Rationalizing The Dodd-Frank Clawback
Harvard Law School; European Corporate Governance Institute (ECGI)
April 13, 2016
On July 1, 2015, the Securities and Exchange Commission (SEC) proposed an excess-pay clawback rule to implement the provisions of Section 954 of the Dodd-Frank Act. I explain why the SEC’s proposed Dodd-Frank clawback, while reducing executives’ incentives to misreport, is overbroad. 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.
Rationalizing The Dodd-Frank Clawback – Introduction
Executives of public firms receive a substantial amount of their pay in the form of incentive compensation—compensation that is tied to a performance metric. Much of this incentive compensation is directly tied to financial accounting results, such as revenues or earnings, or to other performance-related measures. While such incentive compensation can beneficially encourage executives to generate value for shareholders, it can also lead them to misreport financial accounting results or other metrics to generate “excess pay”—extra pay received solely because a pay-relevant metric is erroneous. Such misreporting imposes costs on shareholders of the firm and on the market as whole.
Misreporting is difficult to deter directly through case-by-case enforcement of the securities laws against individual executives. To be sure, extreme forms of misreporting, which are relatively easy to detect and prove, can lead to legal action against individual executives for violating the securities laws. Forfeiture of ill-gotten gains,1 or even more severe punishments, may then follow. However, less extreme forms of misreporting may often go unsanctioned, because of the difficulties of detection and proof, and because the boundaries between good-faith reporting and misreporting are often fuzzy.
The difficulty of deterring misreporting through case-by-case law enforcement has led to a search for alternative regulatory strategies. One such approach is a (no-fault) excess-pay clawback: a mechanism that recovers excess pay without the need to prove misconduct or fault on the part of the executive.2 If executives knew that they would be required to return excess pay, the thinking goes, they would have much less incentive to misreport.
In 2010, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act3 (“Dodd-Frank”), one of whose provisions (Section 954) will require issuers with securities on a national exchange to create and enforce an excess-pay clawback meeting certain requirements (the “Dodd-Frank clawback”).4 On July 1, 2015, the SEC proposed a Rule (Rule 10D-1) to implement the Dodd-Frank clawback (the “SEC’s proposed Dodd-Frank clawback”).5 A final version of the Rule has yet to be adopted.
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.6 There is no need to prove executive misconduct or fault.
The purpose of this Essay is four-fold:
First, to explain that given the current lack of a “reliable” excess-pay clawback at public firms, the Dodd-Frank clawback can be expected to beneficially reduce (at least some) executives’ incentives to misreport financial information to shareholders.
Second, to systematically identify the costs that any reliable excess-pay clawback will inevitably impose.
Third, to argue that the SEC’s proposed Dodd-Frank clawback reaches issuers and executives where it cannot be expected to materially improve incentives, and compensation arrangements where it may well reduce the incentive to misreport but where there is a very high risk that the costs will substantially exceed this benefit.
Fourth, to put 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.
I begin by describing the potential incentive benefits of the Dodd-Frank clawback. I focus on the application of the Dodd-Frank clawback to those executives whose behavior is most likely to be improved by it: top executives at a firm without a controlling shareholder (CS), one with dispersed investors (“a non-CS firm”). At a non-CS firm, directors have small equity stakes and spend relatively little time on firm affairs. For these and other reasons, directors are generally hands-off, turning effective control over to top executives and providing them with high-powered incentives. Given their small equity stakes, directors are unlikely to have a substantial personal interest in taking steps to deter misreporting or, for that matter, pressuring executives to misreport. If misreporting occurs, it is likely to be driven by the executives themselves, who are perhaps seeking to generate excess pay through their high-powered incentives. In this setting, an effective excess-pay clawback is likely to offer the greatest potential incentive benefit.
See full PDF below.