Pay It Back if You Didn’t Earn It

READY for some good news from your humble research assistant? During
this proxy season, almost 300 companies adopted provisions allowing
them to recover executive pay that they find to have been based on
incorrect financial statements. Four years ago, such clawback policies
were found at only 14 companies.

Only in executive payland
would figures like these qualify as progress. But having boards agree
to go after pay that was not in fact earned is, oddly, still something
of a battle. Although pay for nonperformance — or even failure — seems
an obvious no-no, shareholders have had to push hard in recent years to
have companies institute such provisions.

The data on the
growing acceptance of clawback provisions emerged in a study by the
Corporate Library, an independent research concern specializing in
executive pay and corporate governance. It surveyed 2,121 companies and
found that 295 of them, or 14 percent, had clawback provisions. The
most common — in 131 cases — were those that kick in when fraud is
uncovered. But a good number — 115 — are related to performance pay
that was later found to have been improperly awarded because it was
based on incorrect figures rather than malfeasance.

This is only
proper. Corporations go to great lengths to establish benchmarks for
financial performance that must be met before incentive pay is
received. Why should executives keep that compensation if it is
discovered later that the benchmarks went unmet?

“I think the
expansion is pretty significant in terms of the coverage of companies
who have adopted a clause,” said Paul Hodgson, a senior research
associate at the Corporate Library who conducted the study.
“Behind-the-scenes work from some of the more activist funds has
stimulated this. And it is gratifying to see this happening without
legislation.”

THE provisions vary from company to company, of course, and can be found in proxy filings. For example, Waste Management’s
policy, instituted in August, applies only to termination payments.
Under the terms of the policy, those payments can be recovered if
former employees were involved in conduct, uncovered later, that would
have resulted in their being fired for cause.

The policy at General Electric
is also fairly specific. It requires that its board must determine that
an executive has engaged in fraud or intentional misconduct before the
company tries to recover performance-based pay. Then the board can take
disciplinary measures, including possibly terminating the employee or
demanding reimbursement of pay called into question as a result of a
financial restatement.

At other companies, money can be
recovered even from managers who had nothing to do with errors or
misconduct that resulted in earnings restatements. Monsanto’s
provision, instituted in 2006, does not require that money be recovered
solely from executives responsible for misconduct. Neither does the
plan at American Electric Power, put in place last year.

International Paper’s
policy specifies that it will move to recover long-term stock awards if
the company’s financial statements are restated as a result of errors,
omission or fraud. But the provision doesn’t say that executives
reimbursing the company must have been personally involved in the
errors or fraud. Under its plan, International Paper said it could ask
executives for repayment, reduce the amounts they stood to receive in
the future and withhold future equity grants, bonuses or salary
increases.

At Citigroup,
the policy also states that it will move to recoup pay called into
question after a restatement. It can seek reimbursement or cancel
previously issued but unvested restricted stock or options that the
employee holds, the company’s filings said.

The policy at Qwest Communications International
is among the broadest. It states that in the event of a “substantial
restatement of previously issued financial statements,” its directors
will review all performance pay awarded to executives that was based on
the periods during which the results changed.

If the Qwest
board concludes that the restatements would have resulted in different
executive pay packages and that recovering the compensation is in its
interests, it will “pursue all reasonable legal remedies” to get the
money back. Qwest added that its board has not had to take such actions
since the policy was adopted in January 2005.

“All shareholders
suffer from a restatement,” Mr. Hodgson said. “Therefore all executives
who benefited from misstated accounts should see their incentives
adjusted to reflect actual achievements. This is not the approach taken
by the majority of boards, as yet.”

At least one company now subjects its directors to recoupment
policies. Arkansas Best, a transportation company, instituted a
clawback provision this year requiring cancellation of a director’s
unvested stock awards if misconduct by that director resulted in a
financial restatement.

Skeptical shareholders may
well wonder if these new provisions will ever produce an actual
clawback. But Mr. Hodgson made note of one that recently occurred. Warnaco Group">The Warnaco Group,
an apparel maker, said in this year’s proxy that its compensation
committee had cut the incentive pay for three executives in 2006 by a
total of $120,000. The pay cut occurred after the company restated its
results for 2005 as a result of accounting errors and irregularities in
its menswear division.

Now that shareholders have gained some
traction with companies on recovering unearned pay, they should press
compensation committees to change policies so that executives who take
outsized risks to generate fatter pay packages are forced to return
some of that money if the gambles go bad.

Exhibit A for this
problem is every investment bank that made huge bets on risky mortgages
and other securities in recent years.

During the boom, of course, these wagers made huge money for the firms and their executives. The chief executives of Bear Stearns, Merrill Lynch, Citigroup, Lehman Brothers and Morgan Stanley jointly hauled in almost $60 million in cash compensation in 2006 when mortgage mania was propelling their financial results.

Now
those bets have resulted in devastating losses for both the firms and
their shareholders. In the last 12 months, these same five firms have
lost a combined $330 billion in stock market capitalization. And these
unfortunate investors get hammered again as the banks are forced to
raise capital to shore up their battered balance sheets.

“The
investment houses never think about what might build long-term value
for shareholders when they set targets for themselves,” Mr. Hodgson
said. “Their response is, ‘We give stock and it vests over the long
term, and if it tanks, they lose out.’ But these people typically have
so much stock that it enables them to take those risks without the fear
that all their stock will disappear. When you get $50 million a year,
how bad can losing one of those packages be?”

James E. Cayne,
Bear’s former chief executive, can surely say how bad losing all of
your stock can be, but the loss he took after his firm’s demise is the
exception to the rule — so Mr. Hodgson’s question still resonates.

And maybe it’s a question that directors at the big securities firms should also be asking.