Discussion in Japan About “Clawback Clauses”

In Western countries, many companies have introduced “clawback clauses” that require executives to return performance-linked compensation to the company in certain cases. In Japan, very few companies have such clauses. There are dissident voices saying things like “compensation of Japanese executives is less than in Western companies, so there is no need to do that,” or “if you want to demand the return of paid compensation, you can file a derivative lawsuit.” In this article, I would like to review the arguments that have been made so far about clawback clauses, and consider the arguments that should be made in the future.

Most business persons would tend to react negatively if they simplistcally recognize the clawback as a system in which money that was paid to them became a part of their property but then may later be taken away from them. However, clawbacks come in various forms. Reactions might differ if clawbacks are broken down in more detailed terms of when and what to recover, and from whom.

Executive compensation has a fixed portion and a variable portion linked to performance. Finding the best mix between these and the right amount for each in order to erect appropriate incentives is a core aspect of governance, in order to utilize executives’ skills and maximize corporate value. It has been pointed out that the total amount level is too high or the variable part is too large in Western hemisphere, and too low or too small in Japan.

In any case, there is a variable part paid out because the performance was deemed good. But what happens in the case (1) where “the performance was good” later turns out to be a lie, which was intentionally created by accounting fraud led by the CEO? I think most people would think that the company should be able to recover the variable part paid to the CEO.

What happens in the case (2) when the money was paid based on inaccurate information due to the failure of internal control? It is natural for someone to think that the company should be able to recoup the payment, as compensation which should not have been paid has been paid by mistake. Since reporting accurate financial information by establishing and operating internal controls is a manager’s job, it is not reasonable that the manager who fails this job should benefit from the failure. On the other hand, some people would say that it is harsh to recoup from a manager who failed but incurred no legal liability, because internal control has innate limits and promises no perfection.

In either case (1) or (2), it would not be sensible to say that the recoupment is not needed because the sum is small. If you think that a lawsuit should need to be filed to take the money back, in the case of (2) you are in the same league as persons who believe the company should only get the money back from the person who has legal liability.

Furthermore, what about the case (3) in which an executive takes risk to invest in a new business, but loses money and eventually is forced to book an impairment loss? Should the company be able to recover the compensation paid before the impairment loss was booked? What if the impairment was three years after the start of the new business? What if it was ten years after it? More and more people would start to doubt the legitimacy of clawback in some of these cases. Taking risk is part of management, and there can be no guarantees that losses will never occur.

I think that the discussion should be actively conducted at the board of directors in each company from the standpoint “when and which part of whose compensation should be recouped in order to fully incentivise and appropriately evaluate the executives’ performance?” Those discussions should focus on each case (1),(2) and (3) and other cases with respect to the clawback clause. But in Japan, an overall “rejection” response has been preceded without any detailed discussion.

Now, let’s turn our attention to overseas. Section 304 of the Sarbanes-Oxley Act in the US stipulates in a nut-shell as follows.

(Summarizing) “The CEO and CFO who have had to correct their financial reports submitted to the SEC due to misconduct must return the variable compensation portion received within 12 months of the submission of the relevant report(s).”

It is the plain reading of the language of the law that payback is required even if misconduct by the CEO or CFO did not occur and it was someone else’s misconduct, – and in fact. there are appellate court decisions in which such interpretations were made. This is compatible with the idea that a failure of detecting misconduct is a failure of internal control, and thus the the money should be recovered in above case (2).

Section 954 of the Dodd-Frank Act stipulates as follows, in a nutshell:

(Summarizing) The SEC should set guidelines to have the companies establish and disclose policies requiring that the executive officer of the company should pay back the variable portion of any compensation which was paid during the 36 months prior to the submission date of a corrective report and which was overpaid based on the erroneous financial number and would not have been paid based on the correct number.

No one’s misconduct is necessary. Furthermore, it is clear here that the rewards that were erroneously paid are to be recovered in the case (2) above. On the other hand, it should be noted that the law is not asking for the recovery in case (3).

Although SEC guidelines for the Dodd-Frank Act have not yet been issued, many companies have voluntarily set and disclose their policies. This research report over how the companies are conducting clawbacks is helpful.

Glass Lewis, a company that advises regarding proxy voting, has stated
in their advice guidelines for US companies that a clawback clause based on the SOX Act alone is not sufficient. They suggest that a wise board of directors should have a policy to avoid the situation where the compensation paid by mistake is left in the hands of executives. Thus, a company without such a policy might run into negative treatment in terms of proxy voting for its compensation related proposals at its AGM.

Clawback clauses are gradually emerging in Japan, referring to such overseas trends. The GPIF publishes a report listing “superior corporate governance reports as selected by domestic institutional equity investors ”, in which one company has a clawback clause.

In the 2019 shareholder meeting season, there was a company for whom minority shareholders made a proposal for a clawback, seemingly foreseeing such situation as case (3).

In the end, the shareholder proposal was rejected at this company’s AGM. However, the chairman of the board of directors made this public statement, and promised to formulate and disclose a policy regarding clawback.

One of the reasons that such a movement is emerging among Japanese companies may be attributed to the “Guidelines on Executive Compensation (the fourth edition)” of the Japan Association of Corporate Directors. It cited, among other things, clawback as a compensation mechanism intended to prevent excessive risk taking.

As stated above, not only overseas, but also in Japan, the idea of ​​clawback is gradually spreading, and I surely think that it will be prevailing more. However, to reiterate, “clawback” means different things in different places, and I would like to pay most attention to what kind of clauses are going to spread. The focus I would like make in particular is the difference between Japan and the US. In the US, there seems a clear objective –recovering a reward that would not have been paid if the financial report had been accurate, — and the clawback clause is discussed as a means to recoup it and as a measure to prevent false statements which may be committed because of a desire to receive large compensation.

In Japan, where about two-thirds of corporate scandals relate to inappropriate accounting, these arguments would seem to be just as valid as they are in the US. However, in Japan, clawbacks seem to be discussed as a means to avoid excessive risk taking. And it is yet to be made at all clear which part of the already-paid compensation should be recaptured.

While appropriate risk taking is the main focus of the Japanese corporate governance code, this tendency would raise a concern in situations where business judgments are held accountable for the result or where an overly risk averse attitude is promoted.

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