Making Executive Compensation More Accountable

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at a recent open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. Related research from the Program on Corporate Governance about CEO pay includes Paying for Long-Term Performance (discussed on the Forum here) and the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, both by Lucian Bebchuk and Jesse Fried.

When it comes to compensation, Americans believe you should earn your money. They also believe, just as strongly, that you should not keep what you did not earn. It’s fundamental to our values. However, when companies have to restate their financial statements because they violated applicable reporting requirements, their executives may not be required to reimburse any incentive-based compensation that was erroneously paid. In other words, they get to keep what they never should have received in the first place.

And, quite often, we are talking about very large amounts. In today’s corporate world, many executives are earning eye-catching sums. Much of the increase in executive compensation is commonly attributed to the impact of incentive-based compensation, including equity and other performance-based compensation plans.

Incentive-based compensation plans are intended to align the interests of company managers and shareholders. However, when a company is required to issue a restatement, and when its executives have been paid compensation based on inflated financial results, this alignment disappears. In such cases, it is only fair that these erroneously awarded payments be recovered.

To address this improper enrichment, Section 954 of the Dodd-Frank Act mandates that the Commission adopt rules to require that registered stock exchanges impose requirements that obligate listed companies to develop and implement policies that, in the event they are required to issue restatements, result in the recovery—or “clawback”—of erroneously paid incentive-based compensation.

To fulfill that mandate, the Commission is proposing Rule 10D-1 to the Securities Exchange Act of 1934. Consistent with the breadth of the statutory mandate, today’s proposed rules define “incentive-based compensation” as compensation based in whole or in part upon achieving any “financial reporting measure.” This would include compensation based on stock price and/or total shareholder return (“TSR”), which are now widely used. In fact, according to a study released on June 4, 2015, approximately 51% of the top 200 public companies making performance-based grants for executive compensation based it on a TSR measure. Today’s rules recognize this reality by defining incentive compensation to include performance-based compensation paid to executives based on a company’s stock price and/or TSR.

To be clear, as the release points out, the definition of “incentive-based compensation” does not include all forms of executive compensation. For example, it 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. The release asks questions as to whether these or other forms of executive compensation should be included in the definition of incentive-based compensation.

Today’s proposed rules also contain the following components, among others:

  • First, today’s proposed rules apply to incentive-based compensation paid to any executive officers of the issuer. This helps ensure that all of those in a position of responsibility for executive-level decisions would be held accountable for the integrity of the company’s financial statements.
  • Second, 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 the board’s independent directors determines that (i) pursuing such recovery would be impracticable because the direct expense of seeking recovery would exceed the recoverable amounts; or (ii) pursuing such recovery would violate foreign law. Under both of these exceptions, the issuer would be required to meet certain additional conditions designed to prevent these exceptions from undermining the effectiveness of the proposed rules. The release seeks public comment on whether the proposed rules include adequate protections to prevent these two exceptions from creating unintentionally large loop-holes.
  • Third, listed companies will be required to disclose both the substance of their recovery policies and how they implement their policies in practice. The proposed rules would also require each company to disclose when a decision has been made to forego recovery of incentive-based compensation that would otherwise be subject to the clawback policy.
  • Fourth, listed issuers would be prohibited from engaging in an end-run around the clawback policy by indemnifying any current or former executive officer against the loss of erroneously awarded compensation. Moreover, issuers would be prohibited from paying the premiums on an insurance policy that would cover an executive’s potential clawback obligations.

Conclusion

In summary, taken together, the elements of the Commission’s proposed Rule 10D-1 should go a long way toward prohibiting improper enrichment of executives for companies faced with a restatement. Moreover, the existence of a clawback policy should, among other things, incentivize executives to create a culture of compliance that results in accurate reporting of financial performance. The end result is that, hopefully, fewer financial statements will be required to be restated.

For all these reasons, I will support the staff’s recommendation. At their core, today’s proposed rules send the following message: if you did not earn your compensation, you should not keep it.

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