SEC Commissioners Take Conflicting Public Stands on Proposed Compensation Clawbacks (with Stroud Comment)

SEC Commissioner Kara M. Stein issued a statement supporting the proposed rule that would require "the majority of listed issuers to adopt a recoupment, or clawback, policy for when an executive's incentive-based pay is based on erroneous financial reports."

Commissioner Stein declared that this proposed rule would further develop the Dodd-Frank Act's original attempts to increase executive accountability and refocus executives on long-term results by mandating that "the issuer clawback erroneously or incorrectly awarded compensation." She stated that the rule would also discourage artificially inflated financial statements by requiring companies to clawback incentive-based executive compensation if there are material errors in its financial statements. Furthermore, the proposal expands the definition of incentive-based pay to include metrics (such as stock price and total shareholder return) that, according to Commissioner Stein, often constitute crucial factors in determining incentive-based pay. Additionally, the proposed rule provides that disclosures be tagged in eXtensible Business Reporting Language ("XBRL"), which Commissioner Stein firmly believes enables more comparability across companies and improves investors' searches for company information.

In marked contrast, SEC Commissioner Daniel M. Gallagher vehemently refused to recommend the proposed rule. He declared that it was a considerable waste of time and resources. First, he argued that "subjecting a broad swath of executive officers to a no-fault recovery mandate creates the potential for substantial injustice," especially with no "relief valve," and casts the corporate board "as the enemy of the shareholder." Second, he objected to the inclusion of weaker entities unable to bear the cost of compliance such as smaller reporting companies ("SRCs"), emerging growth companies ("EGCs"), foreign private issuers ("FPIs"), and registered investment companies ("RICs"). Finally, he disagreed with basing the required compensation to be clawed back on inconclusive share price metrics such as Total Shareholder Return ("TSR").

Commissioner Gallagher stated that he could accept a "reasonable clawbacks rule," but that the unveiled proposed rule is like the "newest Goya, tortured and and nightmarish."

Stroud Comment: Given the highly partisan atmosphere of Washington in recent years, it is not surprising that the SEC Commissioners would have such divergent opinions of the proposed rule for clawbacks of certain incentive compensation from public company officers. The rationale for Section 954 of the Dodd-Frank Act has a sound, objective basis. Public company officers should not be able to keep erroneously awarded incentive compensation based on flawed financial statements. However, if the rule is finalized in its proposed form, the implementation and operation of clawback policies will be ripe for litigation. It is highly unlikely an executive who is told that he or she must pay back past incentive compensation will do so without a fight, particularly given the open-ended definition of "incentive-based compensation" - "any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure." Further, an issuer will be required to recover "the amount of incentive-based compensation received that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement, and shall be computed without regard to any taxes paid." This would not be an easy calculation, nor would it be one that would go unchallenged.

As proposed, the clawback rule is replete with provisions that will require subjective judgment calls from directors who will likely not be anxious to cast the first stone, so to speak. Relatedly, once the clawback rule is finalized and a company does restate its financials, it is quite reasonable to expect the plaintiffs' bar to quickly file suit alleging breach of fiduciary duty and other sundry misdeeds if clawbacks are not sought at the same time the restatement is announced. Executives signing new public company employment contracts can be expected to have their counsel seek explicit identification of what portions of their compensation constitute "incentive-based compensation" subject to the clawback rule, seeking mitigation in advance of any future accounting issues. Adoption of the final clawback rule will not be the end of this matter. It will be a new beginning.

See: Commissioner Stein's Statement; Commissioner Gallagher's Statement.
Related News: SEC Proposes Rule Requiring Public Companies to Adopt Clawback Policies for Executive Compensation (with Delta Strategy Group Summary and Lofchie Comment and Music Selection) (July 1, 2015).