Corporate Governance

Hampshire Group, Limited v. Kuttner: A Tee Hee Analysis (The Case for A Private Right of Action for Clawbacks)

By J Robert Brown Jr.

In the discussion of the remedy, the company sought a return of the bonuses paid in the year the company restated its financial statements.  The opinion referenced SOX and the clawback provision (which has been amended in Dodd-Frank).  The court had this to say:

• In Sarbanes-Oxley, Congress crafted a provision that requires public company CEOs and CFOs to disgorge bonuses if there is a restatement because of material noncompliance. That provision does not create a private right of action and [the company] cannot rely upon it here, even as to Clayton, who as CFO, was subject to the statute.

The Vice Chancellor considered whether to use equity to order repayment of the bonuses.  Distinguishing an earlier case where he did exactly that, the Vice Chancellor noted:

• I do not find HealthSouth to be controlling here for a few reasons. That case dealt with a situation where it was clear that senior corporate officers had taken action to purposely inflate the corporation's GAAP earnings by a material amount and to thereby artificially lift its stock price. In that context, when the CEO of the corporation causes the company to enter into a transaction with himself using the market price as the litmus test for fairness and the market price is fundamentally tainted, it is far easier to see a gross injustice than in the circumstances here. When the underlying accounting misconduct is designed to pump up the corporation's stock price, there is an obvious danger that equity should address that officers and employees have cooked the books in part to increase the amount of their own bonuses and compensation.

In other words, bonuses would be repaid only by the actual wrongdoers and, even then, only where the wrongdoing was part of a scheme designed to "pump up" the company's stock.  To do otherwise, would "create a strict liability rule in equity that could be counterproductive for stockholders and erode some of the important values served by the business judgment rule."

The court did allow for the recapture of some portion of the bonuses due to a memorandum submitted by the company to employees providing that there could be clawbacks in the case of financial restatements.  The opinion editorialized on the perceived value of such a provision in a contract. 

• In this regard, it is worth noting that the [CEO] policy, although from an ironic source, is a good example of the company-specific flexibility that corporations retain to create more healthy incentives for employees to be scrupulous in complying with their financial reporting and legal obligations. By subjecting the receipt of bonuses to a clawback condition, employers can create an incentive for compliance, but also shape the way they do it and the employees to whom the policy should apply in a way that is contextually appropriate. To fashion a blanket rule of equity that any incentive compensation should be stripped automatically from any employee involved in financial reporting for periods for which a restatement was filed would preclude such private ordering, and substitute a judicial judgment for the business judgment investors bargain for.

Private ordering is an old saw when nothing else is available.  As we have noted, private ordering is often a synonym for a categorical rule determined by management.  See Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.  Nor is there any evidence that private ordering in this context will be any more likely to create an "incentive for compliance" than a categorical rule.

But mostly the position has been emphatically rejected at the federal level.  In the aftermath of Dodd-Frank, Section 10D of the Exchange Act is categorical, applies to "any current or former executive officer," whether or not responsible for the error that resulted in the restatement, and applies for three years from the period  affected by the restatement.  In short, this creates the very kind of liability that the Vice Chancellor viewed as "counterproductive for stockholders" and that will "erode some of the important values served by the business judgment rule." 

The Vice Chancellor is correct that there is no private right of action for violations of Section 10D.  Given the unwillingness of this court to apply something similar under a fiduciary duty theory, perhaps a private right of action ought to go on the list the next time the federal preemption issue arises. 

The opinion in Hampshire Group Limited v. Kuttner is posted on the DU Corporate Governance web site. 

Full post as published by The Race to the Bottom on August 12, 2010 (boomark / email).