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When Should Clawback Provisions Be Used

Holding CEOs Accountable for Fraudulent Activities

I have previously blogged about the 324:1 ratio of pay packages, on average, for S&P 500 CEOs when compared to the average worker Pay.  In this blog I look at claw backs, a provision that enables a company and/or the SEC to go after CEOs who benefit financially from compensation packages during a period when the financial statements contained fraudulent transactions and financial reporting. The Equifax case that was disclosed in September 2017, is one such example where investors lost money because of wrongdoing, but the company did not claw back executive compensation.

Equifax

Former Equifax CEO Richard Smith received as much as $19.6 million in stock bonuses after leaving the company following the disclosure of the company’s massive data breach in 2017.The company paid $700 million for claims tied to it’s the breach.

Smith's stock bonuses covered a period that included his performance in 2017, the year in which Equifax botched a software patch that allowed hackers to enter its databases and obtain the personal financial information of nearly 150 million Americans. On top of the stock awards, Equifax agreed to cover Smith's medical bills for life, a benefit the company estimated was  worth another $103,500, according to a company filing. He also walked away with a $24 million pension, and $50,000 in tax and financial planning services.

What's more, none of Smith's pay was clawed back by the company, a growing but still rarely triggered compensation practice at the time among large companies that is meant to hold top executives accountable if their actions later cause damage to their former employers. Equifax's clawback provision at the time, which the company called "rigorous," covered accounting fraud but not legal settlements like the $700 million deal announced this week. Equifax has since altered its executive clawback provisions to cover damages to the company's reputation as well.

Wells Fargo

In another case, Wells Fargo agreed in 2020 to pay $3 billion to settle criminal charges and a civil action stemming from its widespread mistreatment of customers in its bank over a 14-year period. From 2002 to 2016, employees used fraud to meet impossible sales goals. They opened millions of accounts in customers’ names without their knowledge, signed unwitting account holders up for credit cards and bill payment programs, created fake personal identification numbers, forged signatures and even secretly transferred customers’ money. In this case, the board was able to recoup money because of employee misconduct that caused significant financial or reputational harm, where ten bank executives were stripped of more than $172 million in awards after a scandal involving the creation of fake customer accounts. Clawback

Should Clawbacks be Applied to Errors or Only Financial Restatements?

Fast forward to October 26, 2022, and the SEC said it will make public companies that take back executives’ incentive pay if they find significant errors in financial statements, aiming to improve corporate accountability at a time of rising shareholder discontent over pay practices. We’re talking about errors, not necessarily fraud. Is this a bridge too far?

The SEC approved the rule to apply clawback provisions broadly to public companies, extending a practice that has become widespread in compensation agreements set by corporate boards in recent years. However, those voluntary policies sometimes set a high bar for recouping previously awarded compensation and can be difficult to enforce. That has led some companies to withhold executives’ incentive pay for longer periods to avoid the hassle of having to get it back after the fact.

The rule requires companies to set up procedures for recovering erroneously awarded compensation whether there was misconduct involved. It is broader than the original proposal which triggered clawbacks only if companies identified major accounting errors that required a restatement of prior years’ financial results. Under the completed version, companies will also have to recover executive bonuses if they find smaller errors that significantly affect only the current year’s results.

Conclusions

I am a bit conflicted about applying it to errors that only affect the current year. By applying it to restatements a a pattern of bad behavior demonstrates the intent to deceive. It is the purposeful action that should trigger a clawback, I believe. I’m not sure a one-year time horizon meets this standard.

I understand why the SEC is moving in this direction. Investors are clamoring for accountability, and they deserve it when bad behavior occurs. But, if the transactions being discussed are “smaller errors that significantly affect only the current year’s results,” then perhaps the CEO was kept in the dark and the CFO was responsible for the error. Where is the accountability here?

What do you think? Has anyone reading this blog been involved in or affected by clawback procedures? If so, please comment on this blog and let me know how it went as I am interested in this topic.

Blog posted by Dr. Steven Mintz, The Ethics Sage, on November 30, 2022. You can sign up for Steve’s newsletter and learn more about his activities on his website  (https://www.stevenmintzethics.com/) and by following him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.

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