Monthly Archives: August 2009

The Board’s Role in Risk Management

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, August 8, 2009
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This post comes to us from Jeff Stein and Bill Baxley of King & Spalding.

Risk management is currently a topic of considerable interest to public company boards. While taking measured and informed risks is an important element of any company’s strategy, the financial and economic crisis has led companies and boards to change their approaches to risk management. Moreover, given the events in the capital markets over the past year, institutional investors, regulators and the public are scrutinizing public company boards’ oversight of risk more closely.

Against this background, the Lead Director Network, a group of lead directors, presiding directors and non-executive chairmen from many of America’s leading companies created by King & Spalding and Tapestry Networks, met on July 8, 2009 to discuss the board’s role in risk management. Following this meeting, King & Spalding and Tapestry Networks have published the ViewPoints report here, to present highlights of the discussion that occurred at the meeting and to stimulate further consideration of this subject. The following provides highlights from the meeting, as described in the ViewPoints report.

Greater emphasis on strategic risk assessment. Members of the Lead Director Network generally see room for improvement in the way companies approach risk management. Directors noted that, while the Sarbanes-Oxley Act resulted in boards focusing on compliance and internal controls, the financial crisis is now requiring them to focus on identifying and mitigating broader strategic risks. Directors are thinking about risk in broader terms, moving beyond financial and accounting risks to considering factors that could threaten a company’s operations or business model. At the extreme, directors are seeking to identify and address “black-swan” risks, the seemingly improbable events that could threaten a company’s survival.

The lead director’s role. Lead directors and other board leaders can play a valuable role in the board’s oversight of risk management. While companies have been forming committees or subcommittees to focus on specific or unique risks, directors noted that, given the many types of risk that companies must address, it is essential for the risk oversight function to include active participation from all directors. Directors pointed to situations in which the contemplation of certain risks has essentially been “stuck in committee” — that is, certain risks were being addressed by board committees but not the full board. Lead directors can add value to the risk management process by ensuring that risk management is actively considered by the full board and that committees are used effectively, by acting as a conduit between the board and management and by facilitating open communication and robust debate.

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Directors’ and Officers’ Insurance

Posted by Igor Kirman, Wachtell, Lipton, Rosen & Katz, on
Friday, August 7, 2009
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This post is by Igor Kirman of Wachtell, Lipton, Rosen & Katz. This post was written together with his colleagues Warren R. Stern and Martin J.E. Arms.

At a time of historically significant dislocation in the corporate world, directors and officers now more than ever need to focus their attention on directors’ and officers’ (“D&O”) insurance, as part of their overall strategy involving effective corporate governance and risk management. Although the best protection should continue to come from conscientious attention to directorial and management responsibilities, an effective D&O insurance program, in combination with well-drafted indemnification and exculpation provisions in corporate charters and by-laws, is a critical component of protection for directors and officers at a time of increased scrutiny by shareholders, courts and regulators. Recent judicial developments further highlight the need for careful attention to policy terms, which can be outcome-determinative in significant litigation. Below are some thoughts on D&O insurance in these troubled times.

1. Side A excess coverage:

The main types of coverage provided by many D&O insurance policies are known as A, B and C coverage. The “A” coverage directly indemnifies a director or officer with respect to claims for which the company is not able to indemnify that director or officer, either by reason of law or financial insolvency. (Some companies purchase only A coverage.) The “B” coverage reimburses the company for amounts that it pays to a director or officer through indemnification. The “C” coverage is for claims directly against the company, but, for public companies, that coverage is almost always limited to securities claims. These types of coverage work together to provide broad protection for individuals and the company. But be wary: coverage can be exhausted by claims made on the B and C coverage, i.e., coverage that, in the end, insures the company and not the directors and officers themselves. This may leave directors and officers exposed when they need coverage most — when there is a claim for which the company cannot indemnify them. To avoid this problem, to the extent they do not do so already, companies that purchase A, B, C coverage should consider purchasing additional A-only coverage in excess of the A, B, C coverage. This A-only excess coverage will protect directors and officers if nonindemnifiable claims or obligations arise after the underlying A, B, C coverage has been exhausted. There is also a more comprehensive (and thus more expensive) version of A-only excess coverage known as A-only Difference-in-Conditions (“DIC”) excess coverage. Under DIC coverage, the excess policy will “drop down” to provide coverage when another insurer fails to pay a claim (including as a result of insurer insolvency) or when a company fails to indemnify. DIC policies generally provide broader coverage terms than traditional A-only excess coverage. A DIC policy should also provide coverage if a bankrupt estate successfully argues that the underlying A, B, C policy is the property of the estate. In order to provide the greatest protection against insurer insolvency, companies that purchase DIC excess coverage should consider purchasing it from an insurer that is not on the underlying A, B, C insurance program.

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Bank CEO incentives and the credit crisis

Posted by René Stulz, Ohio State University Fisher College of Business, on
Thursday, August 6, 2009
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This post is by René Stulz of Ohio State University.

In the search of explanations for the dramatic collapse of the stock market capitalization of much of the banking industry in the U.S. during the credit crisis, one prominent argument is that executives at banks had poor incentives. Rudiger Fahlenbrach and I have completed a working paper titled “Bank CEO incentives and the credit crisis” that investigates how closely the interests of the CEOs of banks were aligned with those of their shareholders before the start of the crisis, whether the alignment of interests between CEOs and shareholders can explain the performance of banks in the cross-section during the credit crisis, and how CEOs fared during the crisis. Traditionally, corporate governance experts and economists since Adam Smith have considered that management’s interests are better aligned with those of shareholders when managers’ compensation increases when shareholders gain and falls when shareholders lose. On average, bank CEOs had powerful incentives to maximize shareholder wealth as of 2006. We show that in our sample the median value of a CEOs equity stake (taking into account options) was $36 million. Typically, a CEO’s equity stake was worth more than ten times his compensation in 2006.

Our results show that there is no evidence that banks with a better alignment of CEOs’ interests with those of their shareholders had higher stock returns during the crisis and some evidence that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity. In particular, whether our sample includes investment banks or not, stock return and accounting equity return performance are negatively related to bank CEOs dollar incentives, measured as the dollar change in a CEOs wealth for a 1% change in the stock price. This effect is substantial and is not explained by a few banks where CEOs had extremely high ownership. An increase of one standard deviation in dollar ownership is associated with lower returns of 10.2%. Similarly, a bank’s return on equity in 2008 is negatively related to its CEO’s holdings of shares in 2006 – a one standard deviation increase in dollar ownership is associated with approximately a 10.1% lower return on equity. Though options have been blamed for leading to excessive risk-taking, there is no evidence in our sample that greater sensitivity of CEO pay to stock volatility led to worse stock returns during the credit crisis.

A plausible explanation for these findings is that CEOs focused on the interests of their shareholders in the build-up to the crisis and took actions that they believed the market would welcome. Ex post, these actions were costly to their banks and to themselves when they produced poor results. These poor results were not expected by the CEOs to the extent that they did not reduce or hedge their holdings of shares in anticipation of poor outcomes. Using data on insider trading to estimates sales of shares, we find that CEOs made extremely large losses on their holdings of shares in their bank because they typically did not sell shares. Further, CEOs made large losses on their options.

Our research shows that bank CEOs had very high incentives to maximize shareholder wealth. This evidence makes it implausible that the credit crisis can be blamed on a misalignment of incentives between CEOs and shareholders.

Musings: SEC’s Proposal to Report Voting Results

Posted by Broc Romanek, TheCorporateCounsel.net, on
Thursday, August 6, 2009
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This post is by Broc Romanek of TheCorporateCounsel.net.

For those that regularly read my blog, you know I was happy to see the SEC propose a requirement that would force companies to disclose the voting totals from their shareholder meetings more timely. It has always amazed me that some companies stonewall on the vote results – it’s a poor PR move as it riles shareholders (see this example) and they have to disclose it eventually. But I imagine they do this in the hope that shareholders – and the financial press – will lose interest in the story.

The SEC proposes that disclosure be made within four business days after the end of a shareholder meeting (on a Form 8-K or a periodic report). For a contested director election, the 8-K would be due within 4 business days after the preliminary voting results are determined. The proposal begs the question as to when “preliminary voting results are ‘determined'” (i.e. trigger date). Maybe I’m missing it, but there doesn’t seem to be any exception for other types of contested matters? Anyways, if it’s a contested director election, there could be two Form 8-Ks – one within four business days after the meeting’s end based on a preliminary vote and another one within four business days of the final vote being certified.

Importance of Tabulation Process

On page 44 of the SEC’s proposing release, the SEC provides its discussion of this proposal – and a cost analysis is on page 96. Understandably, there is not a detailed discussion of the tabulation process and what’s involved. But as I wrote about in the Fall ’08 issue of InvestorRelationships.com (it’s free; just need to input contact info) – in my interview with Carl Hagberg – the time is now for companies to rethink how they process their votes as well as who they hire to do it.

For starters, you probably want to hire only those inspectors that have a well-defined process about how they inspect – and you probably should hire only those inspectors whom you feel comfortable would pass muster under the pressures of litigation (eg. an entity that is independent – perhaps one is not your transfer agent). With the loss of broker nonvotes, we can expect closer elections and more litigation over voting results. You need to protect yourself and not rely on procedures that historically have been pretty loose.

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Internal Contradictions in the SEC’s Proposed Proxy Access Rules

Posted by Joseph Grundfest, Stanford Law School, on
Wednesday, August 5, 2009
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Professor Grundfest’s post is based on extracts (with footnotes removed) from his Working Paper of the same name published by the Rock Center For Corporate Governance on July 24, 2009; the complete Working Paper, including footnotes, can be downloaded from Social Sciences Research Network Electronic Paper Collection here.)

Administrative agencies are wise not to contradict themselves when rulemaking: contradictions invite courts to overturn agency action as arbitrary and capricious. Also like Charles Barkley’s claim that he was misquoted in his autobiography, contradictions spawn skepticism as to the credibility of an entire enterprise.

This simple observation strikes a death knell for the Securities and Exchange Commission’s 2009 proposed Proxy Access Rules. If adopted, these rules would dramatically transform the process by which directors of publicly traded corporations are nominated and elected. They would establish a “Mandatory Minimum Access Regime” under which corporations would be compelled, even against the will of the shareholder majority, to provide proxy access in accordance with SEC-established standards. Shareholders could, by majority vote, set less stringent access standards, but could not adopt more stringent proxy access rules.

The Commission proposes to add one new rule and amend an existing rule:

• Proposed Rule 14a-11 would provide for proxy access in the event a nominating shareholder, or group of shareholders, of a large accelerated filer have, for at least one year, held one percent or more of the company’s voting securities. Access would not be available to stockholders seeking a change in control, or to stockholders seeking more than a limited number of seats on a board. Nominating stockholders would be required to make certain disclosures, subject to the antifraud provisions of Rule 14a-9. These disclosures include representations that the nominees satisfy the objective criteria for director independence set forth in listing standards, that there is no agreement with the company regarding the nomination of the nominees, and that the nominating stockholders intend to continue holding the requisite number of shares through the date of the stockholder meeting. Disclosure would also be required of relationships between the nominating stockholders, the nominee, and the company, if any.

• Modifications to Rule 14a-8(i)(8) would recast the election exclusion so as to require that companies include in their proxy materials stockholder proposals that would amend, or propose to amend, the company’s governing documents regarding shareholder nominations. The proposals could not, however, weaken or eliminate the proxy access criteria prescribed by proposed Rule 14a-11.

Taken together, the Proposed Rules create a mandatory form of proxy access to be imposed on all publicly traded corporations subject to the rule, even if the majority of each corporation’s shareholders object strenuously to the operation of the Proposed Rules. The Proposed Rules would permit modifications making access easier for stockholder-nominated directors, but forbid modification making access more difficult. Again, the will of the shareholder majority is irrelevant to the Commission. The Proposed Rules are thus accurately described as creating a “Mandatory Minimum Access Regime.”

The text of the Proposing Release is, however, at war with the text of the Proposed Rules in a clash that generates two profound contradictions. Each contradiction is sufficiently material that there is little prospect that the Proposed Rules can withstand challenge under the Administrative Procedure Act (“APA”).

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An Analysis of ETF Voting Policies, Practices and Patterns

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulatio, on
Wednesday, August 5, 2009
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This post is by Scott Fenn, Senior Managing Director, Proxy Governance Inc.

The Investor Responsibility Research Center Institute and PROXY Governance Inc. recently released an in-depth analysis of the proxy voting policies and recent voting records of seven of the largest exchange-traded fund (ETF) sponsors, which account for some 94% of the ETF market. Entitled “Proxy Voting by Exchange-Traded Funds: An Analysis of ETF Voting Policies, Practices and Patterns,” the study was commissioned by the non-profit IRRC Institute and conducted by PROXY Governance.

The findings indicate a considerable variation in the voting patterns and philosophies of these funds. The key research findings are as follows:

• There appear to be significant differences in the level of detail of proxy voting guidelines utilized by ETF sponsors. The ETF sponsors in the study that relied on guidelines provided by proxy advisory firms appear to have the most detailed and comprehensive, and prescriptive, guidelines. At the other end of the spectrum, Rydex has very summary guidelines that stipulate voting with management on virtually all issues.

• There is significant variation in the voting philosophies and patterns of the largest ETF sponsors, with some funds much more likely to vote against management on both shareholder and management-sponsored proposals than other funds

The three largest ETF sponsors are somewhat less likely to vote against management on shareholder and management proposals than are most of the smaller fund sponsors examined in this study. Yet, the three largest ETF sponsors, on average, appear to withhold votes from incumbent director nominees at a greater number of companies than the smaller funds, which appears to be their preferred means of expressing dissatisfaction with management or board governance rather than voting against management on specific proposals.

• The votes by the specific funds at selected 2008 annual meetings are generally consistent with the written voting policies of those funds. Case-by-case voting policies by many funds on most issues explain much of this consistency. In a few cases, however, specific votes were cast that appear to be potentially contrary to the fund’s written voting guidelines.

• Funds that rely heavily on a proxy advisory firm for voting guidelines or to make their vote decisions tend to vote against management proposals, and in favor of shareholder proposals, more frequently than those that rely on their own guidelines.

The study covers the following seven ETF sponsors – Barclays Global Investors (iShares), State Street Global Advisors (SPDRs), Vanguard Group (Vanguard ETFs), Invesco Ltd. (PowerShares), ProFunds (ProShares), Rydex Investments (RydexShares) and WisdomTree Trust (WisdomTree ETFs). (NB: Barclay’s Plc recently announced that it would sell its Barclay’s Global Investors asset management division, the single largest ETF manager, to BlackRock, Inc.)

The full report is available here and here.

Regulate financial pay to reduce risk-taking

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, August 4, 2009
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Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published in today’s print edition of the Financial Times and available here.

A bill requiring federal regulators to draw up rules for compensation structures in the   financial sector was passed by the US House of Representatives on Friday and will be taken up by the US Senate. Such pay regulations, which authorities around the world are considering, will meet stiff resistance from financial institutions. Yet the case in their favour is compelling.

While the need to reform pay arrangements is now widely accepted, many believe that such reforms should be left to corporate boards and that government intervention should be limited to ensuring the adequacy of corporate governance processes. The Basel committee on Banking Supervision has urged boards to be closely involved in pay-setting; and the bill passed on Friday mandates “say on pay” shareholder votes and bolsters the independence of compensation committees. Would improvements in governance obviate the need for regulating pay structures? Not at all.

Outside the financial sector, government intervention should indeed be limited to improving internal governance, leaving choices over pay structures to shareholders and the directors elected by them. But financial institutions are special, and their special circumstances warrant a broader role for government.

Regulation of pay in financial institutions is justified by the very same moral hazard concerns that provide the basis for existing regulation of the sector. Because the failure of such companies imposes costs on taxpayers that shareholders do not internalise, shareholders’ interests are served by more risk-taking than is socially desirable. For this reason, financial institutions have long been constrained by a substantial body of rules that restrict private choices with respect to loans, investments and capital reserves.

Shareholders’ interest in more risk-taking implies that they could benefit from providing executives with excessive incentives in this direction. Executives with such incentives can use their informational advantages, and whatever discretion they have been left by existing regulations, to increase risks. Regulation of pay structures is a way to counter this. It would make the executives of financial companies work for, not against, the goals of financial regulation.

Opponents of such regulation will argue that the government does not have a legitimate interest in telling shareholders how to spend their money. But it does. Given the government’s interest in financial companies’ stability, intervention in pay structures is as legitimate as the traditional forms of financial regulation.

Opponents may also argue that regulators are at an informational disadvantage when assessing pay arrangements. Yet more informed players inside financial companies lack incentives to internalise the interests of depositors and taxpayers when setting pay structures. Furthermore, limiting structures that incentivise risk-taking is not more demanding in terms of information than regulators’ traditional intervention in investment, lending and capital decisions.

In addition, opponents may argue that pay regulation will drive talent away. But the proposed rules would apply to pay structures and not total compensation, which financial institutions would be free to set at the levels necessary to retain employees.

The regulation of pay structures is considered against the background of news that compensation in the financial sector is returning to the lofty levels of before the crisis. It is thus worth stressing that, while the regulations under consideration would address concerns about incentives, they would not, nor are they intended to, address concerns about overall compensation amounts. Their goal is to promote the safety and soundness of the financial system, not to address shareholder concerns about excessive levels of pay. In the US, such concerns would be best addressed by supplementing the mandated “say on pay” votes with a substantial strengthening of shareholder rights.

Regulating compensation structures should become a critical instrument in financial regulators’ toolkits. It would help prevent in the future the excessive risk-taking that contributed to the current crisis.

Why Do Sellers (Usually) Prefer Auctions?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, August 3, 2009
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This post comes to us from Jeremy Bulow of the Graduate School of Business, Stanford University, and Paul Klemperer of Nuffield College, University of Oxford.

In our paper Why Do Sellers (Usually) Prefer Auctions?, which was recently accepted for publication in the American Economic Review, we focus on comparing the two dominant methods for selling public companies – a simple “plain vanilla” simultaneous auction and an equally simple model of a sequential sales mechanism – when the seller has realistically-limited power and information. (Similar alternative ways of selling are observed for many other assets.) In both processes we model, an unknown number of potential bidders make entry decisions sequentially, before learning their values. In an auction, no credible bidding is possible until all entry decisions have been taken. In a sequential mechanism, potential bidders arrive in turn. Each one observes the current price and bidding history and decides whether to pay the entry cost to learn its value. If it does, and if it succeeds in outbidding any current incumbent (who can respond by raising its own bid), it can also make any additional “jump bid” it wishes to attempt to deter further entry. In both processes, we assume the seller does not have the power or credibility to commit to a take-it-or-leave-it minimum (reservation) price above a buyer’s minimum possible value.

Our central result is that the straightforward, level-playing-field competition that an auction creates is usually more profitable for a seller than a sequential process, even though the sequential mechanism is always more efficient in expectation (as measured by the winner’s expected value less expected aggregate entry costs). Bidders, by contrast, usually prefer to subvert an auction by making pre-emptive “jump bids” when they can. The sequential process is more efficient because although it attracts fewer bidders in expectation, it attracts more bidders when those bidders are most valuable – the existence or absence of early bids informs subsequent entry decisions and attracts additional bidders when the early ones turn out to be weak. But buyers’ ability to make pre-emptive jump bids, which inefficiently deter too many potential rivals from entering, harms the seller.

We identify several factors that may cause the expected revenue between the auction and the sequential mechanism to differ. First, even in the most favorable circumstances, a sequential process could only be superior if the queue of potential bidders is sufficiently longer than the number that would compete in an auction. Second, in a sequential mechanism bidders who deter entry choose a price where the expected distribution of winning values is such that an additional entrant would expect to earn zero. These two factors would be nullified with an infinite stream of potential bidders, and when parameters are such that the expected profits of the marginal bidder who does not enter the auction is exactly zero. The third factor is therefore crucial: the value of the winning bidder is generally less dispersed in the sequential process, because that process is more likely to attract one high-value bidder but will never attract more than one. But entrants prefer more dispersion in the value they have to beat, because dispersion makes the entrant’s option to buy more valuable. Therefore, the expected value of the top bidder in the auction must be higher than in the sequential mechanism to deter entry.

Thus, contrary to our usual instinct that auctions are profitable because they are efficient, it is precisely the inefficiency of the auction – that entry into it is relatively ill-informed and therefore leads to a more random outcome – that makes it more profitable for the seller.

The full paper is available for download here.

The Regulatory Reform Marathon

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Sunday, August 2, 2009
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This post is based on a client memo by Randall Guynn, Arthur Long, Annette Nazareth, Margaret Tahyar, Robert Colby, Courtenay Myers and Reena Agrawal Sahni of Davis Polk & Wardwell LLP.

The Obama Administration is currently on the legislative leg of the regulatory reform marathon that began earlier this year with the release of its Rules of the Road and continued with its White Paper on Financial Regulatory Reform. The Obama Administration released last week its legislative text to implement many elements of the White Paper. Overall, the Administration’s proposed legislation hews closely to the White Paper, though it provides important details in a number of areas where the White Paper was more general. The proposal would expand the Federal Reserve’s powers to include those of a systemic risk regulator, and create a new interagency Financial Services Oversight Council to assist the Federal Reserve in its new mission.

No sooner had the proposed legislation been released, however, than critics began to pull apart the proposals in commentary and through counterproposals. FDIC Chairman Sheila Bair criticized aspects of the proposal to appoint the Federal Reserve as systemic risk regulator, and SEC Chairman Mary Schapiro argued that a council of federal regulators, on which the SEC would have a seat, should have enhanced authority. The House Republicans proposed their own regulatory reform legislation, which contained a number of alternative proposals, including to limit the Federal Reserve’s authority to overseeing monetary policy, to transfer all of the Federal Reserve’s current regulatory authority to a new financial institutions regulator, and to fundamentally reform Fannie Mae and Freddie Mac. House Financial Services Committee Chairman Barney Frank argued that the federal thrift charter should not be abolished, even if the OTS were merged into the OCC in the form of a new national bank supervisor.

This memorandum, The Regulatory Reform Marathon, available here, builds on the analysis in our memorandum on the White Paper, A New Foundation for Financial Regulation?, by discussing the Obama Administration’s proposed legislation and the Republican counterproposal. Specifically, the memorandum discusses the Administration’s proposals for managing systemic risk, including the revised proposal for resolution authority and the proposal to designate certain large, systemically important financial companies as Tier 1 FHCs, subject to enhanced supervision and regulation by the Federal Reserve. The memorandum also discusses the Administration’s proposal to merge the OTS and the OCC, to eliminate the thrift charter, and to expand interstate branching; to expand bank and bank holding company regulation to include holding companies of insured depository institutions that have not otherwise been regulated as bank holding companies; and to enhance standards applicable to, and restrictions on, banks and bank holding companies. The memorandum also contextualizes other proposed regulatory enhancements, including the Administration’s proposal to give the Federal Reserve additional authority over payment, clearing and settlement systems and activities; the proposed reform of the asset-backed securitization markets; and the proposal to create an Office of National Insurance within the Treasury Department.

SEC pursues unprecedented Sarbanes-Oxley “Clawback”

Posted by John F. Savarese, Wachtell, Lipton, Rosen & Katz, on
Saturday, August 1, 2009
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This post is by John F. Savarese of Wachtell, Lipton, Rosen & Katz. It was written together with his colleague Wayne M. Carlin.

In a recently filed case, the SEC is for the first time seeking to “claw back” incentive-based compensation from a former CEO who is not accused of any wrongdoing. The case is emblematic of the new aggressiveness of the SEC’s enforcement program, and is an unfortunate contribution to the overheated atmosphere surrounding executive compensation generally.

The SEC is seeking a court order directing Maynard L. Jenkins, the former CEO of CSK Auto Corporation, to pay back to CSK over $4 million in bonuses and stock sale proceeds that Jenkins received during a period for which CSK’s financial statements were later restated. SEC v. Jenkins, No. CV 09-1510-PHX-JWS (D. Ariz. July 22, 2009). Earlier this year, the SEC brought a settled fraud case against CSK and a separate case charging four former CSK executives with fraud and other violations, all relating to the accounting practices from 2002 to 2004 that led to CSK’s restatement. The SEC has not charged Jenkins – either in the earlier enforcement actions against the company and other executives, or in the new clawback proceeding – with any involvement in or knowledge of accounting improprieties, or any other wrongdoing.

Section 304 of the Sarbanes-Oxley Act requires a CEO or CFO to return incentive-based compensation to an issuer in the event of a financial restatement that occurs “as a result of misconduct . . . .” The statute is at best ambiguous as to whether this obligation arises only where the “misconduct” has been committed by the CEO or CFO in question. As a result of that ambiguity, it has always been an open question whether the SEC would use this weapon against a CEO or CFO who did not personally engage in misconduct, and whether such an aggressive claim would be sustained in litigation.

The SEC’s decision to depart from its prior reasonable restraint in using Section 304 is a regrettable policy choice. Clearly, the SEC believes fraud occurred at CSK, but apparently can find no basis to assert that the CEO was culpable in it. The SEC has not even pursued any of the lesser charges that would be available against a blameworthy executive in these circumstances, such as a negligence-based administrative case. In these circumstances, it is difficult to discern what conduct by similarly situated CEOs the SEC may think this case will deter or encourage. It also remains to be seen whether a federal agency may constitutionally deprive a person who is not alleged to have violated any law of compensation that was lawfully received, particularly where the statute’s intended reach is ambiguous.

Finally, it is far from clear that the SEC’s policy choice in this case is well tailored to the goals of Section 304. Under Section 304, recovered compensation is paid back to “the issuer.” CSK, however, was sold in July 2008 and is now a wholly owned subsidiary of another company. The acquirer presumably paid what it thought CSK was worth one year ago, and the shareholders of CSK received that consideration at that time. The SEC now seeks to recover $4 million from a CEO that it cannot accuse of wrongdoing, in order to pay that money over to a company that was not harmed.

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