January 17, 2017
The potential clawback of executive compensation, an area of focus for compensation committees, attracted headlines in connection with Wells Fargo this fall, particularly in the widely televised interrogation by Senator Elizabeth Warren of former Wells Fargo CEO John Stumpf. The responsibility for enforcement of executive compensation clawbacks lies in the hands of boards and compensation committees. They should be prepared to exercise that authority, in seemingly routine situations as well as crisis settings, by ensuring that equity plans and award agreements contain the proper clawback language and by developing a consensus about how such provisions should be applied generally. Many boards would likely benefit from an advance discussion of the most probable considerations when making clawback decisions, such as the implications for a related company lawsuit, employee morale and retention impacts, shareholder and media responses, and efforts that can minimize management distraction.
In the event that the Dodd-Frank Act clawback regulations become final, which we expect eventually, there will be additional regulatory overlay. If finalized as currently proposed, all companies (including foreign private issuers) listed on a national securities exchange would be required to claw back executive compensation upon a financial statement restatement. Whether proposed compensation regulations applicable to large financial institutions, which have their own clawback requirements, will be finalized in substantially their current form is less clear. Of course, compensation committees at financial institutions with operations in Europe will already be well versed in the clawback requirements of the CRD IV Directive which, in certain circumstances, apply for 10 years from the date of the award and can lead to the clawback of 100 percent of variable pay.
Compensation Program Risk Management
The very public Wells Fargo matter also highlighted a second area for board and compensation committee focus: compensation program risk management. The sales incentive program at issue in that matter was relatively common and not inherently risky. However, aspects of the program’s implementation resulted in findings of fraud, bad press, damaged reputation and lost business opportunities. Importantly, while neither the amount of sales incentives nor the direct impact of any improper conduct were material from a financial perspective to Wells Fargo, the collateral consequences, including the resignation of the CEO, certainly were. It remains to be seen whether any of the U.S. regulators will follow the European Banking Authority’s recent efforts (in guidelines that come into force in January 2018) to specifically target compensation policies and practices that relate to the sale of retail banking products. The types of policies and practices identified by the European Banking Authority as problematic include those where pay is solely linked to a quantitative target of banking products sold, that promote the sale of a particular product over others to the detriment of the consumer or where incentive increases with sales volumes over a particular time period.
Since 2009, in their annual proxy statements, U.S. public companies have been required to “discuss the registrant’s policies and practices of compensating its employees, including non-executive officers, as they relate to risk management practices and risk-taking incentives” to the extent the “risks arising from the registrant’s compensation policies and practices for its employees are reasonably likely to have a material adverse effect on the registrant.” This disclosure requirement led to seemingly boilerplate language to the effect that the company “believes that the risks arising from its compensation policies and practices are not reasonably likely to have a material adverse effect on the company.” While companies and compensation programs vary widely, boards and compensation committees would be well advised to consider the fundamental questions raised by the yearly proxy statement disclosure requirement based on the principles underlying each company’s enterprise risk management functions.
Pay Ratio DisclosureAs evidenced by the wave of “say when on pay” votes occurring in 2017, it has been over six years since the Dodd-Frank Act added to the ever-increasing amount of executive compensation disclosure. Unless rescinded by the new administration, U.S. public companies (with fiscal years beginning on or after January 1, 2017) will be disclosing the ratio of 2017 CEO to median employee pay in their 2018 annual meeting proxy statements. Many companies have started assessing the logistics for identifying the median employee. Compensation committees should request an update on progress and possible disclosure throughout the year, including a comparison of the likely ratio to estimated peer group ratios. In the current environment, both the ratio itself and the geographic location of the median employee (required to be disclosed if cost-of-living adjustments are utilized) may be a focus. Peers in the United Kingdom will be watching with interest, as the British government has recently launched a consultation on introducing a similar disclosure requirement. While one may doubt the materiality of pay ratio disclosure, it could result in unwanted attention from shareholders, employees, politicians and the media for which companies, including boards, should be prepared.