Rationalizing the Dodd-Frank Clawback

Jesse Fried is a Professor of Law at Harvard Law School. This post is based on an article authored by Professor Fried. Related research from the Program on Corporate Governance includes Excess-Pay Clawbacks by Jesse Fried and Nitzan Shilon (discussed on the Forum here).

In Rationalizing the Dodd-Frank Clawback, recently made publicly available on SSRN, I analyze and critique the SEC’s proposed Dodd-Frank clawback. I explain that while the proposed clawback would reduce executives’ incentives to misreport, it is too broad. The economy and investors would be better served by a more narrowly targeted “smart” excess-pay clawback that focuses on fewer issuers, executives, and compensation arrangements.

Section 954 of the 2010 Dodd-Frank Act will, when implemented, require issuers with securities listed on a national exchange to create and enforce an excess-pay clawback. In a nutshell, the Dodd-Frank clawback requires an issuer that has restated its financials to recover from a covered executive who had received “incentive-based compensation” the excess (if any) of (a) the incentive-based compensation she actually received over (b) the incentive-based compensation she would have received under the restated financials. There is no need to prove executive misconduct. On July 1, 2015, the SEC proposed a rule (Proposed Rule 10D-1) to implement the Dodd-Frank clawback. The rule has not yet been finalized.

The paper begins by explaining that the Dodd-Frank clawback can be expected to diminish the expected gains from misreporting, and thus reduce the incentive of executives—specifically, top executives at widely-held firms—to misreport. A reduction in the frequency and severity of misreporting, in turn, will generate various economic benefits, such as reduced restatement-related costs and improved financial-reporting quality.

Dodd-Frank will reduce the expected gain from misreporting because previously there was no reliable excess-pay clawback. Section 304 of the Sarbanes-Oxley Act of 2002 (SOX) gives the SEC the power to force the CEO or CFO to return pay to the firm in certain situations involving a restatement and “misconduct” by the firm itself, even if the SEC cannot show that the executive personally engaged in misconduct. But during SOX’s first decade, when there were approximately 8,000 financial restatements, the SEC used the SOX clawback to recover pay from only six executives who were not alleged to have personally committed misconduct.

Directors could always choose to seek to recover excess pay, under a firm-adopted recovery policy or otherwise. But the overwhelming majority of public firms (about 75%) lack a disclosed recovery policy; in these firms, it is difficult to find any account of directors recouping excess pay. Among the 25% of firms that have disclosed recovery policies, there have been only a few reported instances of recovery, despite hundreds of restatements among these firms. The almost complete absence of recoveries is not surprising. Almost all firm clawback policies give directors discretion to forego recovery, and directors of widely-held firms generally have little interest in getting excess pay back.

After the SEC’s proposed Dodd-Frank clawback is finalized and implemented, executives will face a “reliable” excess-pay clawback for the first time, reducing their expected gains from misreporting and thus their incentive to misreport.

However, the Dodd-Frank clawback will also generate various economic costs—for regulators, issuers, and executives—that will arise with respect to any executive targeted by the clawback, even if the clawback does not improve that executive’s behavior.

After sketching out the benefits and costs of a reliable excess-pay clawback, such as Dodd-Frank, the paper identifies three dimensions along which the SEC’s proposed Dodd-Frank clawback sweeps too broadly. First, it reaches issuers where it is unlikely to generate net economic benefits: “controlled companies” and other types of entities that consist exclusively of controlling-shareholder (CS) firms. While the Dodd-Frank clawback might improve executives’ reporting incentives in a widely-held firm, it is unlikely to do so in a CS firm. The CS has a large financial stake in the company, and exercises control through personally appointed directors. If the CS wants to discourage executives from misreporting, the CS can easily put in place a reliable excess-pay clawback or threaten more severe measures to deter misreporting; the CS does not need the federal government’s help. By the same token, if the CS wants to encourage executives to misreport (say, to enable the firm or itself to sell shares at a higher price), the CS can easily undo the incentives created by the Dodd-Frank clawback through the use of carrots (extra pay) and sticks (implicit threats relating to pay or position) whose magnitudes will dwarf that of the clawback. Thus, the Dodd-Frank clawback cannot be expected to generate material incentive benefits at a CS firm, However, it will still impose costs on regulators, issuers, and executives.

Second, the SEC’s proposed Dodd-Frank clawback reaches too many executives. In particular, it can be expected to reach ten or more executives at each firm, including executives below the top 5 (“below-5 executives”). Application of the clawback to below-5 executives cannot be expected to reduce misreporting. Below-5 executives have much less ability to influence financial reporting results than top-5 executives. More importantly, below-5 executives can be expected to comply with the demands of their superiors, who determine their pay and positions. If top-5 executives signal that below-5 executives should not use their (limited) discretion to misreport, below-5 executives won’t do so, even absent the Dodd-Frank clawback. If, on the other hand, top-5 executives want below-5 executives to misreport, an excess-pay clawback cannot deter the below-5 executives from misreporting. As with the application of the Dodd-Frank clawback to any executive at a CS firm, application of the Dodd-Frank clawback to below-5 executives at any firm is likely to be inefficient: it imposes costs on regulators, issuers, and executives without generating significant incentive benefits.

Third, the SEC’s proposed Dodd-Frank clawback covers too much compensation. The SEC defines covered “incentive compensation” to include not only “accounting-based pay” (pay that is granted, earned or vested based on accounting results) but also “price-based pay” (pay that is granted, earned, or vested based on the stock price). As the paper explains, the clawback is simply not suitable for recovering excess price-based pay: the “but for” stock price is unknowable, and thus the excess amount can only be guesstimated. The need to guesstimate excess price-based pay (and defend the guesstimation to regulators, shareholders, and courts) will lead to large issuer-compliance costs and risk-bearing costs for executives, creating a substantial risk that these costs will exceed any incentive benefits.

After explaining that the SEC’s proposed Dodd-Frank clawback goes too far along these three dimensions, the paper puts forward a more narrowly-targeted “smart” version of the Dodd-Frank clawback—aimed at fewer issuers, executives, and types of compensation—that, I argue, would be more desirable than the SEC’s proposed Dodd-Frank clawback.

The full paper is available for download here.

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