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Andrew Ross Sorkin: 'Clawbacks' Could Backfire

Clawbacks are coming to corporate America.

After the financial crisis, regulators forced Wall Street to adopt programs to be able to "claw back" — or recover — compensation that had been paid to bankers or traders if deals they were involved in soured later. The idea was that traders would be more responsible if they knew they would have to return some of their income should risky trades blow up years after they were made.

Now the Securities and Exchange Commission is extending the clawback idea far beyond Wall Street to all publicly traded companies.

The Dodd-Frank financial overhaul law requires the S.E.C. to devise a rule on clawbacks, and its proposal would obligate publicly traded companies to recover incentive-based compensation from executives for up to three years if they ever have to restate their earnings.

In theory, the new rule should make executives more accountable. If a company earned less than it said it did — and an executive were paid based in part on those incorrect earnings — it only makes sense that the company claw back the compensation. Luis A. Aguilar, an S.E.C. commissioner, said the rule "should go a long way toward prohibiting improper enrichment of executives for companies faced with a restatement."

That's the hope.

In practice, however, the new rule, on which the S.E.C. is seeking public comment, is causing some head-scratching because its language could lead to a different, perverse consequence.

Instead of acting as a check on compensation and accountability, the new law increasingly looks as if it could drive up base salaries — and make executives less aligned with shareholders — or increase incentive pay to even higher levels to account for the risk of any potential clawback.

"The clawback requirements as proposed could influence companies to move away from incentive compensation that is tied to financial performance metrics (as opposed to subjective or operational metrics) to avoid the clawback issue altogether," Jones Day, the law firm, said in a recent note to clients.

Another S.E.C. commissioner is also sounding the alarm about the new rule and its potential ramifications.

The commissioner, Michael S. Piwowar, said during an S.E.C. meeting this month that the new rule would "unintentionally result in a further increase in executive compensation" because of the uncertainty that it will bring. "Prior research and experience suggests that this uncertainty will increase total executive compensation. In particular, corporate executives may lower the value that they attach to the incentive-based component of their pay and demand an offset to bear the increased uncertainty."

The new rule is unique in that recoveries must be made regardless of the fault of any individual executive. And the new regulation applies to a broad group that includes not only senior officers but any other person who performs policy-making functions for the company.

"Imagine a senior leader of a sales unit who falls within the scope of the proposed rules and is subject to a clawback because of an honest but material error committed by the accounting department or even the outside auditors," Jones Day posited. "This is not a far-fetched situation. If a driving force for the clawback rules is to improve financial reporting, then it is at a minimum unclear how imposing strict liability on an executive officer with no role over financial reporting will further that goal."

As part of the law, companies are not allowed to indemnify or reimburse executives.

Already, others are raising questions. On Monday, Keith Paul Bishop, a securities lawyer in California, wrote in The National Law Review that the proposed rule's language suggests that it can be applied to previously negotiated employment contracts. "Does the S.E.C. have the authority to interfere with private, pre-existing contracts?" he asked. (The answer is not straightforward.)

There is also a potential loophole. The new rule allows companies to choose not to pursue a clawback if the costs of doing so might exceed the amount to be recovered.

And then there is the cloud that seems to be looming over not just the new rule but the current dysfunction of the S.E.C.

"The commission has yet again spent significant time and resources on a provision inserted into the Dodd-Frank Act that has nothing to do with the origins of the financial crisis and affects Main Street businesses that are not even part of the financial services sector," Mr. Piwowar said in his testimony. "Why does the commission continue to prioritize our agenda with these types of issues, when rulemakings that are directly related to the financial crisis remain unaddressed?"

Mr. Piwowar is right. This new rule would not have prevented the last financial crisis, nor will it likely prevent the next o ne.

Still, it would be helpful if the S.E.C. could find a way to institute a rule that brings accountability to executives over financial reporting without creating incentives to make them even less aligned with shareholders.

By Andrew Ross Sorkin

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Posted: July 13, 2015 Monday 08:57 PM