Among the many discussions and debates to emerge from revelations that Wells Fargo employees opened nearly 2.5 million unauthorized accounts and credit cards—a trespass that has already led to a $185 million settlement with the government—is when, how, and in what amount executive pay can be reclaimed.
Both the Sarbanes-Oxley Act and a pending rule from the Securities and Exchange Commission demand clawbacks connected to material financial restatements. Whether or not that threshold will be met, Wells Fargo’s board has already pulled back $41 million in unvested equity from CEO John Stumpf.
For insight into how the still-developing controversy may affect boards and their compensation decisions, we talked to John Trentacoste, a director with Farient Advisors, an executive compensation and performance consultancy.
Are there lessons to learn, and discussions worth having, regarding executive compensation and clawbacks in the aftermath of the Wells Fargo controversy?
From what I’ve read, this type of situation would not likely trigger a restatement that is material and fall under an offense that could trigger a clawback under the SEC interpretation. That being said, I think it shows why companies need to go above and beyond the SEC’s definition under the Dodd-Frank Act in order to capture things of this sort.
In financial services, they have been using clawbacks ever since the dust settled after the recession, but these are generally in the rank and file and seldom seen by the newspapers. Risk management, compliance, and good stewardship have been central principles at all of the big banks following the recession and they have used their clawbacks mostly down the line for traders and bankers who didn’t adhere to the prevailing best practices, or acted in a manner that wasn’t commensurate with the banks overall risk tolerance. Banks have been using them; it’s just a matter of visibility.
In this case, the board acted in the best interest of the company and the shareholders and showed that the long-heard excuse “I didn’t know what was going on” will not play anymore. There are people who wanted it to go further, and there are calls for Stumpf’s resignation. But the board’s actions showed that in a high-profile situation, it was ready to take on accountability and use its clawback powers judiciously.
One of the things you constantly need to do is make sure that incentives drive behavior in the most appropriate and responsible way. It is the board’s job to question them—and management’s job to vet them as well—to ensure that they are working as intended.
There is certainly a financial definition to materiality, but I think that definition becomes rewritten [because of the Wells Fargo revelations] to take into account reputational risk, harm to customers, and what stakeholders find to be material. It sets a standard for the next time anything of this nature happens. Even though a CEO might claim he or she “wasn’t responsible” or “didn’t know” what was happening further down in the organization, stakeholders are going to be asking for pay to be clawed back, and the board should really be courageous in doing so.
With big banks it seems nearly impossible to claim materiality after a revelation of this sort and resulting enforcement action because of their size. With Wells Fargo, people are upset … but even a $185 million settlement with the government is a mere footnote in the context of the institution’s multi-billion-dollar revenues.
Shareholders have two questions before them. One is whether a company’s clawback is extensive enough to cover matters of reputational harm that may not be material on the financial statements, but are material in terms of perception, value, and destroying share price.
They should also ask: Do we have a board of directors that, when faced with an issue like this, will have the courage to actually enact a clawback?
Most companies, at least with the clawbacks they have put in before the SEC has its say, do look at things other than material restatements. A lot of these clawbacks, however, are not automatic. They really do rest with the board and its discretion. A magnifying glass will be on them if something happens to see whether or not they use their discretion and take action.
Critics have expressed concern that Stumpf’s $41 million clawback was in unvested equity, with some describing it as merely “paper money” that could ultimately creep back into future awards should he prevail as CEO. Does this raise a question for boards as to how a clawback should be structured and whether reclaiming unvested equities goes far enough?
ABOUT JOHN TRENTACOSTE
John Trentacoste is a director with Farient Advisors responsible for the project management of various client engagements. Trentacoste works closely with client management teams and compensation committees to develop work plans, perform analyses, and develop findings and conclusions.
Prior to joining Farient, Trentacoste worked as an associate at Lyons, Benenson & Company (LB&Co.), a compensation and governance consultancy in New York. At LB&Co., Trentacoste was responsible for the development of client analyses and reports and creating incentive compensation plan components that clearly linked pay and performance. Trentacoste was also a member of LB&Co.’s Special Situations Team, which provided advice and counsel to the portfolio companies of various private equity and hedge funds. Prior to joining LB&Co., Trentacoste worked as an analyst on the equity sales trading of Citi Global Markets and Banking and held Series 7 and 63 licenses.
Trentacoste currently serves as chairman of the junior board of directors of the Alan T. Brown Foundation to Cure Paralysis and has co-chaired the foundation’s junior gala for the past two years.
The question becomes how successful they would be in clawing back compensation that has either vested or was awarded. What is the success rate of actually getting it back? It is much easier for a board to cancel unvested awards. They just cancel them, and they no longer exist.
Boards have a few fundamental questions ahead of them. How much do we take back and in what form? What’s the likelihood of our success in getting this back, especially for vested awards?
They may have another problem. What if a CEO departs after their equity has vested, and the board—within the SEC’s three-year lookback window—comes calling for a clawback. There is a risk that the money may no longer be available. How should the board take that into consideration?
One thing banks are doing is having longer post vesting holding requirements; typically for senior executives it is until retirement. Even though the equity has vested, you cannot sell it. For the CEOs, the holding requirement sometimes extends one year beyond retirement, so in that case they would be encumbered from selling anything.
I don’t know if [the Wells Fargo situation] is going to cause people to call for longer-term vesting. If people start to say that banks should move to five- or six-year vesting on restricted stock units or performance stock units, then you have a question of competitiveness. Can banks actually recruit talent if the pay program looks so different from a general industry pay program?
When you look at Wells Fargo, another challenge for boards that becomes apparent is the issue of timing. They want to be fair to all parties, but face the wrath of shareholders if they don’t move quickly enough.
They are in a tough spot. Their fiduciary responsibility is to the shareholders, and that requires a thorough investigation of what is going on. In my opinion, that means fact finding and not necessarily bending immediately to public sentiment, no matter how loud the critics are. Boards really need to do their own independent investigation.
Compensation plans, when they are crafted, typically include goals and incentives for achieving those targets. Now, however, we see the negative aspects of performance- and inventive-based pay. How should boards address the inherent conflict?
Incentives are extremely powerful when they drive the behaviors they are supposed to drive. If someone is supposed to cross-sell more, you will get more cross-selling. The art of incentive plan design is making sure that there is not a perverse incentive. Without the proper failsafes, people figured out how to game Wells Fargo’s incentives. It is unfortunate.
One of the things you constantly need to do is make sure that incentives drive behavior in the most appropriate and responsible way. It is the board’s job to question them—and management’s job to vet them as well—to ensure that they are working as intended. There is a compliance aspect as well, and making sure you are incentivizing the right behaviors while not being discordant with the firm’s risk profile and risk tolerance. People say that incentive plans don’t necessarily drive behaviors. Well, they do.
There is a lot of focus lately, even more than in the past, on how much executives earn. It was among the controversies with Wells Fargo, and similar scrutiny is inevitable with the SEC’s “pay ratio” rule: a demand for disclosures that compare CEO compensation to the pay of a company’s median employee. How might boards and their compensation committees navigate these choppy waters?
It is a challenge we deal with all the time. Is it enough? Is it too much and out of control? Executive compensation is always a balancing a company’s need to attract, retain, and motivate the top talent with doing right by the stakeholders.
More attention should be focused on what mechanisms are in place to prevent bad behavior and, in an instance of bad behavior, what recourse you have to make it right and take compensation back.
Having a clawback—having a mechanism in place where compensation can be clawed back in the event of bad behavior—is a more pressing focus than the quantum of pay. Shareholders would benefit from really understanding their clawback policies. Boards should be asking themselves whether, if a similar situation happened to them, is the clawback policy, as currently written, allow them to do something and, as importantly, would they do something? That’s a very frank conversation that needs to happen in boardrooms across America right now.