One of the recurrent governance proposals to remedy corporate excesses has been the idea of clawing back the compensation paid to company officials who presided over corporate scandals. Both the Sarbanes Oxley Act and the Dodd-Frank Act included provisions mandating compensation clawbacks for corporate executives at companies that restate their financial statements. As Columbia Law School Professor John Coffee details in his November 21, 2016 CLS Blue Sky Blog article entitled “Clawbacks in the Age of Trump” (here), despite these statutory revisions, the use of “extreme incentive compensation” continues to motivate corporate behavior. In order to counter-balance the impact of incentive compensation, Coffee suggests that companies should adopt their own compensation clawback requirements that apply more broadly than the statutory clawback provisions.
As Coffee details in his article, some of the most egregious recent corporate scandals are best understood as the results of incentive compensation schemes that promised executives enormous financial rewards if they hit specific performance targets. For example, according to Coffee, the drug pricing scandals that have hit Valeant Pharmaceuticals and Mylan N.V. were the result of compensation schemes that as structured “incentivized” the executives at those companies to take risk. Coffee also cites as an example of this phenomenon the recent banking account-opening scandal at Wells Fargo.
The Wells Fargo case is an interesting example in another respect, in Coffee’s analysis, and that is because the problems at that company resulted in massive clawbacks of the incentive compensation paid to the company’s CEO (from whom $41 million was recouped) and Executive Vice President (from whom $19 million was recouped).
These Wells Fargo compensations clawbacks are all the more noteworthy because they took place in circumstances to which the Sarbanes-Oxley Act and Dodd-Frank Act compensation clawbacks would not apply; the statutory clawback provisions are triggered only in the event of a financial restatement. In the case of Wells Fargo, there was no financial restatement so the statutory clawback provisions did not apply. However, Wells Fargo had its own compensation clawback provisions, that applied in a broader range of circumstances than just in the event of a financial restatement.
Coffee suggests that companies can avoid the kind of distorted results that “extreme” incentive compensation has produced at certain companies by counterbalancing the incentive compensation with “an appropriately designed clawback.” The Wells Fargo example, Coffee suggests, shows that “a responsible board can design a clawback that does not require a restatement to trigger it.”
Among the features of the Wells Fargo clawback provisions that Coffee cites are measures providing for a compensation clawback for misconduct “expected to have a reputational or other harm”; misconduct that causes “significant financial or reputational harm to the Company or its executive’s business group”; “improper or grossly negligent failure” to identify and report “risks material to the Company or the executive’s business group”; the making of an award that was based on “materially inaccurate performance metrics, whether or not the executive was responsible for the inaccuracy”; or if the company or the executive’s business group “suffers a material downturn in financial performance or suffers a material failure of risk management.”
As Coffee notes, the provisions “go well beyond financial restatements” but also “leave business judgment discretion in the board as to whether to implement them.” Even if boards might be inclined to “stonewall” on enforcing clawbacks, the “pressure can mount to the point where the board will be compelled to invoke a clawback,” as happened at Wells Fargo.
Coffee puts his remarks in the context of the recent U.S. Presidential election, noting that under a Trump presidency, we “can expect rampant deregulation and reduced enforcement.” The corporate compliance function may also retreat as well. Incentive compensation, Coffee notes, may be here to stay, but it needs to be countbalanced by broad clawbacks. In an era of reduced regulatory enforcement, clawbacks may be “the last line of defense for shareholders.” The proper design of clawbacks “could move to front and center on the corporate governance stage.”
The adoption of compensation clawbacks is one of those perennial topics that always comes up when corporate scandals emerge (as I noted at the early stages of the global financial crisis, here). Part of the appeal of the clawback mechanism, I know, is the instinct that corporate executives should not be able to retain the outsized compensation they garnered as they were mismanaging the company (or even worse, committing fraud).
Coffee’s advocacy of compensation clawbacks is based on a slightly different notion, which is that the threat of a compensation clawback is a necessary safeguard to counteract the distorted incentives of an “extreme” incentive compensation program. I certainly agree with Professor Coffee that broadly based clawback provisions of the kind Wells Fargo adopted would afford corporate boards with tools they might need to deploy in certain kinds of circumstances, and to that extent the clawback provisions seem to represent a well-advised corporate governance approach.
But the assessment that the clawback provisions actually counterbalance the distorted incentives of an “extreme” incentive compensation plan depends on a psychological assessment that may or may not be valid. Individuals who are motivated to take risks to try to capture outsized financial rewards may or may not be deterred by the possibility that they might have to return the money if something goes wrong. It may well be that the possibility of a clawback discourages undesirable behavior, but I think it is an open question whether or not clawbacks actually have this type of deterrent effect.
Indeed, the example on which Coffee relies actually suggests the contrary. Coffee cites the Wells Fargo clawback provisions as “a model,” and indeed the clawback provisions did allow Wells Fargo to recoup compensation paid to company executives who presided over programs that harmed the company and damaged its reputation. But the simple fact is that the existence of the Wells Fargo clawback provisions did not deter the misconduct that caused the problems at the company.
Clawback provisions may or may not be a good idea, but the case has yet to be made that the existence of clawback provisions will deter the kind of undesirable behavior that “extreme” executive compensation can produce.
I did think it was interesting that Coffee put his analysis in the context of the recent Presidential election. He clearly is of the view that in the Trump administration, SEC enforcement will decline, so it will be up to companies to police themselves. In that context, the adoption of compensation clawback provisions may be an appropriate measure for corporate boards to adopt, particularly as a way to give boards tools to use in the event that problems do arise. But clawback provisions as a means to deter misbehavior is an unproven proposition.
Whenever the topic of compensation clawbacks comes up, the next question I always asked get asked is whether or not there is insurance available to protect officials against clawbacks. I always find these questions a bit puzzling. The very idea of a clawback is that it represents a forfeiture of compensation that was earned improperly; I am always unclear when I get asked the insurance-related question why anyone thinks insurance for this type of disgorgement remittance would ever be appropriate. Certainly if clawback provisions are there to provide some type of deterrence, the existence of insurance that would step in and pay clawback amounts would completely undermine any intended deterrent effect.
Moreover, a company’s effort to recoup compensation from an executive that the company asserts was paid improperly would run afoul of standard exclusions found in most D&O insurance policies, including the Insured vs. Insured exclusion (or its modern variant, the Entity vs. Insured exclusion) and the Improper Profit or Remuneration exclusion.
These kinds of insurance-related question come up so often that I wonder why corporate boards are not out in front on these issues, and including within corporate compensation clawback provisions a measure specifying that any clawed back compensation must be paid by the corporate executive himself or herself, without indemnification or insurance from any other source.
That said, I can certainly see the need for a defense cost-based solution that provides corporate executives who want to fight a clawback effort a means to mount their opposition. A defense cost carve-back to the Insured vs. Insured (or Entity vs. Insured exclusion) might allow for this type of defense cost protection.