SEC Enforcement

A federal district court in Texas recently upheld the right of the SEC to seek clawbacks of bonus and other compensation under Section 304 of Sarbanes-Oxley from executives who have not been accused of any wrongdoing, by denying the executives’ motion for summary judgment. In the case, SEC v. Baker, the SEC is seeking reimbursement of bonuses, incentives and compensation from the CEO and CFO of Arthrocare in connection with the company’s restatement of its financial statements. The restatements were due to alleged fraud by two senior vice presidents of Arthrocare. The SEC did not allege that the CEO and CFO committed any conscious wrongdoing.

As we have discussed, the SEC had previously sought clawbacks under Section 304 from executives not charged with personal wrongdoing. The current case in Texas is apparently only the second time that a federal court has upheld the right of the SEC to seek clawbacks where the SEC has not alleged that the executives in question participated in the wrongful conduct. (The first case, SEC v. Jenkins, was decided by a federal district court in Arizona.) The court in Baker rejected the argument that the language of Section 304 required the misconduct of the officer from whom the reimbursement was being sought and found that Section 304 “require[s] only the misconduct of the issuer”. The court also rejected arguments by the defendants that Section 304 is unconstitutional and that they are protected by the Civil Asset Forfeiture Reform Act. In addition to cases where courts have upheld the right to clawbacks, the SEC has previously reached settlements to clawback compensation under Section 304 with executives not charged with personal misconduct.

Prior to these cases, it had been generally viewed that the clawback provisions of the Dodd-Frank Act, which provide for disgorgement regardless of whether misconduct has occurred, are broader than those of Sarbanes-Oxley. While the Dodd-Frank provision remains broader in many respects, this court case brings Section 304 one step closer to the Dodd-Frank provision.

The SEC released its 151-page financial report for its fiscal year ended September 2012. The report discusses all of the different areas that the SEC is responsible for, but the governance community is likely most interested in the following in terms of historical and anticipated activities, and some of the more intriguing factual details: 

• Enforcement is the headline item noted in the report. The SEC brought 734 enforcement actions, the second highest number filed in a single year (735 were filed in 2011). The report credits innovations, including priority focus on cultivating in-depth expertise in financial markets and products, flatter management structures, better use of technology and enhanced ability for using tips. 21 months is the average amount of time between opening an inquiry and commencing an enforcement action.
• Corporation Finance's Disclosure Operations focused on several key elements of pre-IPO disclosures, including the use of non-GAAP measures and disclosure of dual-class structures, non-financial metrics used by the company, stock valuations and shareholder rights. It takes an average of 25 days to issue initial comments on a filing.
• The new SEC website increased daily hits by almost 300%, to 39 million a day. 48% of public companies were reviewed in 2012.  
• Nearly 4,000 people work at the SEC, and the SEC has adopted a "pay for performance" approach for its non-bargaining unit employees.  

2013 initiatives cited include the Commission’s intention to:

• "Propose and adopt" rules to implement the four executive compensation-related provisions of the Dodd-Frank Act, including clawback policy, pay and performance disclosure, pay ratios and employee and director hedging.
• Develop recommendations for an interpretive release addressing issues raised in the "Proxy Plumbing" concept release.
• Prepare a concept release to seek comments on modernizing 13(d) and 13(g) reporting.

A year after opening its new whistleblower office, the SEC announced today that it had paid out $50,000 to an unidentified whistleblower, the first such award under Dodd-Frank. In its press release, the SEC indicated that the award represents the maximum percentage allowed, or 30%, of the amount collected in an enforcement action. The whistleblower reportedly provided documents and other information that led to a court ordering more than $1 million in sanctions. Additional sanctions will increase the payout to the whistleblower. A second individual seeking an award for the same matter was denied since the information provided did not lead to or significantly contribute to the enforcement action. 

The release and orders did not provide any detail regarding the type of information the whistleblower provided,  or whether the whistleblower made any internal reports prior to approaching the SEC. The SEC indicated that the whistleblower office is receiving about 8 tips a day.

In another announcement, the SEC has moved the consideration of proposed rules to eliminate the prohibition against general solicitation and general advertising in securities offerings conducted under Securities Acts Rules 506 and 144A, as mandated under the JOBS Act, from the agenda for tomorrow’s open meeting to a new open meeting to be held next Wednesday, August 29th. The rulemaking has been the subject of some controversy. Rules on conflict minerals and resource extraction remain on the agenda for tomorrow’s open meeting.

Today, the SEC rules on the independence of compensation committees and advisers were published in the Federal Register. As we described in our memo, the listing exchanges have 90 days to propose implementation, and then a year from today to finalize the standards with approval from the SEC.

Since those are the outside dates, the listing exchanges can act much sooner. Depending in part on the comments received on the proposed standards, final standards may be adopted in time to apply to the 2013 annual meeting. We hope that the transition period for compensation committee independence standards will accommodate the fact that many boards evaluate director independence months before proxy statements are issued with related independence disclosure. Companies and boards will need sufficient time to modify their processes to evaluate additional independence factors required, or possibly even change the composition of their compensation committee.

In terms of compensation adviser independence, since there is no public disclosure required, the rules may not be affected by the proxy season (and proxy statement) timing. The importance in this case is for the listing exchanges to provide sufficient transition periods for companies to gather the necessary information and the compensation committee to examine the required factors. Companies will also need to consider whether their governance documents, including committee charters, should be modified to reflect the new rules.

As a reference, in a rule filing on April 2003, NYSE allowed companies 18 months following SEC approval to comply with the requirement to have a majority of independent directors (classified boards had 30 months if the affected director was not up for election). By the time the SEC approved those and other governance rules for NYSE and Nasdaq in November 2003, the implementation schedule had been revised to apply to the following year's annual meeting.

The SEC Staff has agreed that several companies can exclude their proxy access shareholder proposals that were modeled on a template provided by the United States Proxy Exchange, which also became known as the "retail" version because they were generally submitted by retail shareholders. 

- For Sprint, MEMC and Chiquita, the Staff agreed the proposal is vague or indefinite for referring to "the SEC Rule 14a-8(b) eligibility requirements," since the proposal doesn't describe the specific requirements and they are a "central aspect of the proposal."  The Staff went on to say that "while we recognize that some shareholders voting on the proposal may be familiar with the eligibility requirements of Rule 14a-8(b), many other shareholders may not be familiar with the requirements and would not be able to determine the requirements based on the language of the proposal." The basis for this decision may be a bit surprising given that the Staff disagreed this season with companies that had argued that proposals that request the board to have an independent board chairman, by the standard of the New York Stock Exchange, are vague or indefinite by referencing the NYSE standard without sufficiently describing them. 

- For Textron, Goldman Sachs and Bank of America which included the procedural argument, the SEC Staff agreed that the access proposal consists of multiple proposals because paragraph 6 raises a "separate and distinct" proposal relating to events that would not constitute a change of control, while the other paragraphs (1-5 and 7) contained a proposal related to shareholder nominations. 

In addition, as suspected, the Staff rejected KSW's argument that they had substantially implemented a binding proposal that had a threshold of 2% ownership requirement by adopting a bylaw with a 5% ownership requirement.

The SEC Staff made several recent decisions on questions of proof of ownership for submission of shareholder proposals, in light of the requirement under Staff Legal Bulletin 14F, which we previously discussed.  SLB 14F makes clear that only DTC participants are viewed as record holders of securities that are deposited at DTC. 

The Staff declined to grant no-action relief to companies that argued that the proof of ownership was not from a DTC participant when the brokers' letters were from TD Ameritrade, Inc. instead of TD Ameritrade Clearing, the entity named on the DTC participant list.  The proponents in some of these situations provided an additional letter of support from TD Ameritrade in response to the company's no-action letter request, but the SEC Staff gave the same ruling even when proponents did not.  The Staff noted that the proof of ownership from TD Ameritrade, Inc. was sufficient since it was provided by a broker that provides proof of ownership statements of behalf of affiliated DTC participants. 

But even when the Staff agreed with Allergen that the proponent, John Chevedden, failed to provide a statement from the record holder evidencing appropriate documentary support of continuous beneficial ownership, the Staff gave Mr. Chevedden seven additional days to address the deficiency.  Mr. Chevedden had provided proof of ownership only from Ram Trust and not the DTC participant.  The Staff indicated in its response that the company failed to informed the proponent of what would constitute appropriate documentation in its request for additional information from the proponent, and noted SLB 14F states that they will grant no-action relief to a company on the basis that a proponent's proof of ownership is not from a DTC participant only if the company's deficiency letter describes the required proof.  It appears from the filed correspondence that while the company clearly pointed out the problem to Mr. Chevedden in its notice, only a copy of Rule 14a-8, and not a copy of SLB 14F, was included with the letter.   The Staff denied the company's request to reconsider its decision.

Earlier this week, the SEC announced a settlement with the former CFO of Beazer Homes USA to clawback incentive compensation and profits from the sale of Beazer stock of more than $1.4 million pursuant to the Sarbanes-Oxley Act.  Neither the CFO nor Beazer’s CEO, who reached a similar settlement with the SEC earlier this year for almost $6.5 million, was charged with personal misconduct.  Notably, the SEC blames Beazer’s chief accounting officer as the main perpetrator of the fraudulent actions that led to accounting restatements, but in accordance with the Sarbanes-Oxley Act, the SEC could not seek recoupment from any officers other than the CEO and CFO.  The SEC complaint against the chief accounting officer only included traditional cease-and-desist and disgorgement relief.

Section 304 of the Sarbanes-Oxley Act authorizes the SEC to seek recoupment of certain incentive compensation if an issuer must prepare an accounting restatement due to material noncompliance of the issuer with financial reporting requirements “as a result of misconduct.”  The SEC actions against Beazer’s CEO and CFO were criticized for taking an expansive reading of “misconduct” under the statute.  In contrast, the new rules the SEC is expected to promulgate in the coming months to implement the clawback requirements under Dodd-Frank will subject current and former officers to clawbacks, without reference to misconduct by anyone.  Under Dodd-Frank, companies must develop and implement policies with respect to (1) disclosure of incentive-based compensation that is based on publicly reported financial information and (2) clawback of incentive-based compensation from current or former executive officers following a restatement triggered by material noncompliance with any financial reporting requirements under securities laws.  The amount subject to the clawback is the amount in excess of what would have been paid under the restated results during the 3-year period preceding the date on which a company is required to prepare the restatement.

In a number of respects as noted below, the requirements of Dodd-Frank are broader than those of SOX.  Due to its expansive nature, in particular the absence of any misconduct as a trigger, there will likely be more clawback actions under Dodd-Frank than we have seen so far under SOX.  The Dodd-Frank provisions raise a number of interpretative questions, including whether SEC actions against officers will make it difficult for companies not to seek compensation reimbursements under Dodd-Frank if available.

For more information on open issues regarding the clawback under Dodd-Frank and its impact on foreign private issuers, see Compensation Clawback under Dodd Frank: Impact on Foreign Issuers from our Tokyo Office Blog.

The SEC news release regarding the clawback of compensation from Beazer Homes’ former CFO, as well as the related SEC complaint, can be found here.

Contact Ning Chiu. Contact Gillian Emmett Moldowan.

We presented a webcast today discussing the final Dodd-Frank whistleblower rules that the SEC adopted a couple of weeks ago.  It was a good discussion covering the range of challenges that companies are facing and expecting to face.  Based on questions raised by listeners both during and after the podcast it's apparent that many are struggling with how to continue to motivate employees to submit information internally through existing compliance systems, such as hotlines, rather than starting with the government.  Lots of variations on the theme:

• Can I provide by policy that employees are required to provide the company with information concerning suspected noncompliance? (yes)
• Can I enforce this policy by disciplining employees who take their complaints to the government first? (no)
• Can my policy state that employees should raise issues internally before going to the government? (generally not advisable, and in any case most companies have decided it's better not even to allude to the whistleblower bounty program)
• Can I have my own reward system for employees who submit information internally? (generally not advisable)

Bottom line is that the incentives for reporting internally in compliance with a corporate policy are inherently soft; we may celebrate you as a good citizen, may treat this favorably as part of your performance review, but we can't discourage you from going to the government first, and we can't realistically compete with the money that the bounty program could pay.  It's frustrating, but these limitations are to a great extent hardwired into Dodd-Frank and will be difficult to address through rulemaking.

Contact Bill Kelly.

This year a group of investors begin asking companies to host a "fifth analyst call" for institutional investors to take place after the proxy statement is issued and designed to focus on corporate governance.  Occidental Petroleum became the first company to sponsor such a call in late April, hosted by the lead director and audit committee chair, and the compensation committee chair.

In this IR web report, Dominic Jones questions whether Occidental's call, which was not publicly announced or publicly available, may have implicated Regulation FD in light of the fact that (a) the call was held 2 days before the company announced earnings and (b) the stock closed 2.5% higher after the call, beating the results of the S&P 500 and its peers on that day. According to various reports, the company has not made any comments about the call.  The hosts and advocates of the call, Railpen Investments and F&C Asset Management, released a statement indicating 50 investors participated, and the call focused on the proxy statement and governance matters and included a "lively" Q&A. 

Companies have been criticized by investors for raising Regulation FD concerns when refusing to have investors speak directly with board members, leading to SEC C&DI guidance in June 2010 that reiterates that while Regulation FD does not prohibit directors from speaking in private with shareholders, the company should consider implementing policies and procedures intended to help avoid Regulation FD violations, such as pre-clearing discussion topics with the shareholder or having company counsel participate in the meeting. This is an area worth watching.  It certainly seems that the timing of this meeting was unfortunate.

Contact . 

In case you missed it, Dr. Erik Roelofsen, a researcher at the Rotterdam School of Management at Erasmus University, published an interesting study surveying over 400 sell-side and buy-side analysts and portfolio managers about their views and experience with one-on-one meetings with management.  He reports that about 47% of investors and analysts say that they frequently receive material information in these one-on-one meetings.  If this is at all accurate, this is an eye-opening result and reinforces the need for careful consideration of the timing, manner, ground rules and objectives of these sessions.  Reports like this may also attract regulatory scrutiny.

Today's WSJ piece on what are sometimes called "nondeal road shows" is on one level a nonstory; as the story concedes, the practice is not a new one. But coming as it does on the heels of last week's Rajnaratnam verdict, the story provides a good hook to remind companies and senior executives of the perils of private unscripted meetings with hedge funds and other large investors. The effort that companies invest in their disclosure controls and procedures can be significantly undercut by an injudicious remark blurted out after the second bottle of Petrus (and yes, the wines tends to be very good indeed at these dinners). The company may not be aware of the issue until the stock moves the next day, and by then it may be too late to fix (and in any case the SEC may take the view that the communication was "intentional", in which case there is no fix under Reg FD).

What's sometimes not understood is that hedge funds themselves would often rather not participate in these events in light of the compliance risks that these interactions pose. But in a competitive world it can be difficult to stay away if you think that other investors will be there.

Is there a legitimate role for private meetings with major shareholders? Of course. Sometimes there is no substitute for face-to-face interaction, and the risks are manageable if the participants are well prepared and stay on message. But think about the script, the mix of participants, and even the time of day. Somehow the risks seem lower at breakfast than at dinner.

Contact .