CLAW BACKS CLAWING THEIR WAY TO PROMINENCE

By G. A. FINCH

What are we to make of the recent spate of claw-back headlines?

Barclays Bank intends to claw back shares from its former Chief Executive Officer Robert Diamond for the LIBOR rate-fixing scandal

J.P. Morgan Chase has revealed it intends to claw back compensation from its Chief Investment Officer Ina Drew, the trader Bruno Iksil, and others for the $5 billion “whale trading” fiasco.

The defunct “Big Law” firm of Dewey & LeBoeuf LLP, now in bankruptcy, has tendered to over 700 of its former partners a claw-back settlement demand or they will face certain tortuous litigation.

These claw backs aim to retrieve compensation already received by these respective executives and law partners.

As I indicated in a previous blog post, a claw back provision, under certain conditions, permits a company to demand repayment of compensation previously paid to executives.  Those conditions usually involve compensation paid to executives based on performance measures or factual circumstances that turn out to be inaccurate, false, or fraudulent.  It can be based on statute or by contract.

The claw back in the Dewey situation involves the  legal principle of “insider preference” which disallows a transfer of property by a bankruptcy debtor  (like Dewey) to an insider (like one of its  partners) to the disadvantage of another unsecured creditor.

In  Dewey’s case, the  firm’s bankruptcy estate is offering the deal to gain cash to pay down its debt in exchange for the ex-partners’ release from liability.  The alternative is having personal liability for the law firm’s debt and being pursued by its unsecured creditors.

By statute and contract our free market economies attempt to regulate or bind executives to uphold and adhere to legal and moral conduct.

Can we legislate ethics or contract for morality?  The Ten Commandments is a combination of law and covenant to do the right thing.  We also have claw-back laws on the books like the Sarbanes –Oxley Act of 2002 and the U.S. Bankruptcy Code, and in the case of not-for-profits, state not-for-profit corporation laws and common law.

A person’s reputation takes years to build and only a minute to be destroyed by some real or perceived illegal or immoral act.  Executives must be vigilant about their ethics and business choices.

The public, whether they are the residents of Main Street America, the self-described 99 per centers, or good corporate governance types, really is fed up with reckless, risky corporate financial behavior and outsized compensation packages that bear little relation to performance by the executives receiving them.  Greed is not good.  For executives, ethical behavior is always the right thing to do personally, organizationally, and globally.

Claw-back mechanisms are necessary to do justice and to reassure the public that fairness, honesty and proportionality will be promoted and protected.  We are still in uncertain, unstable economic times and there is much economic hardship.  Such conditions make ripe the seeds of class warfare that always underlie the surface of a capitalist economy.  I love capitalism and there is no better system; however, it cannot be unbridled and must be tempered with appropriate controls like statutory and contractual claw-back provisions.

As for the headlines, I say bravo for the increased use of legitimate claw-back mechanisms.

INDEMNIFICATION AND D & O INSURANCE IN EMPLOYMENT CONTRACTS

By G. A. Finch

Indemnification By Employer

In my law practice covering executive employment contracts, I see too infrequently a provision requiring an employer to indemnify an executive for any costs, expenses, liabilities, and losses incurred by the executive in the performance of his duties with the company.  Usually, the indemnification arises in the context of litigation costs.  It should apply to any kind of claim or proceeding including an action, law suit, arbitration, investigation, or administrative proceeding.  It should also apply to both civil and criminal actions, investigation, and proceedings.

The costs, expenses, liabilities and losses should include, but not be limited to, reasonable attorneys’ fees, judgments, interest, expenses of investigation, fines, excise taxes or penalties and amounts paid or to be paid by executive in any settlement.

A well drafted indemnification provision will require the employer to advance to the Executive all his costs and expenses concerning a claim or proceeding.

An indemnification provision may have qualifying language that, as a precondition for indemnification, the Executive must be properly performing his obligations in good faith.

Claw Black of Indemnification Payments

Some indemnification provisions will have a mechanism allowing the employer to claw back the amounts advanced to an Executive if a determination has been made that the Executive was not entitled to indemnification for the subject costs and expenses.

The most comprehensive indemnification provision I have seen used reads as follows: “Employee shall be held harmless and fully indemnified by Employer to the fullest extent permitted by [State X] law without qualification or limitation.”

A companion provision that would be prudent for the Executive to include in his employment agreement is that the employer be required to keep in place directors and officers’ liability insurance coverage for the Executive during his employment with the employer and for four years afterward.

Executives get investigated, prosecuted, and sued all the time.  An Executive’s having indemnification and insurance provisions will offer the Executive some peace of mind.

Indemnification By Employee  

Employers sometimes require an Executive to indemnify the Company.

One kind of Executive’s obligation to indemnify  involves the Executive’s indemnifying, defending, and holding his company harmless from any uninsured portion of any claim, loss or expense arising from any action by the Executive that contravenes the rules and policies of the company, any applicable laws or that arise from intentional misconduct by the Executive.

New Employer’s Protection from Old Employer’s Restrictive Covenants

Another kind of Executive’s obligation to indemnify involves the Executive warranting that Executive is not under any legal or contractual obligations that contravenes the new employer’s employment agreement and execution of the employment agreement will not breach any other agreement by the Executive.  If there is such a breach, then the Executive must indemnify the new employer and must hold the new employer harmless from and against any and all loss, damage, and expense emanating from the claim against the Executive or the new employer arising from Executive’s relationship with his previous employer.  The breaches would typically involve non-compete provisions, non-solicitation provisions, and confidentiality provisions.

Employers must protect themselves from new employees who know they have valid legal obligations to previous employers like confidentiality agreements. One additional way to protect themselves is for the employers to require the prospective employee to provide copies of all employment and separation agreements containing restrictive covenants like non-compete, non-solicitation, and confidential information.

Employers should also be able to be made whole from the bad conduct of their employees giving rise to uninsured liability.

The scope and kind of indemnification by an employee must be appropriately negotiated by each side.  Obviously indemnification amounts can be quite burdensome and even financially catastrophic for an employee.

CLAW BACK: SEC STYLE

In an earlier blog post, we have discussed the Securities Exchange Commission’s (SEC) power to claw back compensation paid to executives by their companies under certain circumstances. The statutory basis of the claw back power against perceived wayward  executives is Section 304 of the Sarbanes-Oxley Act of 2002 (SOX).   We noted in that post that SOX made CEOs and CFOs of companies that are subject to any securities laws financial reporting requirements, liable for repayment of compensation or profits received based on financial misstatements that necessitated an accounting restatement.

Expanding Use of Claw Back

On August 30, 2011, the SEC announced its settlement with the former CFO of Beazer Homes USA, an Atlanta-based  homebuilding company.  Although the SEC did not personally charge the CFO with misconduct, the SEC is forcing him to reimburse his former company over $1.4 million in compensation that he received arising from fraudulent financial statements.  SEC Atlanta  Regional Director Rhea Kemble Dignam commented “O’Leary received substantial incentive compensation and stock sale profits while [the Beazer company] was misleading investors and fraudulently overstating its income.”

Abscence of Charge Not Enough

The CFO was vulnerable to the claw back even though it was the company’s chief accounting officer that was actually charged with
perpetrating the fraudulent overstatement of the company’s income.  The SEC stated in its press release:

“Section 304 requires reimbursement by some senior corporate executives of certain compensation and stock sale profits received while their companies were in material non-compliance with financial reporting requirements due to misconduct … [including] an individual who has not been personally charged with underlying misconduct or alleged to have otherwise violated the federal securities laws.”

Trust But Verify

What is the lesson to be learned from this case?  CEOs and CFOs must be ever vigilant in ensuring that the financial statements of their companies are not misleading or fraudulently prepared by employees.  They must treat their accounting employees, as President Ronald Reagan treated the Russians in  his nuclear missiles treaty: “Trust but verify.”  Even when they may not be personally charged  with wrongdoing, the SEC may hold still hold them personally responsible and   require them to disgorge their compensation.  Who said life was fair?

CREDITORS’ SEEK TO CLAW BACK COMPENSATION FROM FORMER TRIBUNE EXECUTIVES

The Chicago Tribune became its own story to report. The 12 December 2010 Sunday edition of the Chicago Tribune newspaper dramatically reported that the Official Committee of Unsecured Creditors in the Tribune Company’s Chapter 11 bankruptcy case in Delaware now seeks to claw back from approximately 200 employees.   The claw back amounts to around $180 million in compensation paid to the emloyees.

As the term suggests, “claw back” means getting money returned that was previously paid out.  It can be based on statute or by contract.

The creditors seek to tag former Tribune Co. Chairman and CEO Dennis FitzSimons for $28.7 million.  Former Chicago Tribune and Los Angeles Times Publisher David Hiller has $15.4 million at risk.  Other former top and lower echelon Tribune Co. executives face similar risk of loss of fortune.

The Committee of Unsecured Creditors is pressing its case utilizing the bankruptcy legal principle of “insider preference” which disallows a transfer of property by a bankruptcy debtor to an insider more than 90 days prior but within one year after the filing of the petition for bankruptcy.  Executives, managers, and employees are “insiders.”  The idea is not to allow a debtor (in this case the Tribune Co.) to arbitrarily and unfairly give priority in payment to one creditor like an officer,  director, relative, general partner, managing agent, and so forth to the disadvantage of another unsecured creditor like a  trade creditor.   The U.S. Bankruptcy Code aims to ensure equitable treatment for all creditors.

The compensation payments in question resulted from the December 2007 leverage buyout that converted the Tribune Co.  into a private company.  The closing of that deal necessitated cash payments for accumulated restricted stock, deferred compensation, success bonuses, transition pay, phantom equity, and severance benefits.

This is not a pretty picture.  Many junior executives and lower ranking managers have been caught in this litigation net.  They were not involved in the deal making for the ill-fated leveraged buyout.  Their compensation was legitimately earned over the years, but the timing of their payouts was unfortunate.  Much of the money may have been spent.

How does an executive protect himself in this situation?  If he has any inkling that his company may go bankrupt, he should set aside the money  and consult a bankruptcy attorney as to how long his risk is for a claw back from creditors under the bankruptcy code then  in current effect.  The bankruptcy code does change from time to time, and so consultation with a bankruptcy attorney is a smart thing to do.

$43 MILLION IN BONUSES APPROVED FOR TRIBUNE EXECUTIVES

 

The financially troubled Tribune Company had asked a federal bankruptcy court in Delaware to permit the company to give bonuses to a group of high level executives for 2010.  The court approved the bonuses yesterday. The requested bonus amounts to $43 million, if the company reaches an operating cash flow target of at least $685 million.  Since last summer the U.S. Trustee in the bankruptcy proceeding has objected to the Tribune’s filing. Creditors and unions feel that the company doesn’t “get it,” that is, the company is finding money for its executives while union members and lenders take financial hits.  Naturally, the company makes the argument that it needs to incentivize its employees and that its bonus proposals are reasonable.

According to news accounts, the company has agreed to claw back bonus payments made to certain executives who breached their fiduciary duties or otherwise perpetrated wrongs in effecting the 2007 leveraged buyout of the company.  The claw back in this instance is a good thing.

However, what’s wrong with most of this picture?  The optics are terrible.  With the economy moving sideways and the unemployment rate remaining stubbornly high, now is not the time to highly compensate executives of a failed company seeking to reorganize.  In the present economic climate and executive labor market, I do not buy the argument that the company needs generous bonuses to keep its present talent.  Frankly, the present talent should be grateful to be employed.  To borrow a phrase from the first Bill Clinton presidential election, “It’s the economy, stupid!”  Look no further than last week’s midterm elections to see and hear the angst of Eddie Everyman, who voted against the Democrats for their perceived failure to address job creation among other economic worries.

Under ordinary economic circumstances, I am certainly not one to question a company’s judgment or right to provide appropriate compensation to attract and retain talent.  In fact, all things being equal, I advocate it, as I am an unrepentant capitalist.  I certainly do not favor our federal government dictating how much private companies can compensate their executive when those private companies  are not being bailed out by taxpayer dollars  –  let the executive labor market and the board of directors make that determination.

I do, however, think it is absurd from a public relations point of view and an equitable point of view (a bankruptcy court is a court of equity) that  the Tribune Company, while pursuing the benefits of a reorganization under bankruptcy, also seeks to give financial preference to its executives to the detriment of its creditors and unions.

My two cents worth:  In these extraordinary times, the Tribune executives should tighten their belts and make sacrifices like most everyone else.