In the wake of the Securities and Exchange Commission’s proposed clawback rules under the Dodd-Frank Wall Street Protection and Consumer Reform Act of 2010, many US public companies began implementing clawback policies. Although the proposal was originally issued in 2015 and the SEC has yet to adopt final clawback rules, instances of alleged executive misconduct in recent years has begun leading to claims under the clawback policies. Increased scrutiny from legislators, institutional investors, shareholders and the general public has put significant pressure on boards of directors and compensation committees to exercise their rights to claw back compensation in the event of a corporate scandal.
This post discusses two recent developments related to the exercise of compensation clawbacks. The first confirms that boards should have broad discretion in deciding when to exercise a clawback, and the second discusses important indemnification and advancement issues that can arise in connection with a claim for the enforcement of a clawback policy.
Clawbacks and the Business Judgment Rule
Boards of directors and compensation committees are generally responsible for enforcing a company’s clawback policy or other contractual clawback provisions for senior executives, and thus have the ability to determine whether a clawback will be pursued. This raises interesting questions about how a court might assess a board’s decision not to recoup compensation from an executive. Two recent cases in the Delaware Court of Chancery present rare examples of this analysis.
In City of Tamarac Firefighters’ Pension Trust Fund v. Corvi, a shareholder filed a derivative suit against the board of directors of United Continental Holdings, Inc. (“United”), alleging breaches of fiduciary duty, waste and unjust enrichment in connection with separation agreements that United entered into with its former CEO, Jeffrey Smisek, and certain other executive officers. The separation agreements were executed after a federal investigation concerning allegations that Smisek had conspired with the chairman of the Port Authority of New York and New Jersey to reinstitute a Newark-to-Columbia flight in exchange for the approval of certain United development projects. Smisek was entitled to approximately $37 million in payments and benefits pursuant to his separation agreement.
In Corvi, the shareholder plaintiff made two pre-litigation demands on the United board. The initial demand requested that the board recoup compensation from Smisek and the other United executives and modify its clawback policies and future employment agreements to include provisions that would grant the board discretion to exercise a clawback upon its determination that “misconduct, willful or otherwise, has occurred.” After a special committee of the board rejected the initial demand, the plaintiff filed suit. Subsequently, the plaintiff submitted a supplemental demand requesting that the board rescind Smisek’s separation agreement. The special committee formed a sub-committee to review the supplemental demand, and the subcommittee similarly declined to take action.
Vice Chancellor McCormick affirmed that a board’s decision to refuse a pre-suit demand to exercise a clawback is subject to the business judgment rule, and found that the plaintiff failed to plead particularized facts raising a reasonable doubt that the United directors had acted with due care and in good faith in rejecting the demands. In particular, the plaintiff failed to allege that the directors received a financial or personal benefit in approving the separation agreements or in rejecting the demands. Vice Chancellor McCormick explained that there are several valid business reasons for entering into separation agreements, and found that the special committee members were not conflicted in declining to exercise the clawback, stating, “A person is not conflicted when deciding whether to exercise a contractual right for which that person negotiated, at least not by reason of the fact that the person negotiated for the right.” In addition, the terms of the separation agreements were insufficient to support a claim that the United board had acted in bad faith in refusing the demands. Vice Chancellor McCormick emphasized that the special committee’s refusal to revise United’s clawback policy on the basis that the plaintiff’s request was off-market fell “within the bounds of reasonable judgment.” Furthermore, the court dismissed the plaintiff’s waste and unjust enrichment claims on the basis that such claims “merely repackage[d] complaints” related to the separation agreements “under different legal theories.”
The Corvi outcome is similar to a 2017 case in the Delaware Court of Chancery, Andersen v. Mattel, Inc., which also involved a pre-suit demand and a request that a board exercise a clawback. Bryan Stockton, the former CEO of Mattel, Inc. (“Mattel”), was paid $10 million in benefits pursuant to an executive severance plan following his termination of employment with the company. The plaintiff brought suit, claiming breaches of fiduciary duty, unjust enrichment and waste. As in Corvi, the court dismissed the plaintiff’s complaint.
Indemnification and Advancement in Connection With Clawback Claims
In March of 2019, The Hertz Corporation and Hertz Global Holdings, Inc. (collectively, “Hertz”) filed two complaints seeking to claw back compensation from its former executives. One complaint was filed in the United States District Court for the District of New Jersey against Hertz’s former CEO, Mark Frissora, former CFO, Elyse Douglas, and former General Counsel, John Jeffrey Zimmerman (the “New Jersey Complaint”), and the second was filed in a circuit court in Florida against Scott Sider, the former Group President for Rent-A-Car Americas (the “Florida Complaint”, and together with the New Jersey Complaint, the “Complaints”). Hertz seeks to recover approximately $70 million in incentive compensation paid to Frissora, Douglas and Zimmerman, and more than $200 million in damages incurred in connection with a financial restatement. The Complaints also request a declaratory judgment denying the advancement of expenses to the former executives. Each of the executives have filed suit in Delaware’s Court of Chancery seeking advancement of legal expenses from Hertz.
The Complaints allege that Hertz’s Compensation Committee had determined that a compensation clawback was appropriate in accordance with Hertz’s clawback policy, which provides that executive officers receiving certain forms of incentive compensation are required to repay or forfeit such compensation in the event of a financial restatement and a determination that an executive’s gross negligence, fraud or misconduct caused or contributed to the need for the restatement. The gross negligence and misconduct cited by the Complaints related mostly to the alleged failure of the executives to ensure an appropriate “tone at the top” in connection with financial controls. The auditor’s report included with Hertz’s restated financial statements includes the statement that “in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2014, . . . because material weaknesses in internal control over financial reporting existed as of that date[, including] material weaknesses . . . . related to a) an inconsistent and sometimes inappropriate tone at the top . . . under the then existing senior management”.
The Complaints also state that each of the defendants made a claim for advancement of expenses, including legal fees incurred by them in connection with the dispute. The Complaints state Hertz’s view that the defendants are not entitled to indemnification or to advancement of expenses “in a contract-based action that [Hertz was] compelled to bring”, and that “advancement is inconsistent with, and effectively rendered nugatory here by, the ClawBack Enforcement Provision, as it expressly permits Plaintiffs to ‘reduc[e] any amounts that may be owing from time-to-time by’ [Hertz] to such employee”, thus presumably permitting Hertz to offset the amount of indemnification obligation by the amount of compensation required to be repaid.
Hertz’s articles of incorporation and by-laws use a typical formulation to describe the scope of coverage of the obligations:
The Corporation shall indemnify, to the fullest extent permitted by the DGCL and other applicable law, any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (each, a “proceeding”), by reason of the fact that he or she is or was or has agreed to become a Director or officer of the Corporation . . . or by reason of any action alleged to have been taken or omitted in such capacity, against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement. . . .
The Hertz Global Holdings, Inc. by-laws also include the following unusual language:
[N]o indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the Corporation unless and only to the extent that the Delaware Court of Chancery or the court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Delaware Court of Chancery or such other court shall deem proper.
It is not clear what standard a court would apply to determine whether indemnification is “fair and reasonable” in any particular case.
Advancement and indemnification are typically considered important inducements to ensure that qualified individuals will agree to serve as corporate officers. However, when allegations of serious executive misconduct arise, companies may understandably be reluctant to advance legal fees and other expenses, which can be substantial. Delaware courts have recognized indemnification and advancement as two separate concepts, and have found that an executive is not required to prove that he or she will ultimately be indemnified in order to receive advancement. Further, Delaware courts have found that a suit is brought “by reason of the fact” that an individual was an “officer or director” when there is a “nexus or causal connection” between the underlying lawsuit and the individual’s “corporate capacity,” and such a connection exists “if the corporate powers were used or necessary for the commission of the alleged misconduct,” without regard to the individual’s motivation for engaging in that conduct. The Delaware courts have also upheld advancement of expenses even in cases where officers and directors have been accused of fraud and other serious misconduct, including misconduct that had the effect of increasing their own compensation. However, there appears to be no published Delaware opinion that directly addresses indemnification and advancement rights specifically in respect of a clawback claim—i.e., whether the requisite nexus or causal connection exists between the lawsuit and the individual’s exercise of corporate powers.
In sum, the Complaints raise various questions concerning the interaction of typical clawback policies with typical officer and director indemnification and advancement provisions.
- Business Judgment Rule. The business judgment rule should protect directors in the usual situation of claims arising from their decision not to pursue a clawback claim.
- Tone at the Top and Claims of Executive Negligence. In the Hertz case, the company focused its pleading on contractual claims arising from its clawback policy, rather than on common law or statutory causes of action. In particular, Hertz alleged that the executives’ “tone at the top” was “a form of misconduct and gross negligence” that caused the need for a financial restatement, thus triggering its clawback policy. Companies should consider whether contractual provisions in employment agreements—including for example definitions of “cause” and provisions defining the responsibilities of executives—should refer to maintaining appropriate “tone at the top”. Notably, the SEC has not instituted an enforcement action against the former Hertz executives under Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”), and none of the former executives were named in the cease and desist order that the SEC issued against Hertz in connection with the restatement. The SEC’s decision not to institute enforcement proceedings may suggest that an inappropriate “tone at the top” is insufficient to rise to the level of misconduct under the statute.
- Advancement and Indemnification. The Complaints requested a declaratory judgment denying indemnification and advancement of expenses to the former executives. Companies should consider whether they would wish to take a similar view in the event of a clawback dispute. Presumably, companies that adopt clawback policies do not wish to indemnify executives for liabilities incurred under such policies, but the advancement issue is not so easy. In any case, companies should consider whether their indemnification and advancement obligations clearly reflect their intentions. In particular, companies that wish to provide for advancement of expenses may desire to specifically note that intention in their clawback policies.
 The SEC’s 2015 clawback proposal would direct national securities exchanges to establish listing standards that require companies to adopt and implement a written clawback policy providing for the recovery of incentive-based compensation paid to a current or former executive officer due to material non-compliance with financial reporting requirements that resulted in a financial restatement. Under the SEC’s proposed rule, a company would be required to file a copy of its clawback policy with the SEC and make certain disclosures in the event of a restatement.
 See, e.g., Renae Merle, Wells Fargo orders two executives to pay back an additional $75 million after sales scandal probe, Washington Post, Apr. 2017. Clawback of compensation may be sought even in the absence of a contractual right, pursuant for example to the common law “faithless servant” doctrine. See, e.g., Phansalkar v. Andersen Weinroth & Co., L.P., 344 F.3d 184, 189 (2d Cir. 2003).
 Memorandum Opinion, City of Tamarac Firefighters’ Pension Tr. Fund v. Corvi, (Del. Ch. 2019) (C.A. No. 2017-0341-KSJM).
 Id. at 8.
 Id. at 23-24.
 Id. at 28.
 Id. at 30.
 C.A. No. 11816–VCMR, 2017 WL 218913 (Del. Ch. 2017).
 Complaint and Jury Demand, The Hertz Corp. v. Frissora, C.A. No. 2:19-cv-08927-ES-CLW (D.N.J. 2019), ECF No. 1; Complaint, The Hertz Corp. v. Sider, 19-CA-001808 (Fla. 20th Cir. Ct. 2019), ECF No. 87147241.
 Frissora, Douglas, Zimmerman and Sider consolidated their actions demanding advancement and filed a motion for partial summary judgment in the Delaware Court of Chancery. The former executives allege that they are entitled to advancement under Hertz’s by-laws, that Frissora, Douglas and Sider’s separation agreements reserve their rights to advancement under the by-laws, that Zimmerman’s separation agreement provided an independent right to advancement in addition to his rights under the Hertz by-laws, and that Frissora had additional rights to advancement under the terms of his employment agreement. See Plaintiff’s Brief in Support of Their Motion for Partial Summary Judgment, Sider v. Hertz Glob. Holdings, Inc., (Del. Ch. 2019) (Nos. 2019-0237-KSJM, 2019-0240-KSJM, 2019-0243-KSJM, 2019-0246-KSJM), 2019 WL 1864399.
 Complaint and Jury Demand, supra note 9 at 35; Complaint, supra note 9 at 27-28.
 See Homestore, Inc. v. Tafeen, 888 A.2d 204 (Del. 2005); Holley v. Nipro Diagnostics, Inc., C.A. No. 9679-VCP, 2014 WL 7336411 (Del. Ch. 2014) (unpublished opinion).
 Holley, 2014 WL 7336411, at *9; Paolino v. Mace Sec. Int’l, Inc., 985 A.2d 392, 406 (Del. Ch. 2009).
 See, e.g., Holley, 2014 WL 7336411; Reddy v. Elec. Data Sys. Corp., No. CIV.A. 19467, 2002 WL 1358761 (Del. Ch. 2002) (unpublished opinion); Fillip v. Centerstone Linen Sers., LLC, C.A. No. 8712-ML, 2013 WL 6671663 (Del. Ch. 2013) (unpublished opinion); Barrett v. Am. Country Holdings, Inc., 951 A.2d 735 (Del. Ch. 2008). Although the Delaware Supreme Court, in Stifel Fin. Corp. v. Cochran, 809 A.2d 555 (Del. 2002), has found that an executive was not entitled to indemnification for expenses incurred in connection with the arbitration of his employment agreement on the basis that the claims arbitrated were personal rather than arising from the executive’s capacity as an officer of the company, Stifel was distinguished in both Reddy and Fillip on the basis that Stifel was an indemnification, rather than an advancement case, and that it presented an unusual situation in which the officer would have received a windfall had indemnification been permitted. The Court in Fillip found that in order for a Stifel claim to succeed in the advancement context, the claim would have to involve “a specific and limited contractual obligation that bears no causal connection with the person’s official duties.” 2013 WL 6671663, at *9.
 Section 304 of SOX generally provides that in the event a public company is required to issue a restatement due to material noncompliance with financial reporting requirements as a result of misconduct, the SEC may require the CEO and CFO to reimburse the company for any bonus or other incentive or equity-based compensation received from the company, as well as any profits realized from the sale of company securities, during the 12 month period following the issuance of the misstated financials.
 For a more detailed discussion of Hertz’s “tone at the top” allegations, see our blog post “Hertz Pursues Novel Theory to Hold Former Management Team Personally Liable for Restatement and Ensuing Legal Proceedings”.