Excess-Pay: Beyond the 2% Solution

Excess executive pay can impose substantial costs on companies and shareowners even if manipulation or misconduct isn’t involved. Executive pay is the biggest lightening rod in corporate governance, prompting Dodd-Frank to include clawback requirements, mandatory say on pay, and say when on pay votes, as well as the coming ratio between executive pay and the pay of a company’s median employee.

Jesse Fried and Nitzan Shilon’ s important paper, Excess-Pay Clawbacks, highlights the problem of “excess pay” to executives arising from errors in earnings and compensation-related metrics. Although addressed in part by Dodd-Frank, significant additional measures are still needed.

The paper examines excess-pay clawback policies in S&P 500 firms prior to Dodd-Frank.

We find that nearly 50% of S&P 500 firms had no excess clawback policy whatsoever. Of those firms with clear policies, 81% did not require directors to recoup excess pay but rather gave directors discretion to let executives keep excess pay. Of the remaining firms, 86% did not permit directors to recoup excess pay absent a finding of misconduct. As a result, fewer than 2% of S&P firms required executives to return the excess pay under any circumstances.

Dodd-Frank mandates that firms adopt a policy to recover excess payments to executives when there has been a restatement, even those not involving misconduct. Therefore, we can expect increased recoveries, benefiting both companies and shareowners.

Unfortunately, we explain, Dodd-Frank does not appear to require the recovery of all types of excess pay. In particular, Dodd-Frank does not require firms to recoup excess pay from executives in the absence of an earnings restatement and does not appear to require firms to recoup from executives’ excess pay arising from the sale of stock at prices inflated by earnings manipulation.

The loopholes appear to be large indeed and may leave many to concentrate on short-term-ism. The authors go on to make recommendations, primarily:

  • Boards seeking to put in place shareholder-friendly clawback policies should thus require executives to give back excess pay even absent a restatement. Our research suggests that as of mid-2010, approximately 7% of S&P 500 firms already had clawback policies in place that allow for recovery even absent restatement.
  • Structure executive equity arrangements so payouts are based on the average stock price over a significant period of time, say 6 months or a year or, better yet, a “hands-off” arrangement according to a fixed, gradual, and pre-announced schedule.

Fried and Shilonas note that as of mid-2010, 7% of S&P 500 firms had clawback policies in place that allow for recovery even absent restatement. Addressing the second issue, Level 3 Communications apparently has adopted a “hands-off” pay-out according to a fixed, gradual pre-announce schedule. That leaves 499 of the S&P 500 to go. My hunch is that most won’t adopt such policies without considerable shareowner pressure. Why am I so pessimistic? We only need turn to the findings of Fried and Shilonas that “fewer than 2% of S&P 500 firms had policies requiring executives to return excess pay even in the absence of misconduct.” We, as shareowners, must take action ourselves, in the form of letters to boards and proxy proposals, if we are to move beyond the 2% solution.

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