In the recent administrative proceeding In the Matter of Computer Sciences Corp., et al. (3-16575), the SEC alleged that Computer Sciences Corp. (CSC) engaged in accounting and disclosure fraud by concealing major problems with the company’s multibillion-dollar contract with United Kingdom's National Health Service (NHS). In a settlement announced June 5, 2015, the SEC found that CSC's former CEO, Michael Laphen, approved the use of CSC's improper models for CSC's contract with NHS and made misleading statements to investors regarding the NHS contract and CSC's financial performance. Pursuant to the settlement, Laphen agreed to return more than $3.7 million in incentives and bonus compensation to CSC and to pay a $750,000 penalty.

As cases such as this illustrate, the SEC continues to be interested in pursuing CEOs and CFOs pursuant to Sarbanes-Oxley Section 304 to claw back incentive-based compensation when a company's financial statements are restated. The SEC has pursued a number of well-publicized clawback cases under Section 304 even when the CEO or CFO did not personally commit intentional or reckless misconduct resulting in restated financials. However, under Section 304 only the SEC, and not companies or their shareholders, may pursue recovery of incentive-based compensation.

On July 1, 2015, the SEC issued proposed Rule 10D-1 to implement the Dodd-Frank requirement that listed companies adopt a policy to recover (claw back) erroneously awarded compensation. The required policy would obligate the issuer to "claw back" unearned portions of incentive-based compensation paid to executive officers following a restatement of a company's financial statements. Under the proposed rules, executives would have to pay back incentive-based compensation received in the three fiscal years prior to the restatement that would not have received had the company's financial information been accurately reported in the original financial statement(s). Unlike Sarbanes-Oxley, the Dodd-Frank mandate adopts a "no-fault" standard, in which executive officers must reimburse unearned incentive-based compensation regardless of whether the company or any individual committed misconduct.

When finalized, new Rule 10D-1 will require national securities exchanges and associations to adopt listing standards that require listed companies to adopt clawback policies that comply with Rule 10D-1. Should a company fail to adopt a compliant clawback policy, fail to disclose its policy as required by the proposed rules or fail to comply with its adopted policy, the company would be subject to delisting. The proposed rules are not likely to go into effect until sometime in 2016 at the earliest. In the interim, issuers will be well-served to review and perhaps modify existing clawback policies so as to put current executive officers on notice of the impending rules.

Some of the key aspects of proposed Rule 10D-1 are:

• The company's executive officers, defined in Rule 10D-1 to be the Section 16 officers (those who file Form 4s), are subject to this clawback policy.
• The mandatory recovery of excess incentive-based compensation is based on a "no-fault" standard, meaning that recovery is required regardless of the executive officer's responsibility for the accounting errors. Further, issuers cannot indemnify executives for any clawback amounts and are prohibited from paying any portion of insurance premiums for policies that cover clawback amounts.
• The proposed rules define incentive-based compensation as compensation that is granted, earned or vested in whole or in part based on (a) any measures that are determined and presented in accordance with the accounting principles used in preparing the company's financial statements, (b) the company's stock price or (c) the company's total shareholder return. While companies may use a reasonable estimate of the amount to be recovered when dealing with clawbacks of incentive-based compensation based on stock price or total shareholder return, estimating such amounts will be difficult and likely be second-guessed. This provision is certain to be subject to significant comment.

The proposed rules also contain two exceptions to mandatory clawback of incentive-based compensation. First, the company's board of directors has the discretion to decline to pursue a clawback against an executive officer if the board determines that the cost of pursuing the clawback will exceed the amount it would likely recover. In addition, the board would not be required to pursue a clawback when the laws of its home country would prohibit it from doing so. Interestingly, the proposal does not reference state wage payment laws as permitted exceptions to recovery. Several commentators have identified state laws as potentially problematic.

Although these new rules are a long way from being finalized, they will heighten the importance of correctly reporting financial information the first time. Moreover new Rule 10D-1 will place greater scrutiny on the internal review issuers follow when an accounting error is discovered, as well as the decision as to whether a restatement is necessary.

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