The SEC's Immensely Impracticable Impracticability Exception

This week's posts have been discussing the recent adoption by the Securities and Exchange Commission of rules requiring the securities exchanges to adopt listing standards requiring listed companies to develop and implement policies providing for the recovery of erroneously awarded incentive-based compensation received by current or former executive officers.   These rules brook an extremely narrow exception for impracticality, as explained in the adopting release:

However, if the direct expense paid to a third party to assist in enforcing the recovery policy from an executive or former executive officer would exceed the erroneously paid incentive-based compensation, the final rules allow the issuer, under certain circumstances, to determine that recovery would be impracticable, and therefore not pursue the recovery.

The rules require that before concluding that it would be impracticable to recover any amount of erroneously awarded compensation based on expense of enforcement, the issuer must make a reasonable attempt to recover such erroneously awarded compensation, document such reasonable attempt(s) to recover, and provide that documentation to the exchange or association.  17 CFR 240.10D-1(b)(1)(iv)(A).  

Hae Intolerabiles Ineptiae Sunt

If an issuer has erroneously paid $25,000 in incentive-based compensation to an executive officer, this rule would allow the issuer to forego recovery on the basis of impracticability only after it has paid a third party (presumably its lawyers) at least $25,000.01.   Because the rule expressly refers to "expenses paid", it appears to require actual payment.   If an issuer reasonably expects to incur expenses to third parties to effect a recovery, it makes no sense from the stockholders' perspective to require the issuer to spend those funds to support the impracticability of recovery.

The rules as adopted deprive the board of directors of the ability to apply business judgment to the merits of seeking recovery.  For example, the executive may be insolvent and yet the rule will require the corporation to expend funds up to the amount of the erroneously paid compensation before it can stop digging an obviously dry well.  (Interestingly, the adopting release fails to consider the possibility that an executive's obligation to the issuer may be dischargeable in bankruptcy in light of no-fault character of the SEC's rules.)  How does this possibly protect investors?  In what economic universe do the costs incurred in this situation outweigh the possible benefits to investors?   

The rules also don't permit boards of directors to make rational settlement decisions.  As the SEC pointedly observed in the adopting release: "the rule does not permit boards to settle for less than the full recovery amount unless they satisfy the conditions that demonstrate recovery is impracticable".   Outcomes in litigation are only rarely foregone conclusions.  In some cases, executives will dispute the determination of the amount recoverable by the issuer or even that it it is recoverable at all.  In other cases, executives will have meritorious defenses and/or counterclaims.  Thus, rational decisionmakers will only seldom value their litigation claims at 100%.  For example, an issuer may believe that the amount of erroneous incentive-based compensation was $100,000, the executive may dispute this amount and have counterclaims.  In such cases, there will be range of possible litigation outcomes, ranging from the issuer recovering no compensation and even paying the executive to recovery of the entire $100,000.  Given the uncertainties that inevitably inhere in litigation, a settlement may be in the best interests of the issuer.  Yet, the SEC prohibits a settlement unless and until the issuer has expended at least $100,000.