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CALIFORNIA CORPORATE & SECURITIES LAW

Does The SEC Know How To Assess Risks And Rewards?

The Securities and Exchange Commission’s proposed rules governing stock exchange listing standards governing recovery of erroneously awarded compensation cause me to wonder whether the SEC understands how to assess risks and rewards. Proposed Rule 10D-1(b)(1)(iv) would require an issuer to recover such compensation in compliance with its recovery policy “except to the extent that it would be impracticable to do so”.  As proposed, recovery would be considered impracticable “only if the direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered or if recovery would violate home country law.”

Superficially, the SEC’s proposal makes sense, but on closer analysis it turns out to be hopelessly simplistic.  Shareholders do not benefit when issuers are forced to spend a dollar to recover less than a dollar.  The SEC’s approach is too cabined because it focuses solely on “the amount to be recovered”.  It will be the rare case in which recovery is certain.  Thus, an issuer must assess the potential recovery against the odds of recovering it.  A 50% chance of recovery isn’t worth a dollar, it is worth 50 cents.  An issuer should not pay more than 50 cents to recover 50 cents (leaving aside consideration of the time-value of money).  A more sophisticated analysis would evaluate the recovery against a range of probabilities.  In most cases, the amount of “upside” will be bounded by the issuer’s determination of the amount of erroneously awarded compensation.  Thus, there is likely no probability of recovering more than one dollar.

Consider the following example.  An issuer determines that it is required to recover erroneously awarded compensation in the amount of one dollar.  It further judges that it has a 10% chance of recovering a dollar, a 20% chance of recovering 80 cents, a 20% chance of recovering 50 cents and a 50% chance of recovering nothing.  How much should a rational issuer spend on the recovery?  My answer is no more than 36 cents ($1 * .10 = $.10 plus $.80 * .20 = $.16 plus .50 * .20 = $.10).

The SEC’s proposal also ignores other costs.  For example, an issuer may be responsible for arbitration fees if it is determined that its claim is subject to arbitration pursuant to an employment contract.

In an article published last Fall, the The Wall Street Journal found that the SEC collected only 42% of the amounts defendants were ordered to pay or disgorge in the three years ended September 30, 2013.  Thus, it should be no surprise that proposed Rule 10D-1 makes no allowance for collectability.  Yet, it rarely makes economic sense to devote resources to obtaining uncollectible judgments.

Finally, the SEC makes no allowance for the possibility of a negative recovery.  For example, filing a lawsuit may foment a counterclaim.  If the issuer doesn’t prevail, then it could be liable for attorneys’ fees pursuant to applicable state law or an employment agreement with the officer.

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