Excess-pay clawbacks.

• Author: Fried, Jesse M.

1. Introduction II. The Problem of Excess Pay A. Excess Pay and its Costs to Investors 1. The Likelihood of Executives Receiving Excess Pay a. Excess Pay without Misconduct b. Excess Pay Resulting from Misconduct 2. Excess Pay: The Costs to Investors a. Value Diversion b. Value Destruction B. Executives' Ability to Keep Excess Pay 1. The SEC's Reluctance to Recoup Excess Pay a. The SOX Clawback b. The Limited Effectiveness of the SOX Clawback 2. Directors' Reluctance to Recoup Excess Pay a. Personal Benefit of Recouping Excess Pay b. Personal Cost of Recouping Excess Pay (1) Recovering from Current Executives (2) Recovering from Departed Executives III. Excess-Pay Clawback Policies Before Dodd-Frank A. Excess-Pay Clawback Policies in the S&P 500 1. No Excess-Pay Clawback Policy in Almost 50% of Firms 2. The Non-robustness of Excess-Pay Clawback Policies a. No Recovery Required (1) Discretionary Clawbacks (2) The Problem with Giving Boards Discretion b. No Misconduct, No Clawback (1) The Misconduct Hurdle to Recovery (2) Costs of a Misconduct Hurdle 3. The Big Picture B. Explaining the Lack of Robust Clawback Policies 1. Managerial Power 2. Short-termism IV. The Dodd-Frank Clawback and its Implications A. The Dodd-Frank Clawback Requirement and its Benefits 1. The Dodd-Frank Clawback Requirement 2. Benefits of the Dodd-Frank Clawback Requirement B. Will Dodd-Frank Undesirably Reduce Incentive Pay? C. Two Limitations of Dodd-Frank's Requirements 1. No Restatement, No Clawback 2. No Clawback of Excess Stock-Sale Proceeds V. Conclusion I. INTRODUCTION

   On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). (1) Among other things, Dodd-Frank requires publicly-traded firms to adopt policies that compel the recovery of certain payments made to executives on the basis of financial results that turn out to be false and require a restatement. (2) In particular, a firm that is required to restate its financial results must recover certain incentive-based compensation paid to an executive that exceeds the amount he would have received under the restated results. (3) The Securities and Exchange Commission (SEC) is currently developing regulations to implement this new clawback policy requirement. (4)

   A number of legal academics have criticized the federal government for imposing this excess-pay clawback requirement on all publicly traded firms. (5) Mandating such clawback policies, they argue, is an unnecessary and undesirable intrusion into these firms' compensation arrangements; private ordering will yield better results. (6) Indeed, over 80% of Fortune 100 firms had voluntarily adopted some form of clawback policy before Dodd-Frank was enacted (7)--a pattern that appears to support these critics' claims.

   This Article explains why Dodd-Frank's clawback-policy requirement will likely improve compensation arrangements at public firms, but does not go far enough. Part II discusses why a robust excess-pay clawback policy--one that requires firms to recover extra pay received by executives as a result of errors in performance measures--would be expected to boost "firm value," the value flowing to all of the firm's shareholders over time. (8) We begin by showing that an executive's ability to keep excess pay imposes costs on shareholders, even if the executive has not committed misconduct. We then explain why, absent a robust excess-pay clawback policy, executives will often be able to keep any excess pay that they receive. First, the recovery provision of the Sarbanes-Oxley Act of 2002 (SOX) (9) is unlikely to be used to claw back an executive's excess pay. Second, when given discretion, directors cannot be expected to choose to recoup excess pay from either current or departed executives.

   Part III examines excess-pay clawback policies prior to Dodd-Frank: Did firms put in place robust policies-policies requiring boards to recoup excess pay? We find that, before Dodd-Frank, nearly 50% of S&P 500 firms had no excess-pay clawback policy whatsoever. Of those firms with clear policies, 81% did not require directors to recoup excess pay but rather gave directors discretion to allow executives to keep excess pay. Of the remaining firms, 86% did not permit directors to recoup excess pay absent a finding of "misconduct." As a result, less than 2% of S&P 500 firms required directors to recover excess pay from executives whether or not there was misconduct. Thus, on the eve of Dodd-Frank, most S&P 500 executives were not subject to robust excess-pay clawback policies. We conclude Part III by offering two explanations for firms' failure to voluntarily adopt adequate clawback policies before Dodd-Frank.

   Part IV turns to Dodd-Frank's clawback requirement, which mandates that publicly-traded firms adopt a policy to recover certain kinds of excess pay received by executives when a restatement is required, regardless of whether there has been misconduct. We explain why, given the inadequacy of the SOX clawback and firms' own weak excess-pay clawback policies, Dodd-Frank is likely to substantially improve the quality of compensation arrangements at most publicly-traded firms. We also consider--and reject--the argument that Dodd-Frank will undesirably reduce the use of incentive pay in public firms.

   Part IV then explains that Dodd-Frank's requirement does not mandate the recovery of all types of excess pay. First, Dodd-Frank does not compel firms to recoup excess pay from executives unless a restatement is required. Second, Dodd-Frank does not appear to require firms to recoup excess pay arising from executives' sale of company stock at prices inflated by errors in earnings or other metrics. We discuss why permitting executives to keep these forms of excess pay is likely to be detrimental to firms and their shareholders. We also suggest how boards seeking to improve executives' incentives should address these two limitations. Part V concludes.

   Before proceeding, we wish to emphasize that a publicly-traded firm may need to be subject to other types of clawback policies besides one targeted at excess pay. For example, in a financial firm, it may be desirable for the government to recover payments to executives whose decisions put the firm at risk and necessitated a government bailout, whether or not there were errors in the metrics used to determine those payments. (10) Such insolvency clawbacks would deter executives from taking risks at taxpayers' expense. And should the firm require a bailout, insolvency clawbacks would reduce the cost of the bailout to taxpayers. Similarly, it may be desirable to claw back the pay of executives who engage in certain types of misconduct, such as unethical behavior or violations of the duty of loyalty, even if their pay is properly calculated. Such misconduct clawbacks could deter executives from acting in certain ways that harm the corporation and its shareholders. (11) However, our focus in this Article is only on excess-pay clawback policies: policies designed to recover extra pay that executives receive solely because of errors in earnings or other performance metrics.

2. THE PROBLEM OF EXCESS PAY

   This Part describes why excess pay can impose large costs on investors. Part II.A explains that errors in earnings or other compensation-related metrics often inflate executive pay. If such unearned pay were likely to be recovered, it would not impose substantial costs on shareholders. However, as Part II.B discusses, shareholders cannot rely upon the SEC or directors who have discretion over whether to recoup excess pay to recover such pay.

   1. Excess Pay and its Costs to Investors

      Executive compensation arrangements are likely to give rise to erroneously high payouts to executives. These excess payouts can impose substantial costs on shareholders when they are not recovered.

      1. The Likelihood of Executives Receiving Excess Pay

         Executives receive a substantial amount of their pay in the form of incentive compensation--equity and bonuses. (12) Much of this incentive compensation is directly or indirectly tied to quantifiable performance measures. For example, bonuses are often directly linked to a company's annual earnings. (13) In addition, the payoff from executives' sale of equity is indirectly tied to current earnings because reported earnings affect the stock price. (14)

         The mismeasurement of these performance metrics can lead to erroneously high payouts, or "excess pay." (15) As we explain below, such mismeasurement may arise with or without "misconduct" (however that term is defined) by executives or their firm. (16) Thus, even an executive acting in good faith could end up receiving substantial amounts of excess pay.

         Importantly, excess pay is not an inevitable outcome of executive compensation arrangements. Compensation arrangements could be structured to prevent excess pay from arising in the first instance. Firms could address the problem of excess bonus pay (and the need for bonus clawbacks) by keeping the bulk of bonuses in "bonus banks" that deliver value to executives only after the accuracy of the results driving the bonuses is assured. (17) Alternatively, as Sanjai Bhagat and Roberta Romano have emphasized, the problem of excess pay (and the need for clawbacks) could essentially be eliminated altogether by compensating executives primarily with equity that must be held until after retirement. (18) But until boards adopt such approaches--for which they currently show little appetite (19)--compensation arrangements will continue to generate excess pay.

         1. Excess Pay without Misconduct

            Excess pay is not always the result of misconduct; it can arise from the accidental mismeasurement of a compensation metric. Suppose, for example, that an executive is to be paid a bonus of $100,000 for each $10 million in reported earnings. The executive and the firm take all reasonable precautions to ensure the accuracy of reported...