Time to clawback the clawback paper?

20 December 2010 was a significant date for board remuneration committee, their advisers, investors, and other stakeholders. On this date the government not only released the exposure draft of its legislation to implement its response to the Productivity Commission’s recommendations to reform executive remuneration but also a discussion paper seeking comments on clawback of executive remuneration.


The proximity of the release to Christmas and the annual holiday season no doubt means that many people have not yet had an opportunity to focus on either the draft legislation or the clawback discussion paper. But sorry, you are too late to let the government know what you think of their exposure draft legislation.  Consultation on the draft legislation closed on 20 January.


But you can still have input on the government’s intent to legislate on clawbacks.  The closing date for submissions on the clawback paper is 30 March 2011. 


Choosing something constructive to say may be difficult, as the clawback “discussion paper” is a very lightweight document. 


The paper seeks responses to several questions, including


  –     Is clawback needed, and would the benefits outweigh the compliance costs?

  –      How would clawback be implemented?

  –      Who should clawback apply to?

  –      What triggers should apply for clawback?

  –       How should the clawback amount be determined?

  –       When would a clawback amount need to be repaid?


No evidence is provided to substantiate the case for the introduction of clawback, other than the statement:


“Based on information provided by the Australian Securities and Investments Commission (ASIC), material misstatements in the financial statements are not an uncommon occurrence among listed companies in Australia.” (para 2.4)


The government has not shared the ASIC information in the document. 


The paper has a series of assertions and suggestions, as well as somewhat pejorative references to the ‘disgorgement’ of executive pay.


Unfortunately the paper does not present any developed proposals as to how clawback might work in Australia. 


As described in the paper, clawback would involve the creation of an obligation for directors and executives to repay to the company any remuneration that is based on financial information that turns out to be materially misstated (which would limit clawback to pay contingent on financial outcomes only).  Hence, an unintended consequence may be more boards developing entirely discretionary plans, or plans whereby the bonus is payable for anything but financial performance. 


There may be a recovery of remuneration already paid to the executive, or a cancellation of an outstanding but unvested and unpaid future award.  The corporate regulator would also have the power to commence legal action in order to recover these funds. 


The government suggests that several arguments can be presented in favour of clawback, but does not give any indication that it supports these arguments –


·  There is an argument that the introduction of a clawback policy may mitigate the effect of arrangements that could otherwise promote risky behaviour by company executives. For example, a clawback could discourage executives from taking questionable actions that may lift stock prices in the short term but would ultimately result in financial restatements (para 2.12)


·  This is in line with the argument that a requirement to clawback remuneration based on erroneous financial reporting is an important step in reining in excessive executive pay and can help shift management’s focus from short-term profits to long-term growth and stability. This argument is based on the premise that executives would be less willing to undertake excessive short-term risk for quick financial reward when a clawback arrangement is in place (para 2.13)


·  A clawback may be argued to be a preventive rather than a purely remedial or punitive measure. This is because the introduction of a clawback policy removes the incentive for executives to consider deliberately misstating company earnings in order to inflate their bonus figures. An introduction of a well-crafted clawback policy would ensure that executives engaging in misconduct would not be able to receive unearned company funds (para 2.14). 


·  The specific proposal the government asks us to consider is that “…clawback will prevent executive directors, who are responsible for ensuring that a company’s financial statements are true and fair, from being rewarded for breaching this duty. It is also hoped that placing a greater value on the accuracy of financial statements will reduce the need for shareholder class actions arising from the public release of misleading financial statements.  (para 2.10 of the discussion paper).


Suggestions in the paper that clawback could be extended to all KMP, irrespective of fault or misconduct, and that it could apply not just to incentive payments (and equity grants) but to total remuneration (including fixed pay), need to be very carefully considered. 


No consideration is given in the discussion paper to any possible problems with clawback, or to the potential for unforeseen consequences of introducing clawback.  There can be little doubt that implementing clawback that applies to the total remuneration of all executives, irrespective of fault, would force an explosion in fixed pay and, by discouraging incentive pay, would undermine the link between pay and performance that is genuinely in shareholders’ interests.


Nor is any consideration given to alternatives to clawback, such as the deferral of incentive rewards which is easier to implement and effective in ensuring incentive payments accurately reflect underlying performance.  The current situation, under which shareholders are only able to recover overpaid remuneration amounts by commencing legal proceedings, may not be inappropriate if remuneration practices are improved.


In the section headed “Examples of the implementation of clawback proposals in other jurisdictions”, the paper asserts that there have been several examples of governments, regulatory bodies and companies in other jurisdictions invoking or implementing a clawback provision where erroneous financial information is released (para 2.16).  The US Dodd Frank Act is the only example given of legislated clawback.  To the best of our knowledge, this is the only regime where clawback is operating, but only under the flawed and ultimately unworkable Sarbanes Oxley Act.  Provision has been made in the Dodd Frank Act, but US stock exchanges are accountable for framing the regulations to make it work.  So, in effect, there is no regime where a workable clawback regime is currently operating!


There is no reference to the finding of the Productivity Commission that executive remuneration governance in Australia is at a very high level.


The paper refers to a UK House of Commons Treasury Committee paper on reforming banker pay after the GFC that concluded that the use of mechanisms to defer or clawback bonus payments from executives should be encouraged to align the interests of executives more closely with those of shareholders (para 2.20).  Note, encouragement only, and specifically in the banking sector.


In the same section, the paper also refers to a European Corporate Governance Forum statement from March 2009 concerning director remuneration, which took the view that “…the substance of director remuneration should not be regulated at an EU level. Rather, it believes that it is for companies and their shareholders to determine what pay structure and levels are appropriate for their directors in light of their particular circumstances, and that general best practices should be followed so that appropriate consideration is given to the effects of performance-based pay and company risks. One such best practice is in relation to the clawback. The [ECG Forum] document states that ‘to the extent possible under applicable employment laws and companies’ legislation, the company should reserve the right, at the discretion of non-executive directors, to reclaim performance linked remuneration elements which were paid to or vested on executive directors on the basis of results that afterwards were found to have been significantly misstated because of wrongdoing or malpractice’.” (para 2.21)


This statement captures the essence of a sensible and appropriate approach to clawback.  It would be suitable for Australia and would avoid the need for any more regulation of matters that should really be left to the discretion and control of company boards.


Guerdon Associates is yet to make its submission on this matter, but would welcome your views.

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