On March 25, 2019 car rental giant Hertz Corporation filed a complaint against its former CEO (Mark Frissora), CFO (Elyse Douglas), and General Counsel (John Zimmerman) pursuant to its Compensation Recovery Policy (“Hertz Clawback Provisions”).Hertz Corp. v. Frissora, No. 2:19-cv-08927 (D.N.J. Mar. 25, 2019). 

In the complaint, Hertz invoked its Hertz Clawback Provisions against its three former executives to recover incentive compensation that was paid to the executives between 2011 and 2013. Id. at 1. Specifically, the Hertz Clawback Provisions, which were denoted in all three of the prior executives’ employment contracts, required its former executives to forfeit any previously awarded incentive compensation if their “gross negligence and misconduct” resulted in a restatement in the company’s financial statements. Id. 2. Hertz alleged that its former executives acted with gross negligence and misconduct because their “inconsistent and inappropriate tone at the top” strained Hertz’s internal controls and pressured employees to engage in aggressive accounting practices. Id. at 3-5. Lead by Frissora, this management culture exacerbated the risk of a restatement because Hertz lacked competent personnel to monitor and accurately report its finances. Id. This resulted in a restatement of more than $200 million in Hertz’s pre-tax income from 2011 to 2013. Id. at 10-19. As a result, Hertz sought $70 million from its three former executives in previously paid incentive compensation. Id. at 1.

Federal regulations pertaining to clawback provisions were first introduced under the Sarbanes-Oxley Act of 2002 (“SOX”). While SOX does not explicitly mandate corporations to implement clawback provisions, Section 304 requires CEOs and CFOs of public companies to forfeit “any bonus or other incentive based or equity-based compensation” when the corporation engages in financial reporting fraud. (Prescott and Vann, Implications of Clawback Adoption). Notably, SEC action through Section 304 occurs only when the company’s restatement was due to fraud and does not apply to any other situation that requires a restatement. Id. However, in 2010, the Dodd-Frank Act supplemented the SOX clawback rule by requiring the inclusion of clawback provisions in executive compensation contracts. Id. Through the creation of Section 10D in the Securities Exchange Act of 1934, Dodd-Frank mandated companies to include clawback provisions for restatements that were “due to the material noncompliance…with any financial reporting requirement under the securities laws.” 15 U.S. Code §78j-4(b)(1)-(2). 

While Section 10D expanded the extent to which the SEC can enforce clawback rules, it has two important limitations. First, the mandate only applies to “issuers” on the national securities exchanges. Second, Section 10D(b) requires issuer corporations to “develop and implement” their own clawback provisions. Id. In short, while each issuer is required to include clawback provisions, there is no clear guidance as to the composition or enforceability of any particular clawback provision. (Prescott and Vann, Implications of Clawback Adoption). In an attempt to promote uniformity in clawback provision enforcement, the SEC released proposed rules in 2015 that would require all issuers to adopt clawback provisions that “provid[ed] for the recovery…of incentive-based compensation based on financial information required to be reported under securities laws.” (SEC Proposed Rule, pg. 1). However, this proposed rule still has not been formally implemented. Id. 

Historically, clawback provisions have rarely been invoked against former executives by their former employers. A 2017 study found that 272 corporations had both implemented clawback provisions and restated earnings between 2001 and 2013. Of those 272 corporations, there were only three instances where a corporation sought to recover payment from its former executives. (Babenko, Bennett, Bizjak, and Coles, Clawback Provisions, pg. 34-35). Similarly, the SEC has rarely pursued enforcement actions under SOX and Section 10D. Between 2011 and 2016, the SEC brought just 40 clawback cases against former executives. (Gretchen Morgenson, NY Times). Of these cases, only 18 of those cases returned prior compensation to the executive’s former company. Id. 

However, the recent ubiquity of clawback provisions and substantial public discussion surrounding corporate accountability might increase the number of filed lawsuits and clawback settlements. In 2018, 86% of fortune 100 corporations had adopted clawback provisions tied to executive compensation. (“Industry Insights,” Boyden). Additionally, recent high-profile efforts from corporations to claw back executive compensation have been met with success and approval from shareholders and the general public. In April 2017, Wells Fargo recovered more than $180 million from five senior banking executives following their role in the bank’s fraudulent account scandal. (“Wells Fargo Claws Back Millions,” Fortune). Similarly, former JPMorgan Chase CIO forfeited over $100 million to the company in 2013 to account for his role in the London Whale trading scheme. (Gretchen Morgenson, NY Times). 

What remains uncertain is how a court will interpret the Hertz Clawback Provision that allows it to recover executive compensation for gross negligence and misconduct. As illustrated in the cases of Wells Fargo and JPMorgan Chase, clawback provisions are more easily utilized in cases involving outright fraud and blatant malfeasance by executives. What is less clear is whether clawback provisions can be adequately invoked against former executives for less overtly egregious behavior. In its action, Hertz argued that its former executives’ “tone at the top” and “aggressive push for profits” ultimately lead to its restatement. (Complaint, pg. 12-17). The Hertz case aptly illustrates the inevitable tension between two competing policy concerns: first, an entity’s need for adequate protectionary measures from executive malfeasance; and conversely, a fear that overly expansive clawback provisions will stifle risk-taking and excessively punish executives for discretionary management decisions. Because of Hertz’s size and name recognition, this high-profile case may lead to insight as to how a court will examine and analyze similarly expansive and malleable clawback provisions in the future.