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EXCESS PAY CLAWBACKS

Jesse Fried and Nitzan Shilon, in an article published in 2011, analyze the efficiency of clawback policies both under the Sarbanes-Oxley and Dodd-Frank regulation, and recommend several improvements to current legislation.

Many other countries are also deploying these policies, at least in certain sectors, (investment and commercial banks, for instance), and could benefit from this contribution.

1.- The problem of Excess Pay

After Dodd-Frank becomes enforceable, companies need to have a policy to recover payments done on the base of results that have been considered false and restated.

This article suggests the policy leads to at least some firm value generation.

a)      Equity and bonuses are paid in connection with the company`s performance, measured by certain metrics. Errors in metrics, if bonus banks are not used until the metric value is completely certain –or retirement, in the case of equity-, may end in excess payments to executives and directors. It may involve misconduct, (inflated accounting measures), or not, (errors, mainly). The cost for shareholders arises from (i) the value transfer to managers, and (ii) the efficiency costs stemming from mismanagement, (reduction of pay sensitivity to performance, reputation damages that can even lead to bankruptcy, the costs of restatements, and so on).

b)      Managers ability to keep the payments: (i) under Sarbanes-Oxley the Sec could force managers to pay back excess pay, but it rarely did it, because of costs of procedures, and difficulties to prove misconduct; (ii) directors are reluctant to require those payments, for the cost of doing so is high when compared to their personal benefit. The costs arise from the dependency of directors towards current managers, or from litigation against managers having left the firm.

2.- Clawback policies before Dodd-Frank

Approximately 50% of firms did not have clear clawback policies. Of those having them, 81% left the decision to give back excess amounts on directors` hands; for the rest, 86% did not allow executives to pay them back if a “misconduct” estatement hadn`t been issued. Only 2% of firms forced directors to pay back.

Why didn`t firms voluntarily adopt robust policies? Fried and Shilon argue as follows:

 

a)      What`s the problem with the board`s discretion? Under discretion, the executive will likely defend itself in Court, (in the hope the board abandons the claim if costs rise);  also, without discretion, there is a deterrent effect in the policy.

b)      And in cases where misconduct is required for the board to ask for the clawback, (i) there is still a discretionary power to determine whether misconduct existed; (ii) or simply, it may be difficult to find.

Why haven`t firms adopted robust policies? There are two main reasons according to the authors:

 

a)      Managerial power and opposition to adopt them.

b)      Short-termism on the side of directors, who eventually may think such clauses prevent managers from decisions that would raise the stock price in the short-term, (misconduct included or not).

3.- Dodd-Frank

Dodd-Frank requires the Sec to regulate that Stock Exchanges issue a rule that forces companies to have clawback policies for restatement cases, even if no misconduct is found. Those policies include:

–         Current and former executive managers,

–         Any incentive-based compensation having

i.      Involved erroneous data

ii.      Been paid in the three prior years to the requirement of restatement,

iii.      In excess of what would have been paid with restated figures or metrics.

There are nevertheless two defects in the new rule, Fried and Shilon say:

–         First: Not every mistake leads to a restatement:

i.      There can be small errors not requiring restatement,

ii.      There can be non-financial metrics used to determine incentives,

iii.      Also the company can reject to restate the books, even if it is generally agreed that it is required.

–         Second: Not all pay excesses can be called back; for example, stock sales proceeds obtained at high prices after manipulations. In this case several improvements could be introduced:

i.      To let executives sell their stocks but at an average price that avoids inflated temporary values,

ii.      Executives can be prevented from selling their stock when they decide,

iii.      Or they can be forced to announce their decision with a certain advance, so the market can anticipate the “hidden” problems.

Other situations that SHOULD require directors to pay some amounts back:

  • Insolvency situations that arise, without any restatement.
  • Unethical behavior or violation of the duty of loyalty.

Based on Excess-Pay Clawbacks, by Jesse Fried and Nitzan Shilon.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1798185

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