Enforcement efforts targeting executive compensation will have unanticipated consequences.
As if guiding a company through the maelstrom of inflation, recession, workforce participation and quiet quitting wasn’t enough of a challenge. Corporate executives now find themselves — and their compensation arrangements — at the center of aggressive enforcement initiatives from key government regulators.
And their boards of directors are being dragged into the mix, with little hope of avoiding collateral damage to relationships with their CEO, and to the company’s business planning.
What’s prompting this angst is new, heightened pressure from both the Department of Justice and the Securities and Exchange Commission to hold individual executives financially accountable for corporate and/or securities fraud. Both the DOJ and the SEC are doubling down on existing enforcement guidelines to better deter corporate crime, and to support the transparency and accuracy of financial statements. Both regulators see executive compensation as the way to get there.
The DOJ’s position was announced in remarks by Deputy Attorney General Lisa O. Monaco to a corporate compliance audience on September 15. In her remarks, Monaco announced a series of landmark guidelines enhancements the DOJ is implementing to further strengthen how it prioritizes and prosecutes corporate crime.
The SEC’s position was summarized in comments provided by senior commission staff at the September 8 “SEC Speaks” conference, at which the SEC chair, commissioners, senior leaders, and staff provided “essential updates” on the commission’s current initiatives and priorities for the coming year (including but not limited to new enforcement priorities for existing laws).
For its part, DOJ is using a carrot-and-stick approach to encourage companies to reflect corporate values in their executive compensation systems. The carrot is to reward companies (by leniency in fraud investigations) that apply affirmative compensation metrics and benchmarks to incentivize compliant behavior. The stick is to prompt companies to use those systems to impose financial penalties (e.g., clawbacks, escrowing compensation) on employees and executives for corporate misconduct. Notably, the enhanced guidelines incentivize companies to self-report criminal violations by its own executives.
The SEC is pursuing a more aggressive application of a Sarbanes-Oxley provision that allows the SEC to clawback certain elements of executive compensation when the company is required to reissue its financial statements because of its own misconduct. In its heightened focus, the SEC is leveraging the “strict liability” provision of the law that attributes liability to the CEO and CFO for presiding over the company when the misconduct occurred, even when they are not alleged to have engaged in any wrongdoing. Indeed, they may have actually taken steps to strengthen financial controls!
With both enforcement approaches, the name of the game is individual accountability, long a buzz word for prosecutors. The goals are to incentivize a culture of compliance and to assign the cost of misconduct to those who were responsible for it, not on the shareholders who would otherwise suffer from it.
And while that might be great in theory, it might not be so great in practice. Because this new emphasis fails to take into account the collateral harm that can fall upon the company when its senior executives become excessively cautious in their leadership for fear of personal financial ruin in the event of government investigation.
The responsible corporate executive is going to react to all this. She’ll quickly realize that her compensation will be on the line in the event of a corporate fraud investigation, or a misconduct-driven financial restatement. Human nature suggests that the executive will alter her conduct in response; e.g., by taking a pass on strategies that present the slightest bit of legal risk, or by applying potentially intolerable pressure on the company’s internal controls staff. Neither of these may work for the benefit of shareholders.
And it gets worse for those executives who realize that they may be thrown under the bus by the board in its effort to receive some form of cooperation credit from the government as part of an investigation. That introduces an entirely separate level of board/management tension that works for no one.
There’s no doubt that both the DOJ and SEC have devoted substantial effort to these latest guidelines changes, and are motivated by recognizable shareholder interests. But in doing so they have created an enormous hot potato for corporate leadership with significant boomerang potential.
The board’s worry will be that executives become gun-shy, and engage in self-protective conduct that frustrates valid board-endorsed strategies or creates intolerable workplace pressures. Thus instead of simply taking measures to enhance compliance, executives may become excessively risk averse. The board will also worry about the loss of executive loyalty, and the extent to which these government initiatives result in more executive names being added to the rolls of The Great Resignation. And whatever they do, boards won’t want to be viewed as soft on compliance. But they may find themselves between the proverbial rock and a hard place; conflicted by their duty to the company and by their support of the executive team.
This may not have been a challenge that corporate leadership has ever anticipated, but it is most certainly one they are now called upon to confront.
The author thanks his colleagues, Sarah Walters and Eugene Goldman, for their contributions to this post.
