Corporate Governance and the Problem of Executive Compensation: Federalization and the Shift in Compensation Norms
We have been discussing the problem of executive compensation as a matter of corporate governance. We attributed the problem primarily to lax fiduciary standards under state law. The inability (or unwillingness) of states to address the issue has resulted in increased preemption at the federal level. Congress has intervened a number of times in the compensation area, transferring regulatory authority away from the states and, for the most part, to the SEC. Moreover, the issue is a global one, with Great Britain embarking on a path that may presage what will happen in the United States.
The regulation of clawbacks represents an example of reform that illustrates the weakness of the state law regime and the need for federal reform. SOX put in place a requirement that boards clawback performance based compensation paid to the CEO and CFO following certain restatements. In effect, Congress told companies that they had to recoup performance based compensation when the performance metrics used as a basis for computing the compensation proved to be inaccurate. Said another way, Congress mandated the recovery of compensation that should never have been paid in the first instance.
It was remarkable that this took an act of Congress. Rigorous fiduciary duty standards presumably would have caused boards to seek repayment of the compensation in these circumstances. Yet fiduicary standards were not rigorous enough to cause boards to seek the return of funds that were incorrectly paid. As a result, the federal government was forced to act.
SOX imposed clawbacks on a limited basis. Fiduciary duties, however, remained lax and Congress was forced to step in once again. In Dodd-Frank, Congress broadened the category of officers subject to clawbacks, lengthened the time period clawbacks would apply, and expanded the types of restatements that would trigger the recoupment. Again, it was federal intervention rather than fiduciary obligations that ensured companies would collect compensation that should not have been paid.
After two interventions by the federal government, boards may be getting the message. Some companies have gone beyond the legal minimum required by SOX and Dodd-Frank and imposed clawback options on broader swathes of employees for broader types of conduct. Thus, JP Morgan Case indicated in its proxy statement that:
Recoupment policies should go beyond Sarbanes-Oxley and other minimum requirements and include recovery of compensation paid for earnings that were never ultimately realized, or if it’s determined that compensation was based on materially inaccurate performance metrics or a misrepresentation by an employee. We have in place recovery provisions for “cause” terminations, misconduct, detrimental behavior, and actions causing financial or reputational harm to the Firm or its business activities. For members of the Operating Committee and senior employees with primary responsibility for risk positions and risk management, the Firm may cancel or require repayment of shares if employees failed to properly identify, raise, or assess risks material to the Firm or its business activities.
According to the WSJ, the policy was put into play with respect to the recent losses incurred by JP Morgan. The WSJ indicated that three managers with "direct responsibility" over the portfolio "at the center of the trading losses" had been subjected to the recoupment policy.
The article stated that this was the "most prominent instance of a major U.S. bank seeking to recover pay from a high-ranking executive since the financial crisis." In other words, the action is unusual. Nonetheless, it may suggest a shift in traditional norms. Perhaps boards of public entities will take these types of steps more often. Of course, the real test will be whether boards of public companies will apply these broader standards to top executive officers rather than lower level employees.
But if boards look at recoupment in a broader set of circumstances, where recoupment is in the best interests of shareholders, perhaps future federal intervention will be unnecessary.