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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.
PESCANOVA, a fantastic firm, in big trouble
In 1931, a small entrepreneur from Galicia, (Northwestern Spain) died. He had been a meat and cattle dealer. His three sons continued the father`s business, and were very successful, partly because of their innovations, such as the idea to freeze meat for transportation to the market.
They invested the returns in other businesses, as the one we will refer to in this post, Pescanova.
Pescanova is an industrial fishing firm, which was one the first to introduce freezer vessels in the activity in the 60`s. They afterwards bought an old transatlantic boat, which was renewed into a fish processing floating factory. In recent times, it has developed a new but related activity, aquaculture, (they grow turbot, shrimp, and salmon).
It is present in the five continents, it employs more than 8000 people worldwide, it integrates vertically more than 160 companies, it is adapted to new times, (aquaculture already accounts for a third of their Ebitda), and it has acceptable profitability, (as per 3rd quarter results, see here:
http://www.pescanova.com/i/pdf/agenda_inversor/2012/HR_161112_T3.pdf).
Many analysts had been recommending purchasing the company stock, as it had a promising business mix, international exposure that was helping the business grow, and Spanish operations that appeared to be very resilient to the crisis, (in fact revenue was increasing slightly).
But then, the date they should have sent the audited accounts for 2012 to the Spanish SEC equivalent, -www.cnmv.com-, (february 28th) they din`t, and instead they communicated that they would not be sending them until they sold certain assets, or until they renegotiated debt with banks. This second option is followed by the company, (March 1st).
What happens next?
Information is leaking little by little: apparently a larger debt volume exists than the volume registered until now in the company books, and it appears that the complex corporate structure, could have helped hide the high leverage.
On March 12th, the company states that discrepancies had been found between actual debt levels and the volume recorded in the books.
On March 14th, an extraordinary board meeting is held, (after some shareholders and their directors asked it), where the Chairman exposed the firm situation, the need for a reconciliation between debt as recorded in the books, and the real debt volume the company had acquired.
A notice is sent to the regulator, where it is stated the board that day had unanimously agreed to pursue the path to renegotiate the company debt. Slightly afterwards, some board members sent a notice denying such unanimity. They state that once the auditors determine the actual debt value, a board meeting was to be held. The company then answered, (again via notice to the Sec equivalent), that the board decided to pursue the renegotiation, (avoiding to give more details on the eventual vote), and that no board meeting had been called yet.
The same day, banks have built a commission that would be charged with mapping all the company debt, (they will retain a financial advisor and an audit company).
What can be said about the company corporate governance? according to the Corporate Governance Report for 2011:
– The board is made of twelve members, only two of them independents. One of them was recently named Audit Committee Chair. The rest are owners` representatives, except for the Executive Chairman, also owner of a 14% stake.
– There is no Committee responsible for Corporate Governance: the board itself has that role.
– Independents are not a third of the total. Directors are mostly shareholders or their representatives.
– There are not enough tools to counter the power of the main executive, and only board and general assembly are said to be responsible to execute checks and balances, (just a formal say, clearly).
– There is no relevant role for independents in calling the board, including points in the agenda, evaluating the board, or taking care of the external directors`views.
– Audit committee met only twice in 2011; the Compensation and Recruiting committee, three times. The AC is not charged with wistleblowing activities, that have not an established and protective channel.
– There are no limits to the number of directorships they can hold.
– The board is responsible for (among other things) the financing and investing policy, the corporate structure of holding and subsidiaries, and risk assessment and control.
– The Audit Committee is responsible for mapping risks, assessing them, controlling them, including: the perimeter. There is an Internal Audit function.
– Significant holdings include up to 18.931% by non-directors, and 38.276% by directors, thus a total 57.206%.
What did the regulator do?
The regulator has opened an investigation for possible market abuse activities by the company, stemming from the fact that the accounts may have been wrong, and eventually from insider information related transactions.
Of course, it has urged the company to deliver its accounts, but the delay had to be extended, as the company is finding great difficulties in doing so.
Some news in the Press.
News in the press point to a certain subsidiary or subsidiaries, only 49% owned by the Pescanova group, as being involved in certain transactions that stayed out of sight, as the audited consolidated accounts did not include all assets and liabilities for these companies. It appears, according to other sources, that those companies helped the company hide the debt. The company nonetheless, states these companies developed normal activities.
The company auditor (BDO) and the auditor named by the bank group (KPMG) are said to be trying to unveil the truth, so that the company can deliver its reshaped books to the Cnmv, which should take place sometime before the end of March.
On April 4th a board meeting is held, for 13 hours, in which the situation is analysed; as a result, the company issues a notice to the CNMV, (you can see it here http://cnmv.es/Portal/HR/verDoc.axd?t={d615f08f-4665-4dd8-956e-353e109d0add}, where it states: first, the company, given the difficulties in achieving an agreement with creditors, declares voluntarily a bankruptcy situation, (which entails it should prepare an agreement proposal to creditors which will assure the company`s survival); second, the company has decided to ask the judge to revoke the auditor`s nomination and name a different one.
According to the press, the auditor, BDO, did not receive in the last days enough and timely information, so that the company has not been able to provide its accounts, as the auditor would have rejected to sign them. In fact, the company in his statement did not include information as to what the actual debt level is. Also according to the press, Pescanova would be preparing to sue the auditor.
The CNMV has issued a press release on April 5th in which it informs that it has opened a procedure, that could end with a fine being imposed to the company, for having failed to send the second semester accounts and complementary information, required by the Cnmv in two previous deadlines, the last ending on April 5th. That gives time to the company until April 11th.
The situation is worsening day by day, and as the press info show: the auditor –BDO- is still working, but there is not a good relationship with management, so they are probably not receiving much openness from the company. Management is still in place, (no info has been released regarding the internal auditor, CFO, or any other), not a single director has been dismissed, the Executive Chairman rejects to leave, the banks have apparently rejected to offer any help whatsoever before having access to 2012 accounts, (as they fear there is even much more debt that the level published in the press), and the company apparently has only a few days of liquidity.
As one of shareholders points out in its annual accounts, an urgent and not explained cash need in February was the red flag two shareholders raised, in the board that should have (and did not) approve the 2012 accounts. This is very clarifying, but information goes out very slowly.
To be followed and updated…
Just a small update:
– The Executive Chairman sold half his 14% stake months before the problem was unveiled, in order to provide cash to the company: he obtained € 30 million, but gave a 9 million loan to the company. He did not notice that to the market, as he should have done. Of course, after the facts were discovered, the stock price plunged, and trading was suspended: the rest of shareholders are stuck.
– On April 15th the company has filed for bankruptcy.
– On April 15th, the auditor, BDO, rejects that any cause exists for its dismissal as auditor, and demands the company to provide the required information.
– On April 15th the company has not provided to the Cnmv the Second Half 2012 accounts with enough transparency and sound accounting standards.
– The Spanish Sec equivalent, http://www.cnmv.es, has opened an inquiry, and has decided to follow-up the tasks of KPMG, as a forensic auditor retained by the company.
Nobody explains yet the origin of the liquidity shortage and the reason for such an extraordinary unknown debt level, what the debt was used for, and so on.
To be updated…
Basic topics on Corporate Governance 