The Conference Board Governance Center Blog

Dodd-Frank Corporate Clawback Policies and Board Discretion

The Dodd-Frank Act included a host of executive-pay reforms, such as the “say on pay” requirement that affected companies in 2011. One of the Dodd-Frank reforms currently awaiting SEC regulation is the mandate that any company listed on a U.S. securities exchange must have a compliant clawback policy. With SEC action likely during the first half of 2012, we can expect the debate on clawbacks to heat up again.

At its most basic level, a clawback is a provision that allows a company to recoup compensation paid to an executive if some triggering event makes such action necessary or advisable. A common example is when a financial restatement shows that a prior bonus payment was too large in light of the revised results.

Clawback policies first received attention when the courts addressed their use to recoup stock compensation from departing employees who violated covenants such as non-compete provisions. Following the Enron-era scandals and the passage of the Sarbanes Oxley Act, clawbacks became more prevalent as a tool to recoup incentive compensation in the case of employee fraud or misconduct. Equilar recently reported that more than 84% of the Fortune 100 now have some form of clawback policy, up from 17.6% in 2006.

Dodd-Frank requires a “clawback” of incentive-based compensation if a company has a material financial restatement; the clawback applies to any incentive compensation paid within three years prior to the preparation of the restatement. On its face, the Dodd-Frank Act does not require an executive to have been a “bad actor” for the clawback to be triggered, nor does it specifically provide for board discretion in exercising the clawback.

As part of a series of reports designed to spark thoughtful debate about key and sometimes controversial issues that affect governance, The Conference Board recently released a Director Note by Jesse M. Fried and Nitzan Shilon titled, Excess Pay and the Dodd-Frank Clawback.

In the note, Fried and Shilon state: “In a recent study, we found that most firms lack 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.”

According to Fried and Shilon, the defects in most existing clawback policies stem from two primary points:

1. board discretion in deciding whether to seek to clawback compensation; and
2. that policies often require some wrongdoing on the part of an executive before the clawback can be invoked.

The Conference Board’s The 2011 U.S. Director Compensation and Board Practices Report confirms that most existing clawback policies will require modification to comply with final Dodd- Frank requirements.

According to Bill Ide, counsel at McKenna Long LLP, “too many factors can influence both the decision to exercise the clawback and the amount of compensation to be recovered. For example, under TARP [the Troubled Asset Relief Program], companies are not required to execute an unreasonable clawback, such as one where the cost of enforcement exceeds the amount to be recovered.”

Arthur Kohn, partner at Cleary Gottlieb Steen and Hamilton agrees with Ide. “The idea that clawbacks are best addressed though an inflexible rule, rather than through director judgment and discretion, seems intuitively wrong. In many restatement situations, other interests of the corporation, such as the need to defend itself in related securities litigation, will clearly overwhelm in financial and other respects the important interests in seeking recoupment. We believe directors would be prudent to acknowledge the need to balance various likely benefits and costs by adopting a flexible policy, rather than to pretend that the application of an inflexible rule will provide the best outcome overall. “

“From my perspective as a director at two public companies, it is impractical to believe that boards can effectively develop formulaic criteria to set the amount of compensation that would be appropriate to be recouped in all situations,” Ide says.

Both Ide and Kohn agree that boards will have a critical role in the development and enforcement of clawback policies. Kohn notes that “despite Fried and Shilon’s assertions to the contrary, there is no evidence that boards cannot be entrusted with enforcing clawback policies. And failure to adequately enforce or to pursue a clawback claim could expose directors to claims by shareholders. In light of the conflict of interest between boards and management inherent in any clawback policy, it seems particularly important for directors to have the benefit of independent advisors in formulating a policy and in exercising discretion in a clawback situation. It is very likely that the actions of directors will be under the microscope.”

Meredith Cross, director of the SEC’s Division of Corporation Finance, says she has been advised that the Dodd-Frank Act’s clawback requirement “raises several complex concerns, including what to do about incentive compensation that has both formulaic and discretionary components, whether the board will retain any discretion, and what time period is covered.”

So we know there are many aspects of clawback policies that will be debated during the regulatory process. This is the first of several posts over the coming months that will discuss key aspects of clawback policies.

Should the exercise of clawback policies, including the decision regarding the amount to be recouped, be subject to board discretion? We’d like to hear your thoughts.