Department of Justice Clawback Pilot Program

Article written by?Croke Fairchild Duarte & Beres ?Partners? Andrew Gilbert and Geoffrey R. Morgan , Senior Counsel Marshall Scott and Counsel Maggie McTigue .

This paper discusses the recently adopted Pilot Program (“Pilot Program” or “Program”) of the United States Department of Justice (“DOJ”) with respect to the clawback of executive compensation in certain circumstances. Among other objectives, the Program offers possible financial incentives in the form of reduced penalties to public and private companies to adopt compensation recoupment or clawback policies. The Program comes more than 20 years after legislative and regulatory efforts to institute clawbacks into public company executive compensation design and corporate governance practices. The Program is timely as public companies are set in 2023 to implement mandatory clawback policies in order to comply with newly prescribed stock exchange listing requirements.?As companies consider the adoption and implementation of the new mandatory clawback provisions, they should also consider what additional effort should be made to allow the clawback policy to realize the potential benefits of the Program.?This paper discusses those considerations and relates the new Program to the existing laws regulating clawbacks.

Introduction

For the past 20 years, compensation recoupment or “clawbacks” have been evolving and gaining importance in the corporate governance ecosystem. Modern clawbacks began to take on more significant importance with the Sarbanes Oxley Act (“SOX”), which then evolved into broader designs and arrangements with the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), and now appear as a newly featured item in a Department of Justice Pilot Program. This paper first provides some historic backdrop with respect to the evolution of the compensation clawback for public companies, and then discusses the details regarding the new Pilot Program that may apply to both public and private companies. The evolution of clawbacks over the past twenty years has significant meaning for executives whose compensation is subject to such recoupment provisions and to the boards of directors responsible for clawback policy development and implementation.

SOX Clawback

The SOX clawback is a statutory requirement, exclusively enforced by the Securities and Exchange Commission (“SEC”), and provides:

“If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for — ?

(1)??any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever occurs first) of the financial document embodying such financial reporting requirement; and

(2)??any profits realized from the sale of securities of the issuer during the 12-month period.” (15 USC Section 7243(a)).?

Some key features of the SOX clawback:

• Enforced exclusively by the SEC, not the employer or shareholders;
• Based on a statute; not a listing requirement or a corporate policy or a plan or contract provision;
• Required or is triggered only by a financial restatement if the restatement resulted from misconduct;
• Recoupment is limited to the CEO and CFO, but does not require their misconduct;
• Broad scope of compensation subject to recoupment — any bonus or other incentive based-compensation received from the issuer, or any profits realized from the sale of securities during 12-month period following financial restatement; and
• Applies only to publicly listed companies; privately held and not-for-profit organizations are not subject to this law.

Dodd-Frank Clawback

Following the implementation of SOX, the next major development in recoupment policies was the Dodd-Frank clawback. This clawback is a meaningful change from the SOX version. Rather than being only based on a statute, this clawback comes about as a directive to the stock exchanges to develop and maintain as a listing standard a “policy for the recovery of erroneously awarded incentive-based compensation received by current or former executive officers.” In other words, the Dodd-Frank clawback gave the listing exchanges additional regulatory power to impose a clawback requirement outside of the SEC direct enforcement under SOX. (See, SEC Rule 10D-1; NYSE Proposed Listed Company Manual Section 303A.14 and NASDAQ Proposed Listing Rule Section 5608.)

In their effort to meet the SEC mandate, the exchanges have provided draft listing standards that ?generally include the following:

• If (1) a listed company is required to prepare an accounting restatement due to the company’s material non-compliance with any financial reporting requirement (and this includes both a restatement to correct an error in previously issued statements, or correct an error in the current period), and (2) the noncompliance resulted in overpayment of incentive compensation within as many as the three most recently completed fiscal years preceding the date the restatement was required; then
• The company is required to recover from its current or former executive officers (without regard to any misconduct by a specific executive officer), on a reasonably prompt basis, the amount of any such erroneously awarded incentive-based compensation for the past three fiscal years preceding the restatement.

The recoverable compensation may include:

• Incentive or bonus compensation based on one or more financial goals; and
• Performance shares or stock options based on a financial goal, including those granted, earned, or vested based on one or more financial goals, or based on total shareholder return or stock price. ?

Failure to adopt a policy or undertake recoupment generally may result in a delisting (i.e., limited exceptions are available) of the company from the applicable exchange.

The Dodd-Frank recoupment provisions differs from the SOX clawback as follows:

• The company must take affirmative action to adopt a policy and apply the recoupment as a matter of policy, contract, or plan provision and operation;
• The company is responsible for enforcement, not the SEC;
• The recovery period is based on a three-year look-back period, and applies to current and former executives;
• Recovery is mandatory and not in the company’s discretion, subject to limited exceptions;
• A company can add other misconduct or injury as a basis for recovery, e.g., which would be discretionary with the company;
• The amount and source of the recovery for conduct other than resulting from a financial restatement could be defined more broadly or include different values or sources of recoupment; and
• Dodd-Frank applies only to publicly listed companies; privately held and not-for-profit organizations are not subject to this law.??

United States Department of Justice Clawback

The most recent development regarding clawbacks is a “pilot” program announced in March of 2023 by United States Deputy Attorney General Lisa Monaco , and other general pronouncements since.?The DOJ’s corporate criminal enforcement policies have been revised to reflect the Department’s Criminal Division (Division) considerations of how to reward corporations that develop solutions to incentivize better compliance through their compensation systems, including the use of clawback policies. Some of the DOJ’s most publicly discussed considerations have included how policies may seek to potentially shift the burden of corporate financial penalties away from shareholders — who in many cases do not have a role in the misconduct — onto those more directly responsible.

Accordingly, the Division is conducting a Compensation Incentives and Clawbacks Pilot Program. The Program provides:

1. When entering into criminal resolutions, companies will be required to implement compliance-related criteria in their compensation and bonus systems and to report to the Division about such implementation during the term of such resolutions. These criteria may include, but are not limited to: (1) a prohibition on bonuses for employees who do not satisfy compliance performance requirements; (2) disciplinary measures for employees who violate applicable law and others who both (a) had supervisory authority over the employee(s) or business area engaged in the misconduct, and (b) knew of, or were willfully blind to, the misconduct; and (3) incentives for employees who demonstrate full commitment to compliance processes. In making this determination, prosecutors are to be mindful of, and afford due consideration to, how the company has structured its existing compensation program.?(Emphasis added.)
2. The Program directs Division prosecutors to consider possible fine reductions where companies seek to recoup compensation from culpable employees and others who (a) both had supervisory authority over the employee(s) or business area engaged in the misconduct, and (b) knew of, or were willfully blind to, the misconduct. ??
3. Specifically, in such circumstance, Division prosecutors are to accord, in addition to any other reduction available under applicable policy, a reduction of the fine in the amount of 100% of any such compensation that is recouped during the period of the resolution. Any fine reduction afforded under the Program does not affect any applicable restitution, forfeiture, disgorgement, or other agreed-upon payment by the company. At the time of the resolution, the company will be required to pay the full amount of the otherwise applicable fine (Original Fine) less 100% of the amount of compensation the company is attempting to claw back (Possible Clawback Reduction). At the conclusion of the resolution, if the company has not recouped the full amount of compensation it sought to claw back, the company will be required to pay the Possible Clawback Reduction minus 100% of the compensation actually recovered.
4. If a company’s good faith attempts to recoup any such compensation are unsuccessful, Division prosecutors may in their discretion accord a reduction of up to 25% of the amount of compensation the company attempted to clawback. Such reductions may be warranted where, for instance, a company incurred significant litigation costs for shareholders or can demonstrate that it is highly likely that it will successfully recoup the compensation shortly after the end of the resolution term.

The Program is a three-year initiative applicable to all corporate matters handled by the Division and is effective March 15, 2023. It does not modify the Division’s Corporate Enforcement Policy, the Evaluation of Corporate Compliance Programs, or the Principles of Federal Prosecution of Business Organizations. At the end of the pilot period, the Division will determine whether the Program will be extended or modified in any respect.?

What the Program means for clawbacks at this moment may include the following:??

• For companies that are already within the scope of SOX or Dodd-Frank, the Program presents a reason to adopt a clawback policy that addresses a broader range of conduct than the statutory and stock listing requirements. In other words, misconduct that may place the company on a path to a resolution agreement with the DOJ may be other than a financial restatement. Having the ability to pursue recoupment for other misconduct or other sources of recovery may be a necessary condition to enjoying the reduced monetary policies offered under the Program.
• The Program applies to more than publicly-listed companies, and includes any company that experiences misconduct that brings it within the scope of a resolution action with the DOJ; companies not subject to either the SOX clawback or the Dodd-Frank/stock exchange listing requirements now have an additional reason to consider the voluntary adoption and implementation of a clawback policy.?

Recent Illustrative Case

The recent settlement of a misconduct matter involving the McDonald’s Corporation illustrates the expected benefits of the Program. The former CEO of McDonald’s, Steve Easterbrook, was charged with making false and misleading statements to investors about the circumstances leading to his termination in November 2019.?

McDonald’s terminated Easterbrook for exercising poor judgment and engaging in an inappropriate personal relationship with a McDonald’s employee in violation of company policy.?Easterbrook and McDonald’s entered into a separation agreement that concluded his termination was without cause, which allowed him to retain substantial equity compensation that otherwise would have been forfeited. In making this conclusion, McDonald’s exercised discretion that was not disclosed to investors.

Subsequently, McDonald’s discovered through an internal investigation that Easterbrook had engaged in other undisclosed, improper relationships with additional McDonald’s employees.?The SEC claimed that Easterbrook knew or was reckless in not knowing that his failure to disclose these additional violations of company policy prior to his termination would influence McDonald’s disclosures to investors related to his departure and compensation.?

The consequence was that the SEC charged McDonald’s with violating the proxy disclosure rules, with McDonald’s consenting to the SEC’s cease and desist order. = It is important to note, however, that the SEC did not impose a financial penalty on McDonald’s due to its cooperation with the investigation and remedial measures taken by McDonald’s, including its seeking and ultimately recovering the compensation Easterbrook received pursuant to the separation agreement.?

Caremark Compliance

A broader point for consideration is that the Program and its incentive for a more inclusive clawback may have a place in a company’s efforts to comply with the duty of care or the duty of loyalty standards articulated in the Caremark case and subsequent similar-type cases (see, e.g., In re Clovis Oncology, 698 A.2d 959 (1996) and Marchand v Barnhill, 212 A.3d 805 (2019)). So-called “Caremark claims” are claims that directors breached their duty of care or loyalty by not making a good faith effort to oversee the company’s operations. The facts of the Caremark case involve board of director liability related to business risk oversight of mission-critical operations. The Easterbrook/McDonald’s settlement above has since been read to broaden oversight responsibility to include all legal compliance risks of a company, not just the mission-critical ones.

Critical to the Caremark standard is a demonstration by a board that there is board-level oversight of the company’s operations, particularly with respect to legal and regulatory obligations. The systems put in place by the Company need substance, such as process, standards, and protocols that are regularly reported to the board and are affirmatively monitored and relate to the business.

The use of compensation recoupment policies helps to both (1) remind the board of its duty to engage in risk analysis and mitigation, (i.e., defining misconduct for which the clawback provisions of compensation may be activated), and (2) demonstrating to a regulator or internal reviewer that there is a system of oversight and monitoring for which the clawback is a tool of enforcement and discipline.?

Conclusion

When announcing the Pilot Program, the DOJ stated its hope that the Program would help better align the executive compensation of an organization with its corporate compliance function. The Department acknowledged that this closer alignment was different than the perceived past practices. ?

Although publicly listed companies are mandated to adopt the Dodd-Frank clawback in 2023 as a condition of remaining a listed company, the DOJ Program gives those companies an impetus to consider a broader approach — as to the conduct that may trigger a clawback, the range of covered employees, and the sources of recovery — to designing their clawback policy. Also, private companies that are not subject to the Sarbanes-Oxley or the Dodd-Frank clawback may decide to implement a clawback policy from which to benefit in the event of a problem with the DOJ. And both public and private companies may consider better alignment between their executive compensation program and their efforts related to oversight of corporate governance behavior.

It is, of course, impossible for a board of directors to develop reporting systems and monitoring apparatus to prevent all management misconduct or be warned of its development in a timely manner.?Therefore, a broad clawback provision that serves as a “gap filler” to deter management’s misconduct in the first instance and to provide an opportunity to indemnify the company in the event some misconduct “gets by” the board’s best efforts to mitigate risk and monitor behavior may go a good distance in helping a board preserve its defenses under Caremark.

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