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Dissenting Statement at an Open Meeting On Dodd-Frank Act “Clawback” Provision

Commissioner Daniel M. Gallagher

July 1, 2015

Thank you, Chair White. I want to recognize the hard work of the staff of the Division of Corporation Finance, who had primary responsibility for this rule, particularly Keith Higgins, David Fredrickson, Anne Krauskopf, Carolyn Sherman, and Joel Levine. Thanks also to the Division of Economic and Risk Analysis as well as the Office of the General Counsel for your efforts.

Over the past four years, I have made it obvious to most that I am no fan of the Dodd-Frank Act, and certainly not the Act’s executive compensation rulemaking mandates. As I have noted many times in the past, there are real opportunity costs to this agency when our resources are devoted to these politically-motivated mandates.[1] Staff hours spent on clawbacks, pay-for-performance, pay ratio, and hedging rules — not to mention other nonsensical Dodd-Frank mandates like conflict minerals and extractive resources —is time not being spent on meaningful, important projects like the disclosure review project.[2] We desperately need to revamp our disclosure rules to cut through the clutter and ensure that we are only requiring disclosure of information that is important to a reasonable investor’s voting or investment decision. And there are other projects in need of CorpFin’s attention — most notably the much-needed revamp of our shareholder proposal rule. But instead of addressing these actually important issues, for years priority has been placed on plowing through Dodd-Frank’s many intrusions into state corporate governance rules.[3]

Of course, as the Dodd-Frank compensation rules go, this one isn’t the worst — certainly not as bad as the pay ratio rulemaking that the press is reporting will happen next month.[4] Dodd-Frank gave us a canvas, with the basic outlines of the rule sketched in. By prudently using our interpretive and exemptive authority, the Commission could have created a half-decent painting. But, due to the approach that a majority of the Commission has decided to pursue, we instead are unveiling our newest Goya, tortured and nightmarish.

This is truly unfortunate, because the broad theory of this rule makes some sense. If an executive receives remuneration from a company based on the company’s achievements, and those achievements later turn out to have been false, then the executive didn’t really “earn” that compensation, and thus there’s something to be said for a requirement for him or her to pay it back. And the executive, knowing that he or she might be required to repay that money, may take a bit of extra effort to ensure that the company’s achievements are legitimate. So far, so good — but the devils are in the details.

The First Devil

The first devil is in the scope of executives included within the rule. The proposal creates a new definition of “executive officer,” patterned after the Rule 16a-1(f) definition of officer. The definition is broad, including in its scope not just the top executives, but “any other officer who performs a policy-making function” and “any other person who performs similar policy-making functions for the issuer.” The proposal would then subject all of these people to a no-fault clawback regime.

Neither of these interpretive choices is in fact required by the statute, although the proposal would have you think so. First, as the statute did not define “executive officer,” and as we are crafting a new definition, we could have chosen a more limited population.[5] Second, the proposal sees in the words “will recover” the additional words “without regard to fault.” Given the substantial debate over the “no fault” interpretation of the clawback provisions in Section 304 of Sarbanes-Oxley, I assume Congress knew how to write “no fault” if that’s what it intended. Congress did not, so we should have chosen something other than strict liability.[6]

Subjecting a broad swath of executive officers to a no-fault recovery mandate creates the potential for substantial injustice. It means that the rule sweeps far more broadly than the group of individuals ultimately responsible for the financial reporting of the entire issuer. A conscientious but lower-level executive may have every incentive to promote high-quality financial reporting for his or her own corner of the issuer’s operations, but his or her ability to influence higher-ranking executives in their duties or in setting the tone at the top is limited.[7] Similarly, an executive may have limited ability to influence his or her peers in other segments or even other subsidiaries of the issuer. If it later turns out that there was a misstatement caused by activities in areas entirely outside the executive’s control,[8] he or she would now be forced to pay back excess compensation from the past three years.[9]

Changing either of these two features — the scope of the executives covered or the no-fault nature of the rule — would have been more equitable.[10] A no-fault regime covering a narrow scope of those executives who have responsibility for the oversight of the entire corporation’s financial reporting, and who bear responsibility for setting the tone at the top, would have worked. Or, the Commission could have proposed a fault—only regime, covering a broad scope of executives. Today, the Commission does neither.

Even so, I could have gotten comfortable with the broad scope of the proposed rule if it included the relief valve I requested to avoid unjust results. Specifically, we could have given boards of directors broad discretion with respect to clawbacks, allowing the Board to determine: (1) whether to pursue a clawback, (2) whether to settle a clawback obligation for less than the full amount,[11] (3) whether there’s a de minimis amount of compensation that it’s not worth pursuing,[12] or (4) whether to recover through an alternative method.[13] Sadly, the proposed rule does not take that approach, instead giving the Board only the narrowest grounds on which it can decide not to pursue a clawback: if to do so would be “impracticable.” And, for domestic issuers, impracticability is based solely on cost—effectiveness grounds.[14]

This decision reflects a view that a corporate board is the enemy of the shareholder, not to be trusted to do the right thing. This is remarkable, and worthy of note in the broader director community. As I discussed in a recent speech, a good corporate board is a tool for shareholder protection.[15] And board members that fall short of that ideal can readily be voted out by shareholders. Conveniently, a disciplining mechanism is already baked into today’s proposed rule: disclosure of any decision by the compensation committee of the board not to pursue a clawback. So if informed investors disagree with the compensation committee’s decision not to pursue a clawback, they can vote against those directors. In light of these existing protections, I do not understand why the proposed release puts corporate boards not just in handcuffs but in a straitjacket.

The Second Devil

The second devil here is the inclusion of smaller reporting companies, emerging growth companies, foreign private issuers, and registered investment companies within the scope of the rule.

SRCs and EGCs should have been excluded from the scope of the rule. If we are to experiment with corporate governance regulations as we do here, let us at least experiment on large issuers who can more readily bear the fixed costs of compliance than can smaller issuers. If at a future time it can be determined that the rule is achieving the benefits it should in theory promote, at a cost that justifies them, then we could consider whether to eliminate the exemption for SRCs and EGCs.[16] This is well within the Commission’s exemptive authority, and is in no way precluded by the statute.

As for FPIs, injecting U.S. corporate governance theory into foreign countries via a U.S. listing standard is an overreach. The release does not explain how the benefits to be achieved by subjecting FPIs to this rule justify this derogation from international comity and from the goal of extending accommodations to FPIs for the purpose of attracting them to list in the U.S., where investors will be better-protected overall.[17],[18]

The Third Devil[19]

The third devil is that the scope of the required compensation to be clawed back includes compensation based on financial reporting metrics as well as compensation based on share price metrics like Total Shareholder Return, or TSR. Calculating the appropriate amount of clawback for TSR-based compensation is much more difficult than calculating a clawback for a financial reporting measure, requiring an analysis such as an event study to determine what the share price would have been but for the misstatement at the time the compensation was earned. These analyses require substantial use of assumptions and judgment, often producing a range of numbers, rather than a firm number. The release candidly admits this difficulty, and proposes simply that issuers “be permitted to use reasonable estimates.”[20] This is cold comfort for the post-facto second-guessing that is likely to occur.[21] And yet, excluding TSR-based metrics from the scope of the rule would not have been the right approach either, as it would have shifted compensation packages towards these pay metrics, further entrenching the short-termism that is abetted by the Commission’s executive compensation rules.[22] I don’t know what the right answer is here, but I do know that today’s proposal isn’t it.

* * *

At the end of the day, I saw the same dynamic play out here as has played out so many times before. On the road to the open meeting, the Commission came to a four-way stop. We could have sat there indefinitely, or gone straight, towards a reasonable clawbacks rule that I could have supported. Unfortunately, the Commission hung a left and never looked back. And so, for those reasons, I find myself unable to support the recommendation. I have no questions.

[1] Commissioner Daniel M. Gallagher, Dissenting Statement at an Open Meeting Proposing Mandated Pay versus Performance Disclosures (Apr. 29, 2015), available at; Commissioner Daniel M. Gallagher, Dissenting Statement Concerning the Proposal of Rules to Implement the Section 953(b) Pay Ratio Disclosure Provision of the Dodd-Frank Act (Sept. 18, 2013), available at

[2] Given that the Commission has yet to issue a single release soliciting comment for that project, I assume that there’s a substantial amount of work left to go, and that dedicating additional resources from the rulewriting teams would be quite useful to advance that initiative.

[3] And there is no light at the end of the tunnel; in another dubious allocation of resources, CorpFin rulewriting staff apparently has been directed to work on a universal proxy proposal. See Chair Mary Jo White, Building Meaningful Communication and Engagement with Shareholders (June 25, 2015), available at

[4] See David Michaels, SEC Could Make Gabelli Pay New Front in Fight Over Income Divide, Bloomberg (June 18, 2015), at

[5] Specifically, the choice to model our new definition on existing Rule 16a-1(f) was discretionary, rather than required by statute.

[6] We could have chosen a fault-based regime, or a no-fault presumption with mitigating factors to be administered by the Board. For the latter, see infra notes 11-15 & accompanying text.

[7] It’s tone at the top for a reason.

[8] And of course there will be, because despite all the other existing disincentives, including potential criminal sanctions, civil injunctions, penalties, disgorgement, O&D bars, etc., misstatements still occur. I doubt that the potential for clawbacks will add significantly to that deterrent matrix.

[9] What’s so bad about that? After all, as noted supra, the executive really didn’t earn that compensation. Yet, for three-plus years, the executive has relied on having that money in structuring his or her personal finances. And let’s be clear who we are talking about here: these are not all corporate fat cats, who can easily reimburse their company whatever amount, whenever they choose, simply by using a twenty-dollar bill to light their cigars for a few days instead of the usual C-note. The broad scope of this proposed rule through the executive ranks of the SEC’s entire issuer population means that many of those subject to this rule are going to be ordinary folks: folks with credit card or medical bills; folks putting together a downpayment for a house, or with children applying for college financial aid; folks trying to put a little bit away for retirement. In each of these common situations, compensation received in the past has been put to a use that cannot easily be unwound if, up to three years later, the issuer suddenly makes a demand for repayment.

Thus, the proposed rule would subject innocent individuals to an immediate obligation to repay, in cash, money to which they may no longer have ready access. Adding insult to injury, the calculation of the amount to be repaid would be in pre-tax dollars, but will have to be repaid with post-tax dollars. This means that the executive officer’s compensation will effectively be reduced below what he or she should have received had the financial statements been properly stated.

Now, the economic analysis assumes that, in response to this rule, a market for clawbacks insurance will be created, and executive officers will purchase that product. So perhaps these bad results will not come to pass after all, except for the unlucky or unwitting. But this is perverse: the release goes to great lengths to try to prevent this from happening, prohibiting indemnification or direct payment of insurance premia by the issuer, but admits that the insurance market will spring up just the same, with individuals demanding higher salaries in order to compensate for the personal purchase of insurance. That we would justify this rule’s negative impact on individuals through an assumption that rational individuals will simply structure around it is baffling to me. In the end, what has changed? Shareholders will be poorer: their wealth is transferred to insurance companies, and to executives (who will get more pay, and less-well-aligned pay, in response to this rule, according to the economic analysis), and to consultants and advisers (see infra note 12).

[10] Of course, if it were just me deciding, I would have gone with a narrow, fault-only regime.

[11] I note the literal language of Section 10D does not specify the amount to be recovered: it states that if an issuer must prepare an accounting restatement, and if current or former executive officers received incentive-based compensation in excess of what they would have received under the accounting restatement, then the issuer shall recover. Shall recover what? The statute doesn’t actually say. The proposed rule assumes the full excess, but that’s just one way to make sense of the legislative gobbledygook — not the only way.

[12] The draft inexplicably includes no de minimis limit, and then requires that the Board pursue clawback in every single instance before determining that it may be impracticable to do so. But there are inevitably going to be some amounts of compensation that are technically required to be returned that are so low, that the mere mechanics of performing the clawback analysis will vastly outstrip the amount that could be returned to shareholders. The release’s requirement to make a reasonable attempt to actually pursue that compensation before being permitted to call off the hunt as impracticable just compounds that error. Posit an executive that received $1000 in compensation based on TSR. Under the proposed rule, the issuer would likely need to spend thousands of dollars to hire a consultant to do an event study to show that, say, $200 of that executive’s pay was not properly earned. And the issuer would probably need to spend a couple of thousand more on lawyers to advise the board and to draft the demand letter to the executive. If the executive says “no,” the board could then determine that further pursuit of the $200 was not justified based on impracticability, but only after it documents those attempts and provides the documentation to the exchange — of course, at further expense. So an issuer could spend tens or hundreds of thousands of dollars in shareholder money all before being able to determine that the cost of pursuit is not worth the benefit. Thank goodness I suppose that the proposed rule does not require them to throw good money after bad and nonetheless pursue the clawback further. But a de minimis cut-off — a fixed dollar or scaled amount below which pursuit of the clawback would not be required — would have been a logical shareholder protection.

[13] The release gives boards some discretion in how to pursue recovery, but nonetheless states that recovery must be effectuated “reasonably promptly.” It is not clear that, for example, withholding small amounts from the executive’s pay for some extended period of time would be permitted.

[14] This is worse than the comparable provision under the Emergency Economic Stabilization Act of 2008, which gave rise to TARP, which contained a clawback provision for companies receiving financial assistance. As the release makes clear, the board there was able to determine not to exercise clawback rights where it would be “unreasonable” to do so — “for example” where the expense would exceed the amount recovered. The proposed rule is much harsher — boards can avoid clawback only where clawback is “impracticable” due to the “direct costs of enforcing recovery” exceeding the recoverable amounts. Of course, the actual scope of the impracticability requirement is narrower still; see supra n.12.

[15] See Commissioner Daniel M. Gallagher, Activism, Short-Termism, and the SEC: Remarks at the 21st Annual Stanford Directors’ College (June 23, 2015), available at

[16] Obviously, the fact that the rule is working for larger companies does not automatically mean that it would work as well or the same way for SRCs and EGCs, given their different size and attributes — but it would be one very relevant input into that decision-making process.

[17] While I appreciate that there is a special carve-out for FPIs to decline to pursue a clawback based on a foreign conflict of law, two aspects of this carve-out — the legal opinion, and the requirement that the conflict of law be based on a statute that predates our rule — are unnecessary. The latter is frankly offensive to the sovereignty of other countries, and misunderstands the entire reason for conflict of laws exemptions: to prevent registrants from being subject to a Hobson’s choice of violating U.S. law or being subject to liability in their home country.

[18] As to registered investment companies, given the limited number of them that the rule might impact, I am simply not convinced that the costs of adding this regulatory requirement to this entire segment of issuers is worth the benefit. The release admits that there are only a “small number of listed registered management investment companies that are internally managed,” some of which “might” pay executives incentive-based compensation. Those that do not pay incentive-based comp, and have not done so for the prior three years, are exempt, which is good. However, those that do not may feel constrained from doing so in the future; and those that do so now may decide to stop. All such investment companies will at a minimum incur a cost to review the rule and determine whether the exemption applies — and then to ensure that the conditions of the exemption are met in the future.

[19] While not rising to the level of the three fundamental flaws with the Commission’s approach to this proposal that I’ve just discussed, there are some additional details that this rule nonetheless gets wrong, and which I hope commenters will address. If the last three flaws were devils, these are perhaps minor demons.

  • First, the rule’s prohibition on issuers’ payment of indemnification and insurance premia through the Commission’s anti-evasion authority is absurd. I can understand prohibiting indemnification — such a round-trip transaction would make a mockery of the rule. But the economic analysis rightly admits that an insurance market is likely to develop, and that executives are likely to push for higher compensation that they can then use to purchase private clawback insurance. Cash is fungible, and this indirect method is inefficient; we shouldn’t waste our efforts fighting the tide. Moreover, I believe permitting issuers to directly cover the costs of insurance would result in lower costs to shareholders, both because it is more efficient to cut out the middleman in the transaction, and because insurers could potentially be enlisted in helping drive financial reporting quality. For the former, executives will have to demand some amount extra in compensation in order to purchase insurance, but it is doubtful that the amount of demanded compensation would be exactly equal to the cost of insurance. So issuers will wind up overpaying for the cost of insurance. For the latter, issuers that can demonstrate high-quality financial reporting practices and internal controls might be able to achieve discounts on the price of coverage for all their executives. But individual executives’ premia are unlikely to be sensitive to financial reporting quality. See also supra note 9.
  • Second, the rule does not permit existing compensation contracts to be grandfathered, meaning that they may need to be renegotiated to include an obligation to repay the company in the event of a restatement. These compensation contracts are not especially long-term, so grandfathering them would not impede the rule’s objectives, while saving issuers compliance costs.
  • Third, so far I have focused exclusively on what the Commission’s proposal would do. Yet this is a rule regarding listing standards, and so we could have given some discretion to the exchanges to tailor their listing standards. But the Commission is not even comfortable permitting exchanges, with their SRO status, to make those determinations — unless it is to make the rule even harsher. This is also part of two larger issues: it is the latest example of the Commission laundering its corporate governance dirty work through SROs’ listing standards — while this aspect of the rule was statutorily-mandated, there should be a broader conversation about why this indirect rulemaking is appropriate as opposed to a direct SEC regulation, where responsibility for the rule is clear. It also goes to the unresolved question of SROs in the broader federal regulatory scheme. If the Commission is dictating the minutae of listing standards, among other business functions of the “SROs,” can we really call them “self”-regulatory?

[20] Release at 45.

[21] The economic analysis is clearer on this point, noting that notwithstanding the ability to use reasonable estimates, issuers may choose to engage outside experts to conduct a complicated, rigorous analysis to “reduce the likelihood that the reasonableness of the amount of excess incentive-based compensation required to be recovered would be challenged by interested parties . . . .” Release at 128-29.

[22] See Gallagher Pay-for-Performance Statement, supra note 1. Including them within the scope of the rule may have the salutary effect of driving toward use of other metrics that more reliably capture enhancements to shareholder value. In this regard, I note that restatements tied to financial reporting metrics would only trigger clawbacks if the metrics that were restated are those that were used to determine compensation. See Release at 107-08. E.g., if the restatement was of liabilities, compensation tied to gross revenues would not be impacted. Whereas nearly any restatement could theoretically impact stock price, and thus TSR, meaning incentive plans based on TSR are particularly at risk for clawback in the event of a restatement.

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