Employee Benefits & Executive Compensation Blog

The View from Proskauer on Developments in the World of Employee Benefits, Executive Compensation & ERISA Litigation

Final SEC Clawback Rules: Key Dates that Issuers Need to Know

On November 28, 2022, the Securities and Exchange Commission (the “SEC”) published the final clawback rules (the “Final Rules”) under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in the Federal Register.

Now that the Final Rules have been published in the Federal Register, issuers should be aware of the following key deadlines[1]:

  • January 27, 2023: The Final Rules become formally effective (60 days after the Final Rules were published in the Federal Register).
  • February 24, 2023: Outside date for national securities exchanges (“exchanges”) to file proposed listing standards that comply with the Final Rules (this is the last business day before the 90th day post-publication window closes on February 26, 2023).
  • November 28, 2023: Outside date for the exchanges’ listing standards to become effective.
    • On the date that exchanges’ listing standards become effective all incentive-based compensation “received” (as defined in the Final Rules) by executive officers on or after this date must be subject to a compliant clawback policy.
    • Disclosures required by Final Rules must be included in all applicable SEC filings required on or after this date.
  • 60 days after listing standards become effective (latest date: January 27, 2024): Outside date for issuers to adopt compliant clawback policy.

The Final Rules were adopted on October 26, 2022, and we discuss the detailed requirements of the Final Rules and related practical considerations in our earlier blog post. We also discuss the interaction of the Final Rules and the DOJ clawback guidance in this blog post and this Law360 Article.

Proskauer’s Employee Benefits and Executive Compensation team is advising issuers on implementation of new clawback policies and updating existing clawback policies to comply with the listing standards as they are finalized. Please contact a member of the team with questions.

[1]  Please note that some of the date references are to “outside” dates (i.e. the latest possible date) and the timetable could be accelerated depending on exactly when the exchanges and SEC take action, so issuers should continue to monitor developments.

IRS Opens Determination Letter Program to Individually Designed 403(b) Plans

On October 21st, the IRS announced changes to its qualified plan determination letter program. Most notably, the program has been expanded to include section 403(b) tax-sheltered annuity plans (“403(b) plans”). Although 403(b) plans are similar to tax-qualified defined contribution plans (“401(a) plans”), they are subject to unique rules, and, until now, the IRS has not offered a determination letter program for individually designed 403(b) plans.  While not the focus of this blog post, the IRS also harmonized and extended certain “remedial amendment periods” across individually designed 401(a) and 403(b) plans and updated and restructured certain related definitions.

Why Get a Determination Letter?

Like 401(a) plans, 403(b) plans must satisfy detailed requirements in both form and operation.  A failure to comply with either the form requirements or the operational requirements would result in loss of favorable tax treatment—which means that tax-deferred account balances under the 403(b) plan would be subject to immediate income tax, as well as interest and potential penalties.  The determination letter program provides important protection against this untenable result.  Under the program, the IRS reviews the plan document and decides whether the form requirements are satisfied.  (The IRS does not review operations under the program.)  If the determination is favorable, the IRS is generally precluded from subsequently disqualifying the plan based on a form violation or for administering the plan in accordance with the terms of the approved document.

Given the myriad technical requirements for a plan document, the benefit of an IRS determination cannot be understated.  Word of caution, though: the IRS reserves the right to impose sanctions (penalties) if it discovers a violation during the determination process.  Plan sponsors should review the plan documents carefully before requesting the determination; errors that are identified before submission can be corrected under the IRS’s Voluntary Correction Program.

Details of the Determination Letter Program Expansion to 403(b) Plans (Rev. Proc. 2022-40)

As noted above, the IRS has expanded the determination letter program to include 403(b) plans. To protect against the IRS being overwhelmed, the window to request a determination is limited:

  • Plan sponsors can apply only for an initial determination, a determination following a plan merger, or a determination upon the termination of a 403(b) plan.
  • Generally, an initial determination is permitted only for plans that have not received a determination as an individually designed plan, and sponsors may apply on a rolling basis based on their employer identification number (“EIN”). For plans sponsored by employers with EINs that end in 1, 2, or 3, applications may be submitted on or after June 1, 2023; for plans sponsored by employers with EINs that end in 4, 5, or 6, applications may be submitted on or after June 1, 2024; and for plans sponsored by employers with EINs that end in 7, 8, 9, or 0, applications may be submitted on or after June 1, 2025. The Revenue Procedure does specify a deadline for applying.
  • Plan sponsors may also seek a determination letter following a plan merger. As with 401(a) plans, the plan merger would need to occur by the end of the first plan year after the applicable corporate merger, acquisition, or other similar business transaction, and the determination letter application must be filed by the end of the first plan year that starts after the plan merger.

Rev. Proc. 2022-40 also includes caveats regarding limitations on the scope of IRS review and the purposes for which a plan sponsor may rely on the determination letter, which are similar to those that apply to 401(a) plans.  The guidance also says that the IRS will not express an opinion on any issues arising from a plan’s coverage of employees outside the sponsor’s controlled group (i.e., the determination will not cover issues related to being a multiple employer plan). As with other determination letter applications, plan sponsors will need to furnish notices to interested parties during the 10-24 day period before a determination request is filed.

In announcing Rev. Proc. 2022-40, the IRS also said to expect more changes to the general determination letter program procedures in 2023.

Proskauer Prospective

This announcement is a significant and welcome development for 403(b) plan sponsors. Given the myriad technical form requirements for a plan, there is always a risk that an IRS audit might reveal a latent, but disqualifying, error in the plan document.  The determination letter program offers important protection against that risk.

In addition to the protection against audit risk, the market may begin to expect that a 403(b) plan has a favorable determination letter. While determination letters are not technically required, auditors, investment managers, and transaction partners often request favorable determination letters as part of their diligence process.  Not having one could put the sponsor in the difficult position of having to make representations about compliance without the benefit of assurance from the IRS.

ERISA Fee Complaint Dismissed in Pennsylvania District Court, Extending Favorable Trend

In Krutchen v. Ricoh USA, No. 22-cv-678, 2022 U.S. Dist. LEXIS 206792 (E.D. Pa. Nov. 15, 2022), a Pennsylvania district court dismissed an ERISA excessive fee complaint for failing to provide enough information about alleged comparator plans that allegedly paid less for recordkeeping services. The decision is notable for delivering defendants a victory in the Third Circuit, which previously allowed excessive recordkeeping claims to survive dismissal in Sweda v. U. Pennsylvania (we discussed here), and for citing favorably to recent defendant-friendly opinions from the Sixth, Seventh, and Eighth Circuits.

Background

The plaintiffs in Krutchen are former employees of the plan sponsor defendant who participated in its 401(k) plan. The plaintiffs brought claims for breach of the fiduciary duty of prudence and failure to monitor in connection with their allegation that the plan paid excessive recordkeeping fees. In support of their claims, the plaintiffs compared the plan’s expenses to twelve other plans’ recordkeeping expenses, cited a survey of nationwide recordkeeping expenses, and cited case law addressing recordkeeping expenses of other plans.

The District Court’s Decision

The court dismissed plaintiffs’ claims in their entirety but permitted plaintiffs to refile their complaint. In its ruling, the court explained that fiduciaries may select diverse services from bundled offerings or additional a la carte services, as the plan did here. The court recognized that price tag to price tag comparisons without sufficient detail about the services actually being performed are too generalized and speculative to support a plausible inference that defendants breached their fiduciary duties by overpaying for services.

The court faulted plaintiffs for failing to include information regarding the specific services used by the plan, the comparator plans, and the plans reviewed in cited case law. The plaintiffs listed services that all national recordkeepers have the capability to provide and merely alleged that the plan’s selected services “fell within the broad range” of those available. The court found that this did not provide enough information to know whether the fee comparisons were valid or if they were “apples to oranges” comparisons. The court distinguished Sweda, where plaintiffs used “specific comparisons” showing that the “practices of similarly situated fiduciaries” differed from those of the allegedly imprudent plan. The court also found support for its analysis from out-of-circuit decisions in Albert v. Oshkosh Corp., 47 F.4th 570 (7th Cir. 2022) (discussed here); Smith v. CommonSpirit Health, 37 F.4th 1160 (6th Cir. 2022) (discussed here); and Matousek v. MidAmerican Energy Co., 51 F.4th 274 (8th Cir. 2022) (discussed here). Finally, because the duty to monitor claim was derivative of the breach of duty of prudence claim, it was also dismissed.

Proskauer’s Perspective

The decision is a positive development for plan sponsors because it shows that district courts outside of the Sixth, Seventh, and Eighth Circuits seem to be taking to requirements for alleging factual information sufficient to support the validity of comparisons between different plans. Notably, this is the second district court ruling in the Third Circuit in 2022 dismissing recordkeeping claims despite Sweda.

Magistrate Recommends 180° Course Correction on Previously Denied Motions to Dismiss In ERISA Fee Litigation Cases

In a pair of report and recommendations issued the same day, a Magistrate Judge in Wisconsin recently recommended that the district court (i) grant motions for reconsideration of prior denials of motions to dismiss claims challenging defined contribution plans’ fees, and (ii) grant the motions to dismiss in their entirety.  Underpinning the recommendations is the fact that after the motions to dismiss were denied, the Seventh Circuit decided Albert v. Oshkosh Corp., 47 F.4th 570 (7th Cir. Aug. 29, 2022), which we wrote about here, and which the Magistrate concluded warranted dismissal of the claims.  If the recommendations are adopted, these would be the third and fourth motions to dismiss granted in full, along with one that was granted in part, in the Seventh Circuit since Albert, representing a near 100% success rate for defendants since issuance of the decision.

Nohara v. Prevea Clinic, No. 2:20-cv-1079 (E.D. Wis. Oct. 27, 2022)

In Nohara, two participants in their company-offered 401(k) plan claimed that plan fiduciaries breached their duties of loyalty and prudence in connection with (i) excessive recordkeeping and administration fees and (ii) excessive investment management fees.  The excessive investment management fee claim had two components: first, the plan included actively managed funds with higher fees than index funds; second, the plan failed to offer the cheapest share classes available after accounting for potential revenue sharing.  They also made derivative claims for failure to monitor other fiduciaries.

In recommending dismissal of the recordkeeping and administration fee claim, the Magistrate found the claims materially identical to the claims dismissed in Albert.  Like in Albert, the plaintiffs failed to articulate why the plan’s recordkeeper fees were excessive relative to the services rendered, as they instead compared the plan’s fees to average recordkeeping costs of other, allegedly similarly-sized plans.

Next, the Magistrate concluded that as a matter of law plaintiffs’ “net cost” investment management fee claim failed in the wake of Albert.  The Magistrate explained that no court has required such a net cost analysis, and regardless, potential revenue sharing proceeds do not necessarily redound entirely to participants’ benefit.  And with respect to the allegedly high-cost investment options, the Magistrate stated that plaintiffs failed to provide meaningful benchmarks for comparison.  First, the challenged funds and comparators were offered by different providers, and the complaint provided no basis for the Magistrate to believe that the challenged funds and comparators were meaningfully similar.  Second, plaintiffs mostly compared high-cost actively managed funds to low-cost index funds, which are not meaningfully similar comparisons due to the differing investment strategies.

Glick v. Thedacare, No. 20-cv-1236 (E.D. Wis. Oct. 27, 2022)

Plaintiffs’ claims in Glick were similar to those in Nohara, including breach of the duties of loyalty and prudence in connection with excessive fees for (i) recordkeeping and administration, (ii) managed account services and (iii) investment management, as well as derivative monitoring claims.

In recommending the dismissal of all claims, the Magistrate stated that, under Albert, the failure to provide a meaningful benchmark doomed plaintiffs’ excessive fee claims.  Recordkeeping and investment management fees were disposed of mostly for the same reasons described in Nohara.  However, the report also addressed two types of fees that were not specifically at issue in Nohara nor Albert: stable value fund fees and managed account services fees.  Regarding the stable value fund challenge, the Magistrate extended Albert, finding that plaintiffs merely alleged that the comparator stable value fund was materially similar and less expensive than the challenged stable value fund, but failed to allege any details in support of the comparison.  Similarly, the challenge to managed account service fees did not specify the services offered by the plan or plaintiffs’ comparators, and failed to provide factual context about the comparisons, such as the respective plans’ number of participants or amount of assets. Therefore, as with other challenged fees, the Magistrate was unable to draw an inference that defendants engaged in an imprudent process when selecting the challenged funds and services.

Proskauer’s Perspective

The Nohara and Glick recommendations illustrate the influence of Albert in the Seventh Circuit.  If adopted, the recommendations will continue a trend favoring the dismissal of ERISA fee claims in the Seventh Circuit after Albert, which contrasts sharply with the mixed results beforehand.  Finally, Glick shows how Albert’s context-sensitive analysis of fees and comparators can be extended to fees that were not specifically at issue in Albert, thereby providing defendants a versatile tool in defending all types of fee complaints.

Long Time Coming: SEC Adopts Final Dodd-Frank Clawback Rules

Twelve years after the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and many years after the Securities and Exchange Commission started considering regulations implementing the clawback provisions of Dodd-Frank, the SEC published the Final “Clawback” Rules (the “Final Rules”) on October 26, 2022. The Final Rules task national securities exchanges (“exchanges”) with adopting formal listing standards that, in turn, require publicly listed companies to establish compensation clawback policies that meet the standards prescribed in the Final Rules.

As discussed below, the Final Rules impose (i) substantive standards for identifying and calculating “erroneously paid” incentive compensation subject to clawback and (ii) a series of procedural steps to be taken, and disclosures to be made, in implementing the new clawback regimen and protocols.

Effectiveness and Consequences of Non-Compliance.  The Final Rules will not actually go into effect until after exchanges update their listing standards. The timeline is as follows:

  • Exchanges must propose formal listing standards that comply with the Final Rules within 90 days after the Final Rules are published in the Federal Register (the “Publication Date”), which must then be approved by the SEC.
  • Formal listing standards must become effective within 12 months after the Publication Date.
  • Issuers will then have 60 days following SEC approval to adopt a compliant written clawback policy.

Any issuer that fails to comply with an exchange’s compensation recovery policy requirements will be subject to delisting.

Content of Clawback Policy. The written policy required by the exchanges’ formal listing standards must meet strict minimum requirements requiring the recovery of “erroneously awarded” incentive based compensation received by an executive officer:

  • triggered by issuer being required to prepare an accounting restatement due to material non-compliance by the issuer with any financial reporting requirement under the federal securities laws;
  • requires the issuer to recover the gross amount of “excess” incentive-based compensation (i.e., before reduction for withholding and other deductions);
  • covers incentive-based compensation received by current and former executive officers (regardless of whether the officer engaged in any misconduct and regardless of fault), within a three-year “recovery period.”

Restatement. The Final Rules require clawback both in the case of “Big R” Restatements and “little r” restatements. “Big R” Restatements correct errors that resulted in a material accounting misstatement in previously issued financials. On the other hand, “little r” restatements correct errors that are not material to previously issued financials but that would result in a material accounting misstatement if the error were left uncorrected in the current period or if the error correction was recognized in the current period (versus corrected for prior periods). An issuer must consider all relevant facts and circumstances (quantitative and qualitative) surrounding the error in order to assess materiality. Given the extensive reliance in the Final Rules on accounting terminology and methodology, the confirmation of a triggering restatement will require close coordination and review with the issuer’s accounting team and outside accountants.

Incentive-Based Compensation. Incentive-based compensation is defined as “any compensation” that is “granted, earned or vested” based in whole or in part upon the attainment of “financial reporting measures.” Measures count as “financial reporting measures” if they are determined in accordance with the accounting principles the issuer uses to prepare financial statements, including non-GAAP financial measures. Under the Final Rules, stock price and total shareholder return metrics are also deemed to be “financial reporting measures.”

Received. For purposes of the Final Rules, compensation is treated as “received” when the financial reporting measure is attained (even if payment is actually made at a later date). Compensation will be subject to the new rules only if (a) it is received after the recipient becomes a “covered individual” (as described below), and (b) the recipient served as a current or former executive officer at any point during the “recovery period” (discussed below).

Covered Individuals. The Final Rules cover current and former executive officers, which includes an issuer’s president, principal financial officer, principal accounting officer, vice president in charge of a principal business unit, division or function, and any other person who performs policymaking functions and otherwise is an executive officer within the meaning of the Section 16 definition of the Securities Exchange Act of 1934. Coverage (i) is tied to executive officer status at any time during the three-year “recovery period” (i.e., not based on status at the time of clawback or even at the time of the restatement) and (ii) does not require that the officer be “at fault” for accounting errors or be directly responsible for preparation of the accounting statements (i.e., it is a strict liability regime). Issuers are prohibited from indemnifying covered individuals from clawbacks, which affects issuers prospectively and retroactively to the extent existing indemnification agreements contain provisions that would be affected by this prohibition.

Recovery Period and Recovery Amount. The Final Rules define the applicable “recovery period” as the three years immediately preceding the earlier of: (i) the date that the issuer concluded or reasonably should have concluded that a restatement was required or (ii) the date that a court directs the issuer to file a restatement. The amount to be recovered is the excess of the erroneous compensation received versus that amount that would have been received had it been determined based on the restated metrics (computed on  pre-tax basis); in the case of incentive-based compensation based on stock price or total shareholder return, the recovery amount must be based on a “reasonable estimate” of the effect of the accounting restatement on stock price/shareholder return, with supporting documentation provided to the applicable exchange.

Reporting and Disclosure Requirements. The Final Rules establish a new set of reporting and disclosure requirements:

  • Issuers are required to file a copy of their written clawback policy as an exhibit to their Form 10-K, 20-F, 40-F or N-CSR.
  • Checkboxes must be included on any 10-K, 20-F or 40-F filed to indicate whether the filed financial statements are a correction to a previous error and whether the correction required an analysis to determine whether excess incentive-based compensation was received.
  • Issuers are also required to disclose when the clawback policy is applied. A specific disclosure and/or exhibit must also be made on the proxy statement, Form 10-K, 20-F or 40-F to report the information about the restatement and any potential excess incentive-based compensation payments.
  • Inline XBRL tagging is required for the cover page check boxes and data points in an issuer’s compensation clawback disclosure.

Very Limited Exclusions. The Final Rules have very limited safe harbors/exclusions. Notably:

  • No exclusion for EGCs, SRCs, FPIs, controlled companies or companies with only listed debt securities.
  • Compensation not considered “incentive-based compensation” for purposes of the Final Rules:
    • salaries;
    • purely discretionary bonuses;
    • compensation tied to subjective or strategic performance standards (i.e., event-based or operational metrics that are not financial);
    • purely time/service-based awards (e.g., purely time-based equity or equity-based awards, purely service-based retention awards).
  • Clawback is not required where the independent Compensation Committee (or if none exists a majority of independent directors on the Board) has determined that recovery would be “impracticable” and any of the following conditions are met: the direct enforcement expenses paid to a third party would exceed the amount to be recovered (after the issuer has made a reasonable and documented attempt to recover such amounts); where recovery would violate a home country law in effect prior to the Publication Date; or where compliance with the clawback policy would cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code. A decision not to claw back compensation is required to be disclosed and is subject to review by the exchange.

Looking Forward.  Issuers should work with counsel to determine how the Final Rules will affect their approach to incorporating clawback policies and the potential effect of clawback policies in compensation design, as well as related governance and other considerations. We will continue to publish more on this topic as exchanges propose listing standards and as there are further developments.

Proskauer’s Employee Benefits and Executive Compensation team is advising issuers on implementation of new clawback policies and updating existing clawback policies to comply with the listing standards as they are finalized. Please contact a member of the team with questions.

Notice 2022-41: IRS Expands Mid-Year Cafeteria Plan Change Opportunities to Address “Family Glitch”

Updated November 15, 2022

On October 11, 2022, the IRS and the Treasury Department released final regulations relating to premium tax credit eligibility for families, along with companion cafeteria plan guidance in Notice 2022-41.[1]  The final regulations are expected to extend eligibility for premium tax credits to some dependents who were previously ineligible for the credits.

As a result of this expansion, employees who previously elected family coverage under their employer’s health plan may want to change their elections mid-year to enroll in Marketplace coverage and take advantage of the premium tax credits for which family members are newly eligible.  They can do this in two ways: (1) Revoking the employee’s family coverage election so the employee and any family members may enroll in Marketplace coverage instead, or (2) revoking the employee’s family coverage election so the employee’s family members may enroll in Marketplace coverage (with the employee remaining covered under the employer-sponsored plan).

The problem is that under the cafeteria plan rules, the employee is not permitted to change his or her family coverage election mid-year so that the employee’s family members may enroll in a Marketplace plan.  This is where IRS Notice 2022-41 comes in.  The notice expands the cafeteria plan “change in status” rules to permit employees to do precisely that—to prospectively revoke family coverage elections so that family members may enroll instead in Marketplace coverage.  Starting January 1, 2023, a cafeteria plan may permit an employee to revoke prospectively an election for family coverage so that the employee’s family members can enroll in Marketplace coverage if:

  • One or more of the employee’s family members are eligible to enroll in Marketplace coverage during a special enrollment period or during Marketplace annual open enrollment, and
  • The revocation of the employee’s family coverage election corresponds with the intended enrollment of the family member in the Marketplace plan. If the employee does not also enroll in Marketplace coverage, the employee must elect self-only coverage (or family coverage including any already-covered family members) under the group health plan.

For those who think this all sounds awfully familiar—yes, back in 2014, the IRS released similar guidance in Notice 2014-55 that expanded the change in status rules to permit employees to revoke elections for job-based coverage to enroll in Marketplace coverage under certain circumstances.  However, Notice 2014-55 did not permit the revocation of an employee’s election for family coverage when the employee’s family members—and not the employee—become eligible to enroll in Marketplace coverage during a special enrollment period or Marketplace annual enrollment.  Notice 2022-41 fills in this gap.

Employer Action Items

Employers are not required to adopt these new permitted election changes.  Employers that wish to allow employees to make these coverage election changes will need to amend their cafeteria plans to do so.  The deadline to adopt the amendment is the last day of the plan year in which the new permitted election changes are allowed.  However, for plan years beginning in 2023, the employer has until the last day of the 2024 plan year to amend the plan.

[1] On November 9, 2022, the IRS released an updated version of Notice 2022-41, extending the notice to all cafeteria plans.  As originally issued, Notice 2022-41 was limited to non-calendar year cafeteria plans.

IRS Announces 2023 Increases to Qualified Retirement Plan Limits

On October 21st, the IRS released a number of additional inflation adjustments for 2023, including to certain limits for qualified retirement plans.  Perhaps most notably, the annual limit for pre-tax and Roth contributions by employees to 401(k) plans has jumped from $20,500 to $22,500, and the annual limit for “catch-up” contributions to such plans by employees who are age 50 or older has increased from $6,500 to $7,500.  The table below provides an overview of the key adjustments for qualified retirement plans.  Earlier last week, the IRS announced the 2023 inflation adjustments for Flexible Spending Accounts and transportation fringe benefits, as discussed here.

Qualified Defined Benefit Plans

2022

2023

Increase from 2022 to 2023

Annual Maximum Benefit

$245,000 $265,000

$20,000

Qualified Defined Contribution Plans

2022 2023 Increase from 2022 to 2023
Aggregate Annual Contribution Limit

$61,000

$66,000

$5,000

Annual Pre-Tax/Roth Contribution Limit

$20,500

$22,500

$2,000

Catch-Up Contribution Limit for Individuals 50+

$6,500

$7,500

$1,000

Other Adjustments for Qualified Plans

2022 2023 Increase from 2022 to 2023
Annual Participant Compensation Limit

$305,000

$330,000

$25,000

Highly Compensated Employee Threshold

$135,000

$150,000

$15,000

Key Employee Compensation Threshold for Top Heavy Testing

$200,000 $215,000

$15,000

IRS Announces 2023 Increases to Health FSA and Transportation Fringe Benefit Limits

On October 18th, the IRS announced a slew of inflation adjustments for 2023, including to the annual contribution and carryover limits for healthcare flexible spending accounts and the monthly limit for qualified transportation fringe benefits.  The IRS did not increase the annual contribution limit for dependent care flexible spending accounts because that limit is not indexed to inflation.  The new limits are set forth below.  Earlier this year, the IRS released the 2023 inflation adjustments for health savings accounts and high deductible health plans.  The 2023 inflation adjustments for tax-qualified retirement plans are expected to be announced soon.

Health FSAs
2022 2023 Increase from 2022 to 2023
Annual Contribution Limit $2,850 $3,050 $200
Carryover Limit $570 $610 $40
Qualified Transportation Fringe Benefits
2022 2023 Increase from 2022 to 2023
Transportation in a Commuter Vehicle or Transit Pass $280/month $300/month $20/month
Qualified Parking $280/month $300/month

 

$20/month

 

“Clawback Comeback”: DOJ’s New Focus on Clawbacks to Prevent Corporate Crime

In September 2022, Deputy Attorney General Lisa Monaco delivered remarks unveiling the Department of Justice’s revised corporate crime guidance to “prioritize and prosecute corporate crime.” She reiterated that the number one priority for the DOJ is “individual accountability.” To that end, Monaco emphasized that the DOJ will “reward” companies that claw back compensation from executives “when misconduct occurs.” This new focus on “clawbacks” is intended to give general counsels and chief compliance officers the tools to implement “responsible corporate behavior” and to foster a corporate culture that both deters and punishes risky (and possibly criminal) behavior by top executives.

With this focus on executive compensation clawbacks, the DOJ is stepping into an area first highlighted by the Dodd-Frank Act of 2010, which directed the Securities and Exchange Commission to promulgate rules requiring publicly-listed companies to have compensation clawback policies. Twelve years after the passage of Dodd-Frank, the SEC has still not implemented final rules governing clawbacks. However, on June 8, 2022, the SEC requested comments for the third time on its proposed rule, and we expect final rules to be forthcoming.

Some history on clawbacks is useful context for understanding the DOJ approach. Executives can face clawback of previously paid compensation under various circumstances. The difficult issue is determining the reason for clawing back compensation (i.e., was it the result of “fault” or criminal conduct or an accounting mistake) and determining the executive’s “culpability” in securing unjustified compensation. Clawbacks can arise when incentive compensation (annual bonuses or long term equity compensation) pays out on the achievement of financial metrics, such as earnings per share or revenue growth, where the determination that those metrics have been achieved turns out to be incorrect. Errors like this can be due to a range of factors, some implicating an executive’s actions more than others. For example, this can be the result of a misapplication of complicated accounting principles, or inadequate internal controls, or, at worst, actual executive fraud, misconduct, or criminal activity.

The Dodd-Frank Act sought to direct corporate accountability by directing the SEC to require publicly-listed companies to implement compensation clawback policies. To that end, the SEC proposed an expansive rule in 2015 that would have required clawbacks in the event of inaccurate financial statements even in “no fault” situations – for example, an officer’s incentive-based compensation could be clawed back even if there was no misconduct or they bore no responsibility for the inaccuracies in the financial statements. Faced with intense pushback, the SEC did not implement its 2015 proposed rule, although the SEC reopened comment periods in October 2021 and, as noted above, most recently in June 2022. Given the delay in the SEC’s implementation of final rules, public companies have taken various approaches. Some have done nothing while they wait for final SEC action, others have implemented clawback policies relating to accounting restatements, and some have gone further and implemented clawback policies for executive misconduct or criminal activity, and in most cases given the Compensation Committee broad discretion in how to apply such policies. Notably, as part of its most recent reopening of the comment period on the clawback rules, the SEC asked for comments on an SEC Staff memoorandum (issued in June 2022) that included additional analyses addressing the increase in 2015 in voluntary adoption of clawback policies, estimating the number of additional restatements that would potentially trigger a clawback if the rule were expanded to cover a broader scope of accounting revisions and discussing some potential implications for the costs and benefits of the proposed rule[1].

Viewed in this context, Monaco’s call to tie criminal enforcement actions to the existence and application of clawback policies appears to be a signal from the DOJ that they will not wait for the SEC and are willing to encourage market action through their own prosecutorial powers. If Monaco’s proposals are implemented through the DOJ’s prosecutorial guidelines, corporations that are the target of DOJ criminal action may face less drastic criminal penalties if they have adopted and implemented clawback policies in line with the DOJ’s recommendations. Of course, executives involved in criminal conduct could face DOJ criminal action as well as the financial clawback of previously paid compensation. It is unclear from the new policy just how much relief a company subject to a DOJ criminal action would get by adopting and implementing clawback policies – Monaco called on the DOJ’s Criminal Division to “develop further guidance” by the end of this year to “reward corporations that develop and apply compensation clawback policies.”

The DOJ’s revised corporate crime guidance also notes that prosecutors should consider whether a company’s compensation system is structured in a manner that provides “affirmative incentives for compliance-promoting behavior,” such as by using (i) compliance metrics and benchmarks for compensation calculations and (ii) performance reviews that measure and incentivize compliance-promoting behavior.

Now that the DOJ is focusing on executive compensation, companies should consult with their outside counsel for a multi-disciplinary approach to reviewing, implementing and enforcing clawback and other compensation policies. The issues are complicated, and white collar criminal counsel need to work closely with executive compensation and benefits counsel to fully understand the scope and implications of clawback policies. There are many constituents implicated by a clawback policy: the senior executive team, the board of directors, compensation committee, outside shareholders and shareholder advisory services, to name a few. Companies will also need to consider the SEC, and any final rule it promulgates. To that end, companies will need a coordinated and well-quarterbacked legal approach to maximize protection from DOJ criminal prosecutions through the adoption of clawback policies. Proskauer has a long established coordinated team of white collar and executive compensation attorneys who work together to address these type of issues, and will continue to monitor these developments.

[1] The SEC staff memorandum analyses the impact of expanding clawbacks to cover a broader range of accounting restatements. The technical question is whether to also trigger clawbacks as a result of less involved accounting corrections that can be addressed in current year comparative financials (so-called “little R” restatements), versus more involved corrections that require the restatement and reissuance of previously issued financials (so-called “Big R” restatements).

Eighth Circuit Joins Growing Number of Courts Rejecting Common ERISA Fee and Investment Claims

In Matousek v. MidAmerican Energy Co., 2022 WL 6880771, __ F.4th __ (8th Cir. 2022), the Eighth Circuit joined the Sixth and Seventh Circuits in affirming dismissal of ERISA breach of fiduciary duty claims alleging that the plan fiduciaries allowed the plan to pay excessive recordkeeping and administrative fees and offered imprudent investment options.

Background

Plaintiffs, participants in the MidAmerican 401(k) plan, made a now typical series of allegations against their plan fiduciaries: recordkeeping and administrative expenses were excessive, some investment options were too costly and some investments performed poorly.  In furtherance of their claims and in an effort to support an inference of imprudence, plaintiffs offered various comparators, such as other plans’ recordkeeping arrangements and investment options.  They claimed that cheaper and better-performing comparators showed that defendants must have acted imprudently when managing the plan.

The Court’s Decision

In affirming the dismissal of all claims, the Court found that plaintiffs failed to plead “meaningful benchmarks” to support an inference of breach of ERISA’s duty of prudence.  Bolstering its analysis of the requirement for valid comparators, the court cited a recent Seventh Circuit decision upholding the full dismissal of similar claims, which we wrote about here.

Regarding the plan’s recordkeeping expenses, the Court found that plaintiffs’ comparisons created a mismatch.  The plan, in addition to offering a basic suite of recordkeeping services, received and paid for additional services such as individualized investment advice for participants; commissions for individual trades; and trading, loan-origination, returned-payment, and check-service fees.  By contrast, plaintiffs’ comparators included industry averages for recordkeeping services that reflected only basic recordkeeping services.  In other instances, the Court could not ascertain from the complaint what services plaintiffs’ comparators received.  Therefore, the Court was unable to conclude that the services the plan received were the same as the services that plaintiffs’ comparators received.  Accordingly, the court concluded that plaintiffs failed to provide meaningful benchmarks for recordkeeping fees and did not create a plausible inference that the fiduciaries breached their duties.

Regarding the investment options challenged for being too expensive, the Court similarly found that plaintiffs did not provide meaningful benchmarks for comparison.  Plaintiffs identified “peer groups” of funds with lower costs than the plan’s challenged investments, but did not explain what types of funds were in the peer groups, what criteria were used to sort them, and whether they are similar to the plan’s investment options in terms of securities held, investment strategy and risk profile.

Similarly, regarding allegations that some funds performed poorly, the Court found that the benchmarks offered to prove the point were not meaningful because they pursued strategies explicitly at odds with the strategies of the funds challenged.  For example, while a plan investment option pursued a “value” strategy, plaintiffs’ comparator pursued a “growth” strategy.  Due to the contrasting investment styles, the investments had different aims, different risks, and different potential rewards.  Therefore, the Court concluded that plaintiffs’ attempted comparison was neither sound nor meaningful.

Due to plaintiffs’ failure to plead facts supporting the conclusion that their comparators were meaningful benchmarks, the Court held that the complaint did not state create a plausible inference that the plan fiduciaries breached their duties.  The Court also agreed with the defendants that the district court correctly dismissed the complaint with prejudice where plaintiffs failed to affirmatively file a motion to amend the complaint.

Proskauer’s Perspective

The decision is notable because it is yet another indication that, notwithstanding the Supreme Court’s failure to provide helpful guidance in Northwestern v. Hughes, the circuit courts are prepared to lead the way in setting the standard for what type of fee and investment claims can survive dismissal.  And, at least for now, the trend at the circuit court level appears to be very helpful to plan sponsors and fiduciaries seeking to reduce the risks and costs associated with this wave of litigation.

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