Guerdon Associates, as well as many others, made submissions to Treasury on the clawback paper released in December (see HERE)

 

A summary of our main points appears below.

 

Purpose of clawback

 

The Treasury paper does not specifically address the purpose of clawback.  Without such a statement clawback cannot be evaluated. 

 

No evidence

 

The discussion paper provides no evidence to support the introduction of clawback in Australia.  Specifically, we do not know:

·          The extent of financial misstatement

·          The materiality of financial misstatement

·          The causes of financial misstatement

·          The extent to which executive remuneration is a causative factor in financial misstatement

·          The extent to which executives have received additional remuneration as a direct consequence of financial misstatement

·          The extent to which current civil remedies (mostly enshrined within the current Corporations Act) are inadequate in exacting the recovery of overpaid monies and damages from responsible directors and officers resulting from financial misstatement

·          The extent to which criminal sanctions (mostly enshrined within the current Corporations Act) as well as the civil remedies mentioned above are inadequate to deter excessive executive remuneration as a result of financial misstatement.

The absence of transparency is not a good foundation on which to develop public policy.

 

Implementation through black letter law costly and ineffective

 

Clawback through black letter law that is fair, just and cost effective is impossible. 

 

For example:

 

What is to be clawed back?

 

Is it all remuneration?  Is it incentive remuneration?  If the latter, how is this defined?  Is it remuneration that is related just to financial statement misstatement?  If that is the case, what if the actual proportion relating to financial results is not specific?  What if companies, as a result of the legislation, do not specifically relate pay to financial results?  Worse, what if companies avoid the risk of clawback by eliminating performance contingent pay?  Would this be more costly to shareholders?  And if the clawback relates to all remuneration, should it include remuneration relating to environmental and social performance?

 

When is a clawback required?

 

Will a clawback be mandatory whenever a company is “required” to prepare an accounting restatement due to its “material noncompliance” with any financial reporting requirement under the law?  The majority of restatements do not involve egregious circumstances, raising questions as to when a restatement will be considered “required” and what will constitute “material noncompliance.”

 

Will it only be required if there is fraud or misconduct?  Or, at another extreme, will clawback be required if the restatement results from an errant (or aggressive) interpretation of AASB standards?  The latter this would cover most ASX listed companies at some time or another.  Some of these restatements may be “required,” but others would merely be prudent or advisable.  Who makes this determination – the board, the CEO and CFO (who presumably will then be subject to clawback), the auditors, or ASIC? 

 

How far back do you go?

 

Presumably, the Corporations Act would have to specify the period over which clawback could operate.  What period should this be?  The period relating to the restatement?  Or a period greater than this that sowed the seeds for things to go wrong financially? 

 

How does a company go about developing a clawback policy if it is 3 years, as in the US?

 

Assume that in 2011, XYZ Limited is required to restate its 2008, 2009 and 2010 financials, resulting in an EPS for 2008 of $1.94 (down a cent), an EPS of $2.10 in 2009 (down 5 cents), and an EPS of $2.20 in 2010 (down 30 cents, or 12 percent).

 

First, how much of the executive’s bonus for those years was “erroneously awarded”?  In 2008 and 2009, the company did not directly link a percentage of the executive’s award to the EPS goals.  In 2008, would the executive nonetheless have received the same bonus, since the EPS “miss” was only a cent?  If not, what would the bonus have been?  The design of incentive plans will determine how difficult it is to allocate a specific portion of the executive’s bonus to achievement of the EPS goal.  Who is supposed to decide this issue, and how do they do so three years after the fact?

 

Second, assuming a specific portion of the executive’s overall bonus is ultimately allocated to the achievement of reported (and now restated) financial information, how does one address the equity components of the executive’s awards – the share rights and share options?  If they have not vested, are they considered “received” under the Act?  How and when is the equity valued? What if the executive has exercised some options or sold some rights, but not others?

 

Third, assuming XYZ Limited ultimately determines that it needs to clawback a particular amount from the executive, how does it go about doing so?  Can it simply cancel options or rights that have not vested, or have not been exercised or sold, instead of seeking the return of cash?  How are the tax and accounting implications handled?  Can the executive agree to forego a portion of a future bonus instead?

 

Why have a law that will not be enforced?

 

Even more problematic is the question of enforcement.  Currently most Australian companies do not comply with the existing disclosure requirements of section 300A of the Corporations Act.  Yet there have been no prosecutions since this provision became effective from 2005.  If ASIC cannot enforce easily detectable disclosure non compliance, what hope is there for more complex clawback provisions?

 

ASX and Corporate Governance Council unlikely to act on clawback

 

The absence of evidence that there are problems with the misstatement of financial accounts that could be addressed through clawback makes it difficult to see the ASX applying clawback through the listing rules.

 

If forced to choose between legislation or “comply or explain” under the ASX Corporate Governance Council’s (CGC) Principles and Recommendations most stakeholders, for reasons relating to the problems associated with black letter law above, would prefer the “comply or explain” approach.  But again, the rational, evidence-based approach the CGC follows makes it unlikely that it would amend its principles, no matter how much a “comply or explain” approach is preferred to black letter law.

 

Unintended consequences

 

Legislating for clawback is likely to result in:

·          A reduction in performance contingent remuneration in favour of increased fixed remuneration;

·          Performance assessment based on other than financial performance for the payment of bonuses;

·          An increase in executive pay to counter the risk of clawback – the pressure on executive pay will be greatest if clawback applies to all remuneration (including fixed pay), and irrespective of any fault of the executive;

·          A smaller pool of possible recruits into executive ranks, as they seek employment overseas, in private companies, or decide not to migrate to Australia to take up executive positions;

·          Higher compliance costs;

·          Unduly conservative interpretation of accounting standards;

·          Uncorrected accounts (if the risk of clawback discourages corrections).

These consequences would apply all of the time, for all listed companies, even if clawback only applies in a very small number of cases.  None of these outcomes are in the interests of the stakeholders of listed companies. 

 

Try deferral or “holdback” first

 

Holdback is the cancellation, withdrawal or continued deferral of a due payment.  Typically, it is a deferral of an incentive payment beyond the performance period.

 

Almost all APRA regulated companies have these provisions.  Over 40% of non-financial ASX 50 companies have these provisions.  The trend to adopt such a practice has escalated rapidly since the GFC.

 

Given the rapid take-up of deferral, it would be wise to defer any clawback requirements until there is an assessment of the success of holdback provisions in case of financial misstatement.

 

Concluding comments

 

There is no evidence that misstatement of financial accounts is a problem requiring regulation, and certainly no evidence that executive remuneration is in some way connected with any misstatement problem. 

 

Current civil and criminal actions are sufficient to both counter wrongdoing, and to allow affected parties to seek justice in the event of wrongdoing.  Legislating further will only increase compliance costs.

 

See our full submission HERE

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