The proposed rule provided that companies "must recover erroneously awarded compensation". The only exception was where repayment was "impracticable." Impracticability was defined narrowly. "Recovery would be impracticable only if the direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered, or if recovery would violate home country law." Such a determination could only be made after the company first made "a reasonable attempt to recover that erroneously awarded compensation."
Other factors other than cost could not be concluded. As the Commission reasoned:
- We believe the unqualified “no-fault” recovery mandate of Section 10D intends that the issuer should pursue recovery in most instances. For example, we do not believe the extent to which an individual executive officer may be responsible for the financial statement errors requiring the restatement could be considered in seeking the recovery. Further, we do not view inconsistency between the proposed rule and rule amendments and existing compensation contracts, in itself, as a basis for finding recovery to be impracticable, because issuers can amend those contracts to accommodate recovery.
Exchange Act Release No. 75342 (July 1, 2015).
In proposing a "must recover" standard, therefore, the Commission rejected a standard that would leave the matter to the discretion of the board. Commissioner Gallagher gave this as one reason for his dissent.
- Specifically, we could have given boards of directors broad discretion with respect to clawbacks, allowing the Board to determine: (1) whether to pursue a clawback, (2) whether to settle a clawback obligation for less than the full amount, (3) whether there’s a de minimis amount of compensation that it’s not worth pursuing, or (4) whether to recover through an alternative method.
From his perspective, the failure to provide boards with this type of broad discretion reflected "a view that a corporate board is the enemy of the shareholder, not to be trusted to do the right thing." He did not make the case that boards would use the authority in an appropriate manner. Instead, he argued that if the board did not, shareholders could respond by voting "against those directors."
In a plurality system of voting, the common standard applicable to public companies, voting against directors will not ensure their defeat. Moreover, as the chair of the SEC noted recently, even companies with majority vote provisions do not automatically remove directors when they fail to receive majority support. The voting process will not, therefore, ensure that boards will properly exercise their discretion with respect to clawbacks.
What is supposed to ensure that directors do so is their fiduciary obligations to shareholders. Directors should seek clawbacks where it is in the best interests of shareholders to do so. Where they do not, shareholders can bring an action for breach of fiduciary duty. Yet under state law there is no meaningful obligation to seek clawbacks. Moreover, boards that decide not to do so will have no trouble justifying the behavior as consistent with their fiduciary obligations.
The lack of discretion in Proposed Rule 10D-1 does not arise from an absence of trust. It arosen part as a result of language in the statute (which provides that boards "will recover" erroneously paid amounts) and in part because shareholders have no meaningful recourse in the event the discretion is not properly exercised. Had fiduciary duties been more robust and shareholders had meaningful recourse under state law for improperly exercised discretion, greater discretion for the board in making a clawback decision would have been more defensible.