When employees are offered incentives such as bonuses, stock options, or other types of rewards, companies may establish provisions that allow recovery of part or all of the incentives offered. These types of policies are known as “clawbacks.” Such policies seek to encourage executives to abstain from certain kinds of conduct that are viewed as negative, unnecessary, or otherwise undesired by directors and shareholders. For example, companies that operate in the financial industry adopt these policies in cases where executives could harm the company by taking excessive risks or engaging in behavior that embarrasses the company.
These policies seemed like a great idea in retrospect of the collapse of Enron. Advocates believed that these policies could stifle corrupt corporate behavior like the kind that led to the energy criss of 2001 and prevent executives from making unnecessary bets like those that tanked the housing market in the late 2000s. However, clawbacks are very rare and don’t extend to every type of compensation. Additionally, the events that trigger them are very restricted. In fact, the Securities Exchange Commission (“SEC”) has only brought forty cases attempting to recover compensation since 2011 and of those only 18 have generated cash payments from executives.
On July 1, 2015, the SEC issued proposed rule 10D-1, which directs stock exchanges to require each listed company to incorporate the so-called “clawbacks” into company policies and delist any company which fails to do so. With this rule, executives are discouraged from careless financial reporting practices and are encouraged to avoid excessive risk taking in financial transactions. Yet, the rule implemented by the SEC is limited because it only allows companies to recover a fraction of executives’ compensation packages.
Boards have discretion as to how and when this policy applies. Nevertheless, it appears that clawbacks are only pursued when directors are pushed against a wall. This makes logical sense. The fact that directors have to take money back from an executive out of compensation they’ve already been paid because of misconduct, gross negligence, or “material” errors makes the company look bad, makes the directors that allowed such behavior to occur look bad, and damages trust between shareholders (both current and potential), directors, and corporate officers.
Further, the fact that boards have discretion to determine whether any wrongdoing actually has any “material” effect on the company also leaves a dubious zone regarding as to what directors actually consider material.
For example, the recent case of Wells Fargo is a situation in which the scope of the clawbacks was very limited. In this case, the provisions established that the company could recover only a portion of the executives’ pay, and that it would only be triggered in situations where accounting anomalies were found to have a substantial effect on the company.
Pressure from Congress may have been a key element that triggered the directors of Wells Fargo to clawback $60 million in stock grants. Even though this was a crucial decision from the board, it came almost three years after news of the account-opening scandal broke. It begs the question if this decision could actually have a significant effect on the financial outcomes of the scandal and whether it can actually prevent future scandals like it.
Additionally, even though this decision to recover executives’ pay was due to Congressional pressure, Wells Fargo could have inadvertently admitted corporate wrongdoing and possibly opened the door for shareholder lawsuits alleging breaches of fiduciary duties.
clawbacks-not-the-punitive-threat-they-were-thought-to-be (PDF)