Is The Proposed SEC Clawback Rule A Mistake? Some Expert Perspectives

On July 1, 2015, the Securities and Exchange Commission voted 3-2 to propose new rules requiring that public companies “clawback” the incentive pay of executives if a company’s financial statements are later found to contain errors, expanding existing clawback scenarios to apply more broadly to restatements, including those issued because of mistakes. Here’s more, from the SEC’s news release:

Under the proposed new Rule 10D-1, companies [listed on national securities exchanges] would be required to develop and enforce recovery policies that in the event of an accounting restatement, “claw back” from current and former executive officers incentive-based compensation they would not have received based on the restatement. Recovery would be required without regard to fault. The proposed rules would also require disclosure of listed companies’ recovery policies, and their actions under those policies.

“These listing standards will require executive officers to return incentive-based compensation that was not earned,” said SEC Chair Mary Jo White. “The proposed rules would result in increased accountability and greater focus on the quality of financial reporting, which will benefit investors and the markets.”

The proposed rule seems well-intentioned — but it it wise? On Wednesday night, here in New York City, Above the Law and Wolters Kluwer hosted a panel discussion on the new SEC clawback rule, featuring the following panelists (with ATL editor Joe Patrice as moderator):

• Ralph Ferrara, a securities litigation partner at Proskauer and former general counsel of the SEC;
• Marc D. Powers, head of the securities litigation practice at BakerHostetler; and
• Thornton McEnery, senior editor of Dealbreaker, the finance-focused website of Breaking Media.

The authority for the proposed rule comes from the Dodd-Frank Act, the financial-sector reform law enacted in 2010, in the wake of the financial crisis. Perhaps channeling their clients, many Wall Street lawyers aren’t fans of Dodd-Frank — including Ferrara, who called it a triumph of regulatory zeal over logic.

As Ferrara explained, the clawback rule is being promulgated pursuant to section 954 of Dodd-Frank, “Recovery of Erroneously Awarded Compensation.” The rule has been about five years in the making and reflects comments from many different constituencies. Ferrara expects that it will be adopted and “we’ll have to live with it” (notwithstanding his concerns with the rule, discussed below).

One of the proposed rule’s biggest changes, as noted by Ferrara, is that it expands the clawback framework to a larger group of executives, not just the CEO or CFO. An executive could have nothing to do with the financial-reporting aspects of the business but could still see her compensation subject to clawbacks. This will create much anxiety in the corridors of corporate America.

On the bright side for Biglaw, though, it could create a lot of new work for outside law firms. As Marc Powers pithily described it, the clawback rule is “a full employment act for securities lawyers.”

It should create more work for outside counsel — but new headaches for in-house counsel, Ferrara predicted. Any executive with incentive-based compensation will want in-house counsel to figure out: how can we reform our executive compensation plan? How can compensation be protected from potential clawbacks? How can incentive-based compensation be tied to operational benchmarks that are unrelated to financial reporting (and therefore not covered by the proposed rule, which goes to financial restatements)?

Of course, the SEC staffers who developed the rule were aware of these possible responses. The proposed rule, contemplating the parties trying to “contract around” its provisions, attempts to limit what companies can do to basically dodge the rules (e.g., certain insurance arrangements). So one possible (unintended) consequence, identified by dissenting commissioner Michael S. Piwowar, might simply be an increase in already high base compensation, to offset potential clawbacks of incentive pay.

Based in part on these unintended consequences, as well as problems they foresee relating to implementation, both Ralph Ferrara and Marc Powers said they would vote against the proposed rule if they were SEC commissioners (even if, as securities lawyers, they are looking forward to the influx of work). There are simply too many shortcomings and unresolved questions in it, despite the fact that it amounts to some 200 pages of text.

Indeed, Ferrara said the SEC clawback rule even raises some constitutional questions, relating to Fifth Amendment takings and to the impairment of contracts. He said he expects the proposed rule, if enacted, to eventually come before the U.S. Supreme Court in some form before all is said and done.

Powers highlighted issues of fairness and substantial injustice. What happens if an executive retires from a company and gets hit with a clawback claim, years later, for millions of dollars — perhaps after she has spent that money? McEnery noted that the rule raises tax issues too, concerning IRS treatment of clawed-back compensation.

What’s driving the SEC clawback rule? Situating it in a larger context, Ferrara said it reflects the agency’s (unfortunate) shift from being forward-looking, prophylactic, and remedial to being retrospective, retributive, and penal. Although Ferrara had warm words for SEC Chair Mary Jo White as both a lawyer and a friend, he couldn’t help wondering whether the shift could reflect her background and the background of her chief lieutenants as former criminal prosecutors. Is the agency starting to think that the whole world of business is infected by criminality or impropriety, and is that sort of mindset what’s driving this rule?

Powers was slightly gentler, even if still critical. He noted that the rule has admirable goals and can be fixed with some tweaks. But Ferrara did not express optimism regarding fixes, noting how long the rule has been worked on and how it already reflects commentary from various affected constituencies.

“I spent ten years at the SEC, and I love the SEC,” Ferrara said. But this new rule is, in a word, “Pathetic.”

Thanks to Wolters Kluwer’s RBsourceFilings for sponsoring this lively and interesting discussion. Thanks also to speakers, our guests, and Marino Legal Academy for providing CLE. We hope to see many of you at other events in the future. And if you’d be interested in sponsoring an Above the Law event, please drop us a line — we’d love to hear from you.