Executive Pay Claw backs – Things Just (Almost) Got Real!

The Date: July 1, 2015.

The Place: Washington D.C.

The Situation: The SEC proposes rules for executive compensation claw back provisions required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Post:

The SEC has finally proposed the long-awaited rules for executive pay claw back. Rule 10D-1 describes who, what, when and how “erroneously awarded executive compensation” must be returned to the company.

Who: The net is fairly deep and broad.

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.

The definition of “Executive Officer” is modeled after that of “Officer” under Section 16 of the Act. This includes the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs policy-making functions for the company.

Applies to all listed companies except certain registered investment companies to the extent they do not provide incentive-based compensation to their employees.

What: Incentive Pay, long-term and short-term (especially equity compensation).

Any incentive pay received during the three fiscal years prior to the required restatement. Incentive-based compensation that is granted, earned or vested based wholly or in part on the attainment of any financial reporting measure would be subject to recovery. Financial reporting measures are those based on the accounting principles used in preparing the company’s financial statements, any measures derived wholly or in part from such financial information, and stock price and total shareholder return.

When: Soon, There are several dates of which to be aware.

August 30, 2015 – final date to submit comments before rule is finalized

90 days after rule is adopted: The national securities exchanges and associations must file their proposed rules to the SEC.

60 days after exchange rules are final: Listed companies must adopt a recovery policy for any qualifying incentive compensation that is received after the final version of Rule 10D-1 is published.

How: Disclosure of both policy and claw backs

Companies must disclose their recovery policy in their annual report.

They must also disclose the date they were required to prepare a restatement, the aggregate incentive compensation amount that must be recovered and the aggregate dollar amount of all incentive compensation that remain outstanding at the end of the last fiscal year. (This part should be fun.)

The company must provide the name of each person that it will pursue for claw back along with the amounts due and any reasoning of why a specific individual is not being pursued for recovery.

If the executive does not pay back amounts due within 180 days of the recovery effort beginning, their name and the amount due will be disclosed in the annual report.

Conclusion: Claw backs will become formal some time after January 2016, and they will be pretty much what was expected.

Unlike many recent Dodd-Frank-related rules claw backs will apply to nearly all publicly-listed companies, regardless of size or date of IPO. If you do not have a formal recovery policy in place, now is a good time to start internal discussions.

Dan Walter is the President and CEO of Performensation a firm committed to aligning pay with company strategy and culture. Regular Comp Cafe readers may notice that it is odd Dan is posting two days in a row. He is just covering for a fellow contributor who was unable to get to an internet connection to post their own article. Things will go back to normal beginning tomorrow. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.

Comments

[Trevor Norcross]

Thanks for the post Dan,
How do you think companies respond? Do you see this increasing the cost of labor for Officers with this additional risk? What about Finance roles as companies look to make sure they don't have any material errors? Do you see companies adjusting their mix of pay to de-risk incentive exposure?

What are the potential negative unintended consequences this could cause? For many financially sound companies with the right controls this may be a non-issue. What do you see happening with less financially sound companies without the right controls?

[John Rothgeb]

Trevor Norcross, what "additional risk"? The risk of the company getting money back that it shouldn't have paid? The risk of having proper financial controls? Did you just really characterize it that way? It should actually lower the cost of labor for Officers unless Officers demand higher pay and incentive compensation based on the possibility that they might have to repay and overpayment. I honestly don't think that is likely in light of the huge increases in the cost of labor for Officers over the last couple of decades already. The SEC is just enforcing good fiscal policy that should have been there in the first place. In my humble opinion, the unintended consequence is that companies might automate their incentive payments or at least start to understand and police their Excel errors for the first time.

[Trevor Norcross]

Hi John,
I'm not sure of your background. Over the many years I have been dealing with exec comp in many companies it is always more complex than you allude to. This issue is not about making a bonus calculation error that you seem to reference in your last sentence. The material errors we are talking about are in fiscal reporting (accounting restatments). Automating the calculation of the payment has no relevance to the issue if there was an error in the underlying data.

This is not about simply transposing numbers and paying an Officer $1.5M instead of $1.05M.

There are many reasons for the increasing cost of labor for officers vs other segments of the workforce that we just don't have time to go into.

Hope that provides a little more clarity.

[Tony Bergmann-Porter]

I predict an increase in the number of private companies.

[Dan Walter]

Sorry for the delayed response.
Good questions and perspectives. I do believe that there are risks to any and all forms of executive compensation regulation. Even when reform is needed, the rules that are created can never out-race those with good imaginations.

Let's start with John's perspective.
The risk isn't about having better financial controls.Financial controls will always continue to evolve (and generally for the better)
There is a risk of higher cost of labor, here's way:
A. Some executives (and their advisors) will view the risk of losing pay as something for which there should be compensation (yes, it's perverse). It is likely some will argue pay should go up to make up for the small chance that it will be lost. While I think this will not become the norm, it is absolutely something that may become the norm.

But Trevor's questions may be a bit broader and deeper than this.

How do you think companies respond? I think most companies have already been creating some version of claw back policies.These will evolve quickly to meet these rules. Then companies will evaluate pay programs to determine how to avoid the rules altogether.

Do you see this increasing the cost of labor for Officers with this additional risk? As mentioned prior. Any additional risk to executive compensation is usually met by offering more compensation. This rule could backfire.

What about Finance roles as companies look to make sure they don't have any material errors? I think this will be generally a non-issue for most publicly traded companies. Most have fairly strong financial controls in place already. Most only restate after something truly unusual occurs. Because of the complexity of some businesses it is not altogether unexpected that there may be occasional mistakes. Auditors and companies in industries with a strong legacy should be fine. Those in emerging industries will need to be careful and be aware that mistakes can occur.

Do you see companies adjusting their mix of pay to de-risk incentive exposure? I absolutely see companies looking at pay mix, and at the metrics used to drive pay. Read this next section again and ask yourself how many metric that fit these qualifications may be able to replaced my metrics that do NOT fit the qualifications.

"Incentive-based compensation that is granted, earned or vested based wholly or in part on the attainment of any financial reporting measure would be subject to recovery. Financial reporting measures are those based on the accounting principles used in preparing the company’s financial statements, any measures derived wholly or in part from such financial information, and stock price and total shareholder return."

So change the metrics based on financia information, stock price and shareholder return to internal measures that DRIVE these results instead of DERIVE from these results?

What are the potential negative unintended consequences this could cause?
- Potential increase in executive compensation levels
- Potential for recovery from someone who honestly had no part in the issue and does not have the money to pay things back. This can especially be the case if the compensation paid is equity and the individual does not immediately trasnact that equity into cash, and the stock price then drops and the equity no longer has a value anywhere near the value required for recovery
- Potential for recovering from estates and beneficiaries? Seems doubtful this will be required, but it may be. And if the "B Movie" scenario pays out in full, will some executive end their own life in an attempt to ensure that their surviving family gets to keep the compensation?
- Potential for companies to mve away from metrics that shareholders like and understand to metrics that are more opaque and less directly linked to shareholder value...all to avoid the possibility of loss.
- What about IPOs in new industries, where auditors may have honest differences of opinions on how the accounting should work? If the "best practice" becomes different than a company;s legacy practice, will a resulting restatement truly be worthy of recovery (remember this is a "no fault" rule)

For many (MOST) financially sound companies with the right controls this may be a non-issue. AGREED

What do you see happening with less financially sound companies without the right controls?
I do believe this will make those with lay financial controls take notice. I also believe it wile be one more motivator to go private for those at the fringes of the public company spectrum.
The rule may also have the effect of slowing company that may have otherwise decided to IPO. With the super-high pre-IPO valuations in place and a secondary market that requires far less regulation, and reporting are simply asking (or forcing) investors to move to a market with far less controls that those that existed for public companies prior to Dodd Frank. This then begs the question of will the SEC or other agencies get involved in far more regulation of privately held companies?

Will the 500 shareholder rule (required for SEC reporting) also become the $10Billion Market cap/Value rule? Too soon to tell, but the risks are real.

[Dan Walter]

Then there are things that haven;t even been discussed at all yet.

What if the compensation was donated to a charitable organization? Who will need to pay the company back?

What if the proceeds were split in a divorce proceeding?

Even after the rule is finalized I am sure there will be years of questions and clarifications.

While I have no objection to the concept of claw back provisions, I think that actualization of these will be far less simple than the rule would make things appear.

[Trevor Norcross]

Wow, what a complete response. Thanks Dan.

I agree that regulations that are created will never out-pace those with good imaginations.