Once upon a time critics of corporate America complained that executive salaries were too high, and too often disconnected from the performance of the firm. Senior managers are making millions while the company loses money—where’s the logic in that? So today many firms, including large banks and other financial services companies, have performance-based compensation packages—at least some of the money executives make is tied to the firm’s annual profits. Now incentives are aligned smartly, right?
A potential complication creeps in, however, when a firm needs to restate its earnings. If a major deal goes south and restated earnings are lower than they were initially reported, perhaps we should restate an executive’s compensation as well, the thinking goes. This is the idea behind a provision of the Dodd-Frank Wall Street “Reform” Act. As Andrew Ross Sorkin reports in The New York Times, the Securities and Exchange Commission is currently working on a new rule which would expand this “clawback” concept from where it is already in force among Wall Street firms to all publicly traded companies. If restated profits were lower than they were in the year in which performance-related compensation was paid out, the company can demand that some of that bonus be repaid—as long as three years later.
Not surprisingly, this federal rule is already having perverse consequences. As SEC Commissioner Michael Piwowar said during a recent SEC meeting, the rule would “unintentionally result in a further increase in executive compensation” because of the uncertainty that it will bring. “Prior research and experience suggests that this uncertainty will increase total executive compensation. In particular, corporate executives may lower the value that they attach to the incentive-based component of their pay and demand an offset to bear the increased uncertainty.” This is hardly the result that Wall Street’s populist critics and Dodd-Frank supporters were hoping for.
In addition, clawbacks can be made regardless of the performance of an individual employee. Firms don’t have to prove that a specific person was responsible for lower earnings in order to recover funds. According to an analysis by the law firm Jones Day, an honest mistake by a firm’s accounting department, or even outside auditors, could trigger a clawback demand years after the fact.
All of this could be a sign that Dodd-Frank and the SEC are creating more problems than they’re solving by trying to micromanage what every firm pays its senior managers. Just don’t expect the law’s supporters to ever admit it.
This article originally appeared in Competitive Enterprise Institute’s OpenMarket.