Executives at companies that misreport finances will lose their bonuses under a new rule adopted by the Securities and Exchange Commission yesterday (Oct. 26).
The rule, which is set to take effect in a year, will require all public companies to adopt so-called “clawback” policies that rescind executives’ incentive-based compensation if their firms revise previous financial statements to correct an accounting error (a practice commonly known as a restatement). Should an error occur, companies must have a policy to recover executives’ incentive-based pay, including stock options, dating back three years from when a restatement is issued.
Though the rule is intended to prevent corporate executives from holding onto erroneously-awarded pay, such policies have proven difficult to enforce for companies in the S&P 500, most of which already have clawback regulations in place. Previous examples of unsuccessful clawback attempts at companies like Goldman Sachs (GS) suggest recovering executives’ bonuses may prove tricky, even with stronger regulatory oversight.
SEC seeks to crack down on executives who misreport financials
A clawback rule was included in the 2010 Dodd-Frank act passed by Congress following the financial crisis, but never adopted by the SEC. Though a rule was introduced in 2015, it was never finalized, and remained untouched in the years that followed, when Republicans controlled the agency. Gary Gensler, a Democratic appointee and the current SEC chair, announced earlier this month the agency was reopening comments on the 2015 rule. It passed 3-2, with all Democrats on the Commission in favor, and Republicans against.
Gensler explained the reasoning behind the policy in a statement ahead of yesterday’s vote. “Corporate executives often are paid based on the performance of the companies they lead, with factors that may include revenue and business profits,” he said. “If the company makes a material error in preparing the financial statements required under the securities laws, however, then an executive may receive compensation for reaching a milestone that in reality was never hit.”
One of the most notorious financial restatements in history occurred at the Enron Corporation, which admitted in 2001 to overstating its profits by about $600 million over a period of five years. The Enron scandal helped prompt passage of the Sarbanes-Oxley Act in 2002, which mandated certain financial record-keeping requirements for public companies, and included a provision requiring chief executive officers and chief financial officers to repay bonuses and other incentive or equity-based compensation to their company following a restatement.
Most S&P 500 companies adopted clawback policies in the wake of Sarbanes-Oxley, and today all but 21 of these firms have some kind of clawback in place, according to ISS Corporate Solutions, a data and analytics provider to corporations.
Since the SEC rule applies to all public companies, it will widen the pool of U.S. firms where executives are liable to lose their bonuses should an accounting error occur. ISS notes that smaller companies are less likely to have clawback policies on the books, particularly in sectors such as healthcare and communication services. Hester M. Peirce, a commissioner who voted against the rule, cited one estimate suggesting the rule could apply to as many as 50,000 public company employees.
This rule will also expand the types of restatements that could trigger a clawback. Whereas the 2015 rule would have only applied to major accounting errors, prompting a restatement of financial results from previous years, the recent rule passed by the SEC will require companies to claw back incentive pay when smaller errors occur as well.
Past examples suggest SEC rules may be difficult to enforce
While the SEC rule is intended to prevent executives from providing misleading financial statements that inflate their earnings, “it’s not clear it’s going to accomplish that,” said Sanjai Bhagat, a finance professor at the University of Colorado Boulder who previously worked for the SEC.
“When companies have tried to use clawbacks to get compensation back from their managers…the companies have not been very successful,” he noted. Goldman Sachs, for example, hasn’t been able to claw back money from some executives over the 1MDB corruption scandal, during which executives paid bribes to foreign officials to obtain business for the bank. One former Goldman executive, Gary Cohn, never returned his pay to the company, and instead gave it to charity.
Part of what makes clawbacks hard to enforce is the way executives are typically compensated, with incentives based on short-term measures such as stock options, said Bhagat. By the time executives are ordered to pay back their companies, sometimes the funds have already been spent. In an article for the Harvard Business Review published last year, Bhagat and Charles M. Elson, founder of the University of Delaware’s Weinberg Center for Corporate Governance, argued the issue could be addressed by providing incentive compensation in the form of restricted equity that can’t be sold or exercised until after an executive has left the company.
This approach, “would address the SEC’s concerns about clawbacks in a much more effective way,” said Bhagat.
In recent years some companies have started to delay paying out top executives in case they’re found responsible for misconduct down the road. As Elson told the Wall Street Journal last year, “the most effective way to recoup it is to never give it out to begin with.”
