The Wallet as Behavioral Enforcer

Most organizations remain conflicted about how to encourage compliant behavior.

There is lots of rhetoric about level playing fields and doing the right thing - but it is often directed at new markets in Asia or at upstart competitors rather than at any internal processes that might actually influence one's own operations.

The reasons are understandable if not laudable. Legal and ethical behavior is expensive and in a global economy, there is a persistent fear that obeying the rules puts one at a competitive disadvantage. The 'everyone else is doing it' argument doesnt get a lot of sympathy from the public, regulators and government officials - at least publicly - but it remains a constant in the whisper wars.

Arguments that the market will take care of 'the problem' through the design and imposition of effective compensation policies have long been popular. Instituting such procedures, however, is disruptive - and not in the way that most executives today like to think of it. Disruption is something they prefer to do to someone else, not to have done to them. Refocusing an organization is time-consuming, distracting and difficult. Unintended consequences are rife.

But, as the following article explains, the market may be starting to respond. Shareholders are ever more acutely conscious of value's sources and uses. They resent having to pay for an organization's misdeeds and missteps. Increasingly, they are demanding clawback rules that impact executives' compensation when violations can be ascribed to operations under their oversight. Whether this will become widespread - or work any better than previous attempts - is not yet clear, but it seems apparent that the financial community, despite its own questionable record in such matters - is no longer inclined to foot the bill without a requisite sacrifice from the managers' they deem responsible. JL

Gretchen Morgenson reports in the New York Times:

Some large shareholders have been working to expand clawback provisions. Disturbed by companies engaging in improprieties and leaving their shareholders with the bill for the ensuing legal settlements and regulatory fines, activist investors are trying to put strong recovery policies in place.

There is a lot we don’t yet know about the disastrous decisions made by General Motors after it became aware of faulty ignition switches in its Chevrolet Cobalts more than 10 years ago.

Who decided — and who agreed — that 90 cents was too much to pay for each switch that would have apparently fixed the problem that has been linked to 13 deaths?

How much did that decision add to the company’s bottom line and contribute to its executives’ compensation over the years? What will the company have to pay in possible regulatory penalties and legal settlements?

Those questions may be answered in the coming months as various investigations move forward. But this much is pretty clear right now: While shareholders of G.M. will shoulder the costs of fines, settlements and the loss of trust arising from the mess, the executives responsible for monitoring internal risks like these are unlikely to be held to account by returning past pay.

That’s because G.M.’s compensation policies, like a vast majority of those across corporate America, require recovery of bonuses in only a few circumstances, mostly related to accounting. They do not require recovery when executives take shortcuts or engage in other types of unethical behavior that imperils customers and the company itself.

Like most United States companies, G.M. can recoup incentive compensation from top executives if that monetary award was found to have been based on “materially inaccurate financial statements or other materially inaccurate performance metric criteria,” according to its most recent proxy. Typically, such policies state that pay can be retrieved only from the highest-ranking officers of companies and only when misconduct is intentional.

Some large shareholders have been working to expand these so-called clawback provisions. Disturbed by companies engaging in improprieties and leaving their shareholders with the bill for the ensuing legal settlements and regulatory fines, these activist investors are trying to put strong recovery policies in place. The goal is to make sure that insiders who engage in questionable conduct are required to pay the piper — and that the companies let shareholders know they have done so.

Scott M. Stringer, the New York City comptroller, is one of these investors. As overseer of five municipal employee pension funds with assets of $140 billion, Mr. Stringer and his staff have successfully negotiated expanded thresholds for clawbacks at five companies this year: Allergan, Halliburton, Northrop Grumman, PNC Financial and United Technologies. The companies were chosen because they are in heavily regulated industries and were subject to large regulatory settlements in recent years.

Under the agreements, pay can be retrieved from a wider array of senior executives than is typical. And recoveries can be sought not only for intentional misconduct and gross negligence, but also for violations of law or company policies that cause significant financial or reputational harm to the institution.

These new clawback thresholds also state that executives can be forced to give back pay even if they did not commit the misconduct themselves; they could run afoul of the rules by failing to monitor conduct or risk-taking by subordinates. Think Citigroup, with the losses arising from its Banamex unit in Mexico.

Finally, Mr. Stringer also requested these companies to disclose, every year, whether or not pay was recovered and the circumstances that led to any recoveries.

“Misconduct that causes financial or reputational harm is significant, especially to those of us who invest in these companies,” Mr. Stringer said in an interview on Thursday. “We’re actually getting companies to adopt clawback policies that are meaningful. We speak to the issue of financial accountability but also to setting a tone at the top.”

The concept of clawing back executive pay initially gained traction after the accounting frauds at Enron and WorldCom in the early 2000s. In 2002, the Sarbanes-Oxley law required boards to recover some incentive pay from a chief executive and chief financial officer if a company did not comply with financial reporting requirements. Boards could also recover gains the executives made from stock sales during the same 12-month period in which they were given incentive pay.

But some investors have found the law to be so narrowly written that it hasn’t been the punishing stick it was meant to be. After all, as the G.M. and Citigroup cases show, harmful misconduct at companies can extend far beyond accounting shenanigans. Expanding the reasons for clawbacks could protect shareholders — and others — from executives looking to cut corners to earn a bigger paycheck.

Mr. Stringer is not alone in this approach. Last year, LongView Funds, a unit of Amalgamated Bank, persuaded several pharmaceutical companies in which it owned shares to strengthen their policies. Amgen’s board and management, for example, agreed to consider employee misconduct “that caused serious financial or reputational damage to the company” when determining whether an employee would earn a cash incentive award. And Pfizer’s most recent proxy notes that it can cancel awards if an employee “engages in misconduct that is detrimental to the company,” something that LongView had requested.

It is pretty clear that clawback policies need tightening at many companies. A 2012 article in “The Corporate Board” by Jesse Fried, a professor at Harvard Law School, and Nitzan Shilon, then a doctoral candidate in juridical science, found that just over half of 485 companies in the Standard & Poor’s 500-stock index had any clawback provisions as of mid-2010.

The authors also concluded that of those, 81 percent gave boards discretion to let an executive keep excess pay even if the board found that the executive had committed misconduct.

Mr. Stringer and his colleagues say it’s time to change that leniency. In their negotiations with companies, they argued that it might be appropriate to hold senior executives accountable if they failed in their oversight of others.

Which brings us back to the G.M. crisis. It is unclear whether the company will make its internal review of the matter public. If it doesn’t, we may never know how many G.M. executives knew about the Cobalt problems and looked the other way.

In the meantime, though, this debacle shows the importance of policies that hold high-level employees accountable for conduct that, even if not illegal, can do serious damage to their companies. Directors creating such policies would be sending a clear signal that they take their duties to the company’s owners seriously.