The finalization of the pay ratio has drawn a lot of attention, but it isn’t the only thing the SEC has been up to this summer. On July 1, the commission released a 198 page draft proposal proposing specifics on another element of Dodd Frank. This clawback rule will require companies to recoup incentive-based compensation following a material restatement. This will be accomplished, as stated in the SEC press release, by “directing national securities exchanges and associations to establish listing standards requiring companies to adopt policies that require executive officers to pay back incentive-based compensation that they were awarded erroneously.”
Even the acknowledgement that such bonuses can be “erroneous” is a step in the right direction. But there’s a hole in the proposed regulation large enough to drive a massive claw-grabber construction vehicle through. Boards has some discretion on whether to seek recovery if, “pursuit of recovery would be impracticable because it would impose undue costs on the issuer.” For example, if the amount to be recovered is less than the companies would need to pay lawyers in order to conduct the recovery. I expect attorneys to develop specialties in making – or at least claiming to make – these tasks prohibitively expensive.
Also, according to a Towers Watson analysis, “in cases where the incentive compensation is based on the company’s stock price or total shareholder return, the SEC deferred to companies as to how to value the compensation to be clawed back, allowing the use of ‘reasonable estimates.’ ” Companies will be charged individually with teasing out an appropriate clawback amount and the task will be extraordinarily complex. Quoting again from Towers Watson again: “For options that were exercised, performance share plans and relative-TSR [total shareholder return] plans, the determination of what stock value increases were attributable to misstated financials will be a difficult process, one that will require economic expertise perhaps beyond that possessed by many companies.”
There is a possibility that good can come from this rule. As Peter Henning wrote in the New York Times “the perception of a potential threat” could itself have power. Likewise, the use of the discretionary loophole noted above would require disclosure of both the names of executives, amounts not pursued and the rationale involved. Henning notes that, “Investors and the media are sure to pounce on any disclosure that looks as if a company gave an executive a pass. Avoiding the harsh glare of the public spotlight may be reason enough for executives to repay money.” One hopes so, but a better plan would be to tighten these loopholes.
The full clawback proposal appeared in the Federal Register on July 14 and final day for comments will be September 14. Anyone can express their thoughts, using the link on this page to Submit Comments on S7-12-15. You can also see comments already filed, including this common-sense anonymous one: “I support this proposal. It makes sense to hold executives accountable for honesty and integrity in financial reporting.”