language of the statute indicates that the misconduct of corporate officers, agents or employees acting within the scope of their agency or employment is sufficient misconduct to meet this element of the statute."1

Following are additional provisions in §304 that should be noted:

• The clawback from the CEO and the CFO is of any incentive compensation paid during the 12 months following the date on which the original financial statement (giving rise to the restatement) was issued publicly or was filed with the SEC (whichever occurred first). It is important to note that the clawback is of all incentive compensation received during the 12-month period (not just the excess over what the compensation would have been absent the misstatement, which is the rule under DFA §954, as discussed below).

• In addition to the clawback, §304(a)(2) requires a recovery from the CEO and the CFO of any gains realized upon sale of securities of the issuer during the same 12-month period noted in clause (i) above.2

EESA §111(b)(3)(B)

EESA §111(b)(2) provides that institutions receiving assistance under TARP must maintain certain standards for executive compensation and corporate governance. This includes a requirement, in EESA §111(b)(3)(B), for

"[a] provision for the recovery by such TARP recipient of any bonus, retention award, or incentive compensation paid to a senior executive officer and any of the next 20 most highly-compensated employees of the TARP recipient based on statements of earnings, revenues, gains or other criteria that are later found to be materially inaccurate."

Unlike SOA §304, EESA §111(b)(3)(B) contains no provision limiting it to cases of misconduct. Unlike DFA §954, discussed below, EESA §111(b)(3)(B) is of all bonuses, retention awards and incentive compensation and does not explicitly limit the clawback to the excess of such amounts over the amounts that would have been paid if the materially inaccurate statement had not occurred.3 In contrast to both SOA and DFA, EESA does not tie the financial misstatement to a required restatement under the securities laws.4

EESA §111(b)(3)(B), as noted above, will be of diminishing influence as TARP recipients repay their obligations to the Treasury and cease to be subject to EESA.5

Dodd-Frank Act §954

DFA §954 requires the Securities and Exchange Commission to direct national securities exchanges to prohibit the listing of any security of a company that fails to adopt a policy in compliance with rules to be issued by the SEC under §954 for clawing back "excess" incentive pay.6 The new clawback rules apply to "any current or former executive officer of the issuer" (as noted in the accompanying chart, "executive officer" presumably has the meaning given to it by Rule 3b-7 under the Securities Exchange Act of 1934). The clawback is to be made if the listed company is required to file a financial restatement under securities laws due to material noncompliance under those laws. The clawback applies to "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."

Section 954 provides a "trifecta" for its implementation: (a) the SEC is to adopt rules under §954; (b) employers are to adopt policies for disclosure and clawback of incentive-based compensation based on those rules; and (c) the securities exchanges are required to prohibit the listing of any security of a company that fails to conform with requirements noted in clauses (a) and (b). This "trifecta" creates an uncertain procedure for implementing DFA §954.

Interpretation and Design Issues Under DFA §954. In the case of many incentive compensation plans, it will be difficult to identify whether all or any part of an incentive award is attributable to an erroneous financial statement to which DFA §954 applies. For example:

• If payment of all or a portion of an incentive award is subject to the discretion of the Board or a Committee, does the award (or such portion of it as is subject to discretion) avoid clawback?

• Are stock-based awards that are not subject to financial performance targets excluded from clawback even though erroneously reported financial data may have affected the stock price at the time such stock-based awards were earned out?

• Does a "holdback" award (discussed below) avoid the "clawback" rule? Suppose, for example, an award "cliff" vests and pays out at the end of five years with accelerated vesting (but not accelerated payout) occurring if performance targets are met prior to the end of the fifth year. Assume, for example, performance targets are met at the end of three years, but would not have been met under a required financial restatement. Two years later the award "cliff" vests and pays out without regard to performance. The clawback rule of DFA §954 does not appear to apply because accelerated vesting, not accelerated payout, is triggered by achievement of performance targets.

Presumably these and other interpretive questions under §954 will be addressed in forthcoming SEC regulations.

Employer-Initiated Policies

Relatively few U.S. corporations have adopted policies mandating clawback of excess pay, whether due to innocent error or other circumstances. A recent study by Professor Jesse Fried of Harvard Law School indicates that prior to the enactment of DFA, less than one half of the S&P 500 corporations had policies on clawing back of excess pay. Of that minority, fewer than one-fifth (fewer than one-tenth of the entire S&P 500) had policies mandating clawbacks, under specified circumstances (in contrast to policies of the remainder, which left the board with discretion whether to claw back), and a minimal number of those companies mandating clawback in Professor Fried's study (2 percent of the S&P) had policies mandating clawback of excess pay based on innocent error.7

The enactment of DFA §954, as noted, will require all listed companies to have policies mandating clawbacks where excess pay is the result of "material non-compliance…with any financial reporting requirement under the securities laws." At the same time, it would appear unlikely that public companies generally will adopt mandatory clawback policies regarding excess pay going beyond the requirements of such federal legislation.

In contrast to "excess pay" situations, for some time a number of U.S. corporations have provided for clawback of stock option gains (or, in some cases, other realized value from equity awards) from executives, or former executives, who have violated restrictive covenants such as no-compete and no-solicit agreements.8


As noted above, a "holdback," for purposes of this column, means a holding back of compensation that is subject to one or more conditions precedent which, if not met, will result in forfeiture. Many different kinds of deferred awards are "holdbacks" in this sense. Applicable conditions precedent include continued employment for a specified period of time, performance goals (corporate and/or individual) and post-employment conditions, including restrictive covenants such as those covering confidentiality, non-competition and non-solicitation of employees or of customers.

For federal income tax purposes, "holdbacks" generally are not taxable to the executive until paid out (or made available without substantial restriction on receipt). If the executive forfeits the compensation before it is paid (or becomes available), for whatever reason, there has been no tax to the executive. If, on the other hand, compensation has been paid to the executive, a tax has been incurred.9 Complicated tax rules govern the extent to which an executive, having received compensation, can recover the tax paid on that compensation if there is a clawback of the compensation in a later taxable year. The issues that are involved are very complex and go beyond the scope of today's column.10 For a further discussion of the different tax rules that may apply in clawback situations, see James E. Maule, 502-3rd T.M. Portfolio (BNA Gross Income: Tax Benefit, Claim of Right and Assignment of Income), pp. A34-A45; Rosina B. Barker and Kevin P. O'Brien "Taxing Clawbacks: Theory and Practice" Special Report, Tax Notes (Oct. 25, 2010), p. 423.

As noted above, "holdbacks" may afford performance-related vesting opportunities, free of clawback rules (because they involve accelerated vesting rather than payout). An example, also noted above, would be one providing "cliff" vesting for deferred awards as to which vesting accelerates if performance-related targets are achieved prior to the end of the "cliff" vesting period. Careful attention must be given to tax issues that may be involved, including Code Section 409A. For further discussion of these issues, see commentaries cited in the preceding paragraph.


1. Another case involving a clawback action brought by the SEC is SEC v. McCarthy, No: 1:11-CV-667-CAP (N.D. Ga. March 3, 2011). This case was promptly settled. See SEC Release 2011-61 (March 3, 2011).

2. Each of the three statutory clawback provisions raises constitutional issues. As one example, the clawback requirement of SOA §304(a)(2) applies to gains realized during the applicable 12-month period regardless of the period the securities on which the gains were realized had been held. To the extent the gains relate to a period of holding that predates the enactment of SOA §304(a)(2), a due process issue appears to exist.

3. Section 30.8 of EESA Interim Final Rule (IFR), addressing EESA §111(b)(3)(B), does not clarify what the statute means by a bonus "based" on inaccurate information. 31CFR Part 30, 74 Fed. Reg. 28395 at 28414 (June 15, 2009), IFR §30.8 provides that bonus payments covered by §111(b)(3)(B) must be subject to clawback "if the bonus payment was based on materially inaccurate financial statements…or any other materially inaccurate performance metric criteria." The Interim Final Rule does not say whether "if" should be read "to the extent that."

4. Financial institutions subject to TARP that are public companies are subject to restatement requirements under the securities laws. A misstatement giving rise to such a restatement, in all likelihood, would be considered a materially inaccurate statement for purposes of EESA §111(b)(3)(B). What if no restatement under the securities laws is required? Interim Final Rule §30.8 under EESA §111(b)(3)(B) creates a presumption of a materially inaccurate statement in the case of any executive subject to that clawback rule "who knowingly engaged in providing inaccurate information (including knowingly failing to timely correct inaccurate information) relating to [the applicable] financial statements or performance metrics." Beyond that, it does not provide much guidance as to misstatements or as to clawback consequences associated with misstatements.

5. At its peak, TARP covered approximately 700 financial institutions. As of April 30, 2011, that number had been reduced to slightly more than 625. Of the approximately 30 financial institutions that received $1 billion or more under TARP, only five remained subject to TARP as of April 30. In addition, a number of non-financial institutions remained subject to TARP as of April 30.

6. The requirement as to prohibiting listing also applies to a "national securities association." One national securities association, the Financial Industry Regulatory Authority (FINRA), is registered with the SEC under Section 15A(a) of the Securities Exchange Act of 1934.

7. See Jesse Fried and Nitzan Shilon, Excess-Pay Clawbacks (working paper, 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1798185. The paper is scheduled for publication in a forthcoming issue of the Journal of Corporation Law.

8.For a history of cases involving enforcement by IBM of clawbacks based on no-compete clauses, see International Business Machines Corp. v. Bajorek, 191 F.3d 1033 (9th Cir. 1999), Lucente v. International Business Machines Corporation, 310 F.3d 243 (2d Cir. 2002), and International Business Machines Corporation v. Martson, 37 F.Supp.2d 613 (S.D.N.Y. 1999).

9. If repayment is in the same year in which the original payment was received, the original payment is not subject to tax. See Rev. Rul. 79-311, 1979-2 C.B. 25.

10. The issues include whether a clawback is deductible as a trade or business expense under Internal Revenue Code §162(a) and/or as a loss in connection with a trade or business (Code Section 165(c)(1)). In any event, a "floor" equal to 2 percent of adjusted gross income for the taxable year is imposed on itemized deductions such as those just noted (i.e., they are deductible only to the extent they exceed, in the aggregate, the "floor" (Code Section 67)). If the executive's tax is determined under the Code's alternative minimum tax (AMT) provisions, the tax benefit of the foregoing deductions will be lost—that is, they are not allowed under AMT. (Code Section 55; see Section 56(b)(1)(A)(i)). Another rule that may be involved is the rule for claiming recovery of previously paid tax under the "claim of right" provisions of Code Section 1341. Other issues may arise under the deferred compensation rules of Code Section 409A and the FICA withholding tax rules under Code Section 6413.