The Securities and Exchange Commission has proposed yet another controversial executive compensation rule required by the Dodd-Frank Act—a “clawback” requirement demanding the recovery of erroneously awarded compensation from both current and former executives at listed companies.
For public companies, the amount clawed back would be what was received in excess of the corrected restatement of a company’s financials. There is no requirement that any misconduct occurred in connection with the problematic accounting that necessitated a restatement, nor is there any requirement that the executive officer had a role in the preparation of the company’s financial statements.
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, although the proposal does seek public comments on whether they should be included.
In a departure from clawback requirements in Section 304 of the Sarbanes-Oxley Act, the proposed SEC rule applies to a broader selection of executive officers at a company, beyond the CEO and CFO.
While the proposed rules would require companies to pursue recovery of all incentive-based compensation, there are two exceptions for situations where a majority of independent directors determine that pursuing recovery would be impracticable, either because the expense of doing so would exceed the recoverable amounts or recovery would violate foreign law.
Companies would be prohibited from indemnifying any current or former executive officer against the loss of erroneously awarded compensation. They are also prohibited from paying the premiums on an insurance policy that would cover an executive’s potential clawback obligations.
The proposal would require issuers to file their recovery policies, and if a restatement is completed that requires recovery, to disclose instances in which executives did not repay within 180 days, or the issuer exercised the discretion not to pursue recovery. Disclosures are required to be in XBRL (eXtensible Business Reporting Language).
“By providing for recovery of compensation that was based on inaccurate financial reporting measures, the proposed rules should increase accountability and bring greater focus to the quality of financial reporting,” SEC Chairman Mary Jo White said before the 3-2 vote (with Republicans Daniel Gallagher and Michael Piwowar dissenting).
White expects the 60-day public comment period to address differing views on whether stock price and total shareholder return should be considered as metrics for purposes of the rule. “Some believe that they should not because estimating the stock price impact of a restatement could add to the complexity and burden of determining how much compensation must be recovered,” she said. “Others persuasively argue that, because stock price and total shareholder return are frequently used metrics for performance, excluding them would create a significant loophole that would diminish the statute’s objective. The proposal seeks to strike a balance between these competing considerations.”
Commissioner Louis Aguilar supported the use of total shareholder return, pointing to recent research that approximately 51 percent of the top 200 public companies make performance-based grants for executive compensation based on it.
Gallagher’s concerns included the broad scope of executives affected by the proposal, which applies to any executive with even a minimal influence on financial reporting. The proposal’s definition of an executive officer is a new one that goes beyond the Congressional mandate, he added.
“I assume Congress knew how to write no fault if that’s what it intended,” Gallagher said. “Congress did not do so, so we should have chosen something other than strict liability. Subjecting a broad swath of executive officers to a no-fault recovery mandate creates the potential for substantial injustice. A conscientious, but lower level, executive may have every incentive to promote high quality financial reporting for his or her own corner of the issuer’s operations, but his or her ability to influence higher ranking executives in their duties, or setting tone at the top, is limited.”
Gallagher also took umbrage with how, in his view, the rule undermines board discretion and the inclusion of smaller reporting companies, emerging growth companies, foreign private issuers, and registered investment companies in its scope.
“SRCs and EGCs should have been excluded from the scope of the rule,” he said. “If we are to experiment with corporate governance regulations, as we do here, let us at least experiment on large issuers who can more readily bear the fixed cost of compliance.”