Of all the executive compensation rules shepherded along by the Securities and Exchange Commission lately, the “clawback” rule proposed last week is among the more straightforward. The rule—a requirement that executive officers repay incentive-based compensation based on financial results that are later restated—lacks the political agenda of the forthcoming pay ratio disclosure rule, nor does it have the long-term implications of the pay-for-performance rules proposed earlier this year.
The clawback rule’s simplicity, however, will force companies to make difficult, confusing choices. Exactly how should the clawback be calculated? What should you do when an executive is no longer at the company, or the money is unavailable to reclaim?
Formally, the rule requires stock exchanges to adopt standards requiring all listed companies to have a “compensation recovery policy.” The amount to be recovered would be the difference between what an executive was originally paid, and what he or she should have been paid based on the restated financial results.
Recovery would apply to incentive-based compensation that is based on either accounting-related metrics or stock price and total shareholder return metrics. The definition of incentive-based compensation does not include bonuses paid solely at the discretion of a company’s board of directors, or equity awards that vest solely upon completion of a specified employment period.
The clawback rule does not require that any misconduct that occurred happened in connection with the problematic accounting, or that an executive officer had a role in preparing the company’s financial statements.
That rather black-and-white approach, compensation experts say, is part of the challenge.
Andrew Liazos, a partner at law firm McDermott Will & Emery, says boards will worry that they have little discretion to consider special facts or circumstances after a restatement.
The rule is much broader than the inclusion of stock options awarded as compensation in clawback calculations, he says. Many public companies have recently introduced performance shares and other equity awards based directly on results shown in the financial statements. These awards would be subject to the new rule. The same goes for traditional short-term and long-term cash incentives designed to qualify as “performance-based compensation.”
“Even more alarming is the ambiguity regarding the amount that should be recovered,” Liazos says. “How does one determine precisely when a public company ‘is required to prepare the accounting restatement’? Is it the date when the facts requiring the restatement are first known by management? When the work to do the restatement is done? When the restatement is actually filed?”
The SEC proposal is vague on how to determine the amount of excess compensation that otherwise would not have been paid after the accounting restatement. “What if an executive received a stock option that vested solely upon continued employment—will the officer forfeit stock options granted during the three-year look-back period regardless of the amount of the misstatement?” Liazos asks.
“Even more alarming is the ambiguity regarding the amount that should be recovered. How does one determine precisely when a public company ‘is required to prepare the accounting restatement’?”
Andrew Liazos, Partner McDermott Will & Emery
The SEC sidestepped a “black-letter rule for how to deal with equity value gains” and how to measure the amount that would need to be clawed back after a restatement, says Steve Seelig, executive compensation counsel at Towers Watson.
“Maybe it was because it was too difficult to come up with a workable rule, or perhaps they thought it would be best for companies to figure out how to do that,” Seelig says. He gave the example of rosy financial results that send a stock up 20 percent, followed by a restatement and the stock only falling back 10 percent. “What value ought to be ascribed to the gain?” he asked. “Is it that 10 percent [the stock] went up? Is it something else? I think there is a lot of complicated economic analysis that will need to take place by companies and their consultants in figuring out what that value would have been.”
More Details, More Devils
Because the rule covers executives beyond the CEO and CFO, another important question is how to reclaim compensation if an executive is no longer with the company at the time of the restatement. The proposed rule does allow an exception for situations where the expense of recovery would exceed the recoverable amounts.
“I suppose you could look at that former executive you want to seek out and just say it is not worth it,” Seelig says. “But you are on a slippery slope and need to determine whether you had a restatement that meets the threshold of materiality. If you say you haven’t met that threshold, you are going to be subjected to second-guessing from the plaintiffs bar.”
CLAWBACK FAST SHEET
The following is from a fact sheet the Securities and Exchange Commission released in conjunction with its executive compensation “clawback” rule proposal.
Listing Standards – Proposed Rule 10D-1 under the Securities Exchange Act
The proposed rules would require national securities exchanges and associations to establish listing standards that would require listed companies to adopt and comply with a compensation recovery policy in which:
Recovery would be required from current and former executive officers who received incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement to correct a material error. The recovery would be required on a “no fault” basis, without regard to whether any misconduct occurred or an executive officer’s responsibility for the erroneous financial statements.
Companies would be required to recover the amount of incentive-based compensation received by an executive officer that exceeds the amount the executive officer would have received had the incentive-based compensation been determined based on the accounting restatement. For incentive-based compensation based on stock price or total shareholder return, companies could use a reasonable estimate of the effect of the restatement on the applicable measure to determine the amount to be recovered.
Companies would have discretion not to recover the excess incentive-based compensation received by executive officers if the direct expense of enforcing recovery would exceed the amount to be recovered or, for foreign private issuers, in specified circumstances where recovery would violate home country law.
Under the proposed rules, a company would be subject to delisting if it does not adopt a compensation recovery policy that complies with the applicable listing standard, disclose the policy in accordance with Commission rules or comply with the policy’s recovery provisions.
The proposal requires the exchanges to file their proposed listing rules no later than 90 days following the publication of the adopted version of Rule 10D-1 in the Federal Register. The proposal also requires the listing rules to become effective no later than one year following the publication date.
Each listed company would be required to adopt its recovery policy no later than 60 days following the date on which the listing exchange’s listing rule becomes effective. Each listed company would be required to recover all excess incentive-based compensation received by current and former executive officers on or after the effective date of Rule 10D-1 that results from attaining a financial reporting measure based on financial information for any fiscal period ending on or after the effective date of Rule 10D-1.
Listed companies would be required to comply with the new disclosures in proxy or information statements and Exchange Act annual reports filed on or after the effective date of the listing exchange’s rule.
Alan Johnson of the executive compensation firm Johnson Associates, raises even more complicated scenarios not addressed in the SEC rule. “What if the guy dies, are they going to go after the widow? What if there was a merger? There could be all kinds of things that affect your ability to reclaim the money,” he says. What about the taxes executives have already paid on that compensation—does the company owe them a refund for that?
Ultimately, Seelig says, companies will need to balance several factors as they write a clawback policy: what will be a material amount of compensation to be recouped; how much a company wants to pursue (and annoy) former executives; and the risks of civil litigation from the plaintiff’s bar.
Even the actual exercise of clawing back compensation is unclear. Robin Ferracone, CEO of executive compensation consultant Farient Advisors, gives the example of a company that determines a currently employed executive owes $1 million in a clawback. “Rather than have that executive write a check, I suspect companies will consider taking that million out of the executive’s compensation for the next year to offset it,” she says. “Whether that is allowed or not by the SEC is the question.”
Boards will also likely explore the increased use of holding requirements to take care of the departure situations, where executives cannot immediately liquidate a compensation award, Ferracone says. Holding target-based bonus pay in escrow could be another option.
That even an honest error can trigger a clawback also concerns Johnson. “There are going to be a lot of accounting changes in the next few years, so there is likely to be a rash of restatements when people get some of this stuff wrong,” he says. “Unfortunately, it will fuel the narrative that all executives are crooks, but these will simply be mistakes or different interpretations.”
Johnson predicts that clawbacks will continue to push companies away from using objective formulas or accounting metrics to determine pay, in favor of using discretion in determining pay. “Unfortunately, that runs up against the proxy advisers ISS and Glass Lewis who love objective formulas,” he says.
Clawbacks could also have the unintended consequence where executives, fearing their pay is more at risk than it might otherwise have been before the rule, will ask for a greater salary. “That’s typically the way these negotiations work,” Seelig says.