Payback Time? The SEC Launches a Second 'Clawback' Case

Federal officials are stepping up their use of "clawbacks" to recover executive pay for company performances that proved illusory, filing their second case in four months against a company CEO who was not accused of individual misconduct. The latest action was revealed in a Nov. 16 filing by Beazer Homes USA (BZH), which said that on Nov. 13 the U.S. Securities & Exchange Commission notified the company's CEO, Ian J. McCarthy, that it would recommend that a civil lawsuit be brought against him to recoup "certain incentive compensation and other amounts allegedly due" under Section 304 of the Sarbanes-Oxley Act of 2002. The notification, called a Wells notice, provides Beazer Homes an opportunity to refute the reasons set forth for such a recommendation—which the company said McCarthy plans to do. The company could not be reached for further comment. An SEC spokesperson declined to confirm the notification or offer comment. In July, the SEC asked a court in Arizona to order Maynard L. Jenkins, former CEO of CSK Auto, to reimburse the company and its shareholders more than $4 million he received in bonuses and in profits from selling stock while the company engaged in alleged accounting fraud. (CSK became a subsidiary of O'Reilly Automotive (ORLY) in July, after the alleged conduct took place.) According to The Wall Street Journal, Jenkins is fighting the clawback. His attorneys argued in a filing in U.S. District Court in Phoenix that "The SEC's nonsensical view is that Mr. Jenkins must pay…for that misconduct by others because he was 'captain of the ship,' despite the fact that under its own view of the evidence, his crew was mutinous—deceiving him, and secretly circumventing the ship's controls." The case against CSK is significant because it was "the first action seeking reimbursement under Section 304 from an individual who is not alleged to have otherwise violated the securities laws," the SEC said in a prepared statement. The SEC's complaint did not allege that Jenkins engaged in any fraudulent conduct. The same holds true for Beazer Homes' McCarthy, according to the company's statement, as the SEC did not "allege any lack of due care by Mr. McCarthy in connection with the Company's financial statements or other disclosures." The potential clawback stems from money McCarthy reaped when, the SEC alleges, Beazer Homes "fraudulently misstated its net income for the purpose of improperly managing its quarterly and annual earnings." Beazer Homes settled that action in September 2008 without admitting fault. Crisis Fosters a Rage for ClawbacksThe cases represent a shift away from how the SEC has historically used the Sarbanes-Oxley Act, the 2002 statute put in place following the Enron and Worldcom accounting scandals. Previously the law was interpreted as allowing regulators to recoup incentive-based pay from top officials who have knowingly profited when their public company engaged in misconduct or misled investors. "The seminal change is that the CEO [or chief financial officer] is not personally accused of any misconduct—it's the fact that now some misconduct occurred on his or her watch that's now sufficient in the SEC's mind," says Colin J. Diamond, a partner at White & Case in New York. The use of clawbacks is likely to grow as pressure mounts to redress the difference between big executive pay packages and shareholder losses at companies whose values crumbled during the financial crisis. "It stems from the general sensitivity and public anger over the level of executive compensation and the sense that it was excessive greed that brought on the current financial crisis that's affecting everybody," says Pamela Baker, a partner at Sonnenschein Nath & Rosenthal and chair of the firm's national employee benefits and executive compensation practice group. G-20 and Some Banks Endorse ClawbacksMany companies already have some kind of internal clawback provision on the books. Some of the bank-reform bills working their way through Congress would expand the government's authority to demand them. Perhaps the most prominent measure was presented earlier this month by Senator Christopher Dodd (D-Conn.) as part of his proposed overhaul of the financial industry. Dodd's amendment would require publicly traded companies to recoup any incentive-based compensation, including stock options, from current or former executive officers—whether or not they committed individual wrongdoing—if erroneous data warrant an accounting restatement. At its September meeting in Pittsburgh, the Group of Twenty, or G-20, organization of finance ministers and central bankers recommended deferring some banker bonuses and allowing clawbacks. On Nov. 10, Commerzbank joined some financial institutions, including Morgan Stanley (MS) and UBS (UBS), in reforming its bonus payment system to include clawback provisions. But much as they satisfy an emotional need to see justice brought to the executive suite, clawbacks are not easy to implement or enforce. Such actions can be massively expensive and time-consuming. It's unlikely that any current or former employees will willingly return compensation they received—and may perceive that they earned fairly. Often the amount sought will amount to barely more than the cost of litigation, says Diamond. Even Broader Definition of Who's Responsible?There's a reason that Kenneth R. Feinberg, the Treasury Dept.'s special master on compensation, has focused more attention on limiting current and future executive payouts at companies that received government bailouts. Feinberg has said he is reluctant to impose widespread clawbacks, although he has the right to do so. "I'm wary of exercising that authority in too many cases," he said at a Chicago Bar Assn. meeting in September, citing the difficulty of recouping money "already paid and maybe already spent and already taxed." "It seems easy and enticing but is actually very difficult to do," says Alan Johnson of executive compensation consulting firm Johnson Associates. Keeping the clawback provisions limited to the CEO and CFO is simple enough, he says, but hundreds of people can lose their employer's money, even in a good year. Broadening the definition of contributing to wrongdoing and those who can be deemed responsible "risks turning into a witch hunt," Johnson says. Many of his clients, including corporate and financial companies, are keeping a close eye on Congress and the SEC to see how the issue is resolved, he says. Sonnenschein's Baker has seen an increase in calls by activist shareholders for companies to withhold pay if performance doesn't hold up. Instead of paying bonuses in full at the end of each year, she says, companies can hold on to the funds for three to five years. But that might bring further problems. "That's a long drought, and companies worry: Would you go and work for a company like that if another across the street will give you your bonus right away?" Clawbacks are only one of the ways that the government is trying to reshape executive compensation, says Ken Raskin, head of White & Case's executive compensation, benefits, and employment law practice. Raskin argues that a one-size-fits-all solution covering all companies isn't practical. "Companies have historically had the option to tailor their clawback policies in a way that works best for them."

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