SEC's Corporate Clawback Policy Proposal Expands Executive Accountability, but Raises Concerns about Costs, Incentivization and Corporate Growth
On July 1, 2015, the Securities and Exchange Commission (the “SEC”) issued the long awaited proposal for new corporate clawback policies under section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This controversial proposal requires publicly traded companies to adopt and disclose policies which will force current and former executive officers to pay back incentive-based compensation in the event of a financial restatement. The policy covers all incentive-based compensation that is granted, earned or vested based wholly, or in part, upon the attainment of any financial reporting measures, including accounting-related measures, as well as stock price and total shareholder return metrics. The amount of money recovered, or “clawed back,” is measured as the excess compensation actually paid beyond what would have been paid based on the restated financial statements. Companies who fail to comply with these new requirements will be subject to delisting.
The new proposal is far more stringent than the existing clawback rules under the Sarbanes-Oxley Act of 2002, which affect only chief executive officers (CEOs) and chief financial officers (CFOs) and are limited to restatements that are a direct result of misconduct, such as fraud. Under the new proposed rules, the clawback is enforceable even if the restatement is a result of an unintentional mistake and includes all executive officers of the company, not just CEOs and CFOs. The period for recovery of pay could expand up to three years prior to the restatement, as opposed to just one year under the current Sarbanes-Oxley rules. Additionally, under the proposed rules, companies are prohibited from indemnifying officers against recovery losses, nor are they permitted to pay premiums on insurance related to potential payback obligations.
Advocates of the proposal believe the policy will discourage officers from financial wrong-doing. “These listing standards will require executive officers to return incentive-based compensation that was not earned,” said SEC Chair Mary Jo White. “The proposed rules would result in increased accountability and greater focus on the quality of financial reporting, which will benefit investors and the markets.”
Opponents of the proposal are concerned that the baseline pay of executive compensation would be significantly increased in an effort to reduce the amounts subject to the new rule. According to SEC Commissioner Michael S. Piwowar, “A recovery policy would introduce uncertainty in the amount of incentive-based compensation that executives will ultimately retain. Prior research and experience suggests that this uncertainty will increase total executive compensation. In particular, corporate executives may lower the value that they attach to the incentive-based component of their pay and demand an offset to bear the increased uncertainty.” Additionally, by having a substantial, fixed base salary and eliminating the variable component associated with incentive-based pay, executives will not be motivated to perform well, and thus will not focus on growing the company, but rather on keeping their jobs.
Due to the “no fault” provisions, dissenters of the new proposal are fearful companies will focus more on compliance, rather than on strategic business plans and operations. Since the new proposal impacts all executives, even those with no control over the financial reporting or accounting are now “on the hook” for material but honest errors. Although compliance is an essential component in all corporate organizations, it can be costly, especially for smaller reporting companies and emerging growth companies, which will now need to focus their limited time and financial resources on adopting and implementing these new policies. Again, this will directly affect the company’s bottom line, and ultimately, the shareholders’ return.
Other concerns include how to properly calculate the clawback in situations where compensation was based on stock price, how to enforce the clawback if an executive is no longer employed, and how to address substantial tax consequences to an affected executive, especially to an officer who is not at fault.
Overall, clawback policies can be valuable to an organization if designed properly; however, publicly traded companies and investors need to be aware of the benefits and consequences of the new proposed rules.
What are your thoughts? Visit the SEC website for more information.
