Excess-Pay Clawbacks

Jesse Fried is a Professor of Law at Harvard Law School.

In the paper, Excess-Pay Clawbacks, which was recently made publicly available on SSRN, Nitzan Shilon and I identify substantial deficiencies in the clawback arrangements of public companies. We also explain why the Dodd-Frank Act’s clawback requirement is likely to improve these arrangements, but does not go far enough.

The paper begins by highlighting the problem of “excess pay” – excessively high payouts to executives arising from errors in earnings and other compensation-related metrics. Such excess pay, we explain, can impose substantial costs on shareholders even if there is no manipulation or other misconduct. Unfortunately, directors frequently use their discretion to let current and departed executives keep excess pay. Thus, an optimal clawback policy would require directors to recover excess pay from either current or departed executives.

The paper then examines excess-pay clawback policies in S&P 500 firms prior to Dodd-Frank. We find that nearly 50% of S&P 500 firms had no excess clawback policy whatsoever. Of those firms with clear policies, 81% did not require directors to recoup excess pay but rather gave directors discretion to let executives keep excess pay. Of the remaining firms, 86% did not permit directors to recoup excess pay absent a finding of misconduct. As a result, fewer than 2% of S&P firms required executives to return the excess pay under any circumstances. Thus, on the eve of Dodd-Frank, most executives were not subject to sufficiently robust excess-pay clawback policies.

The paper then turns to Dodd-Frank’s clawback requirement. Dodd-Frank mandates that firms adopt a policy to recover excess payments to executives when there has been a restatement, even if there has been no misconduct. Given the inadequacy of firms’ excess-pay clawback policies, Dodd-Frank is likely to substantially improve the quality of clawback arrangements at most publicly-traded firms. In particular, Dodd-Frank will substantially increase the likelihood that excess pay will be recovered from executives and thus reduce the costs of excess pay to shareholders.

Unfortunately, we explain, Dodd-Frank does not appear to require the recovery of all types of excess pay. In particular, Dodd-Frank does not require firms to recoup excess pay from executives in the absence of an earnings restatement and does not appear to require firms to recoup from executives’ excess pay arising from the sale of stock at prices inflated by earnings manipulation. We conclude by explaining why permitting executives to keep both types of excess pay is likely to be undesirable and suggesting how boards seeking to improve executives’ incentives should address these two issues.

The full paper is available for download here.

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