CLS Blue Sky Blog

Shareholder Activism in the Era of Trump: What Strategy Works?

In the approaching Era of Trump, we are likely to see much deregulation, reduced public enforcement, and possibly some curbs on private enforcement.  Corporate compliance efforts may also be downsized, and compliance officials may learn again to defer to the judgment of the entrepreneurs in the corporation’s profit centers.  If a bubble develops in financial stocks (as seems more than possible), some corporate debacles and scandals become predictable.  What defenses do shareholders have in this brave new world?

Here, Wells Fargo & Co’s decision to claw back a record $60 million from two senior executives ($41 million from CEO John Stumpf and $19 million from Executive Vice President Carrie Tolstedt, both retired) has not received the attention it now deserves.  Strikingly, these clawbacks were not the product of federal legislation but of investor activism.  Neither the Dodd-Frank Act nor Sarbanes-Oxley would have mandated a clawback, because their provisions apply only if Wells Fargo had announced an accounting restatement (which it has not done and probably will not do).[1]  Instead, Wells Fargo’s far broader clawback policy was the result of pressure from New York City’s pension funds in 2013, which had threatened to file a shareholder proxy resolution unless Wells Fargo adopted a policy broadly authorizing clawbacks beyond the context of restatements.  Possibly, this could become the next focal point for investor activism.

The case for broad clawbacks comes into clearer focus when one looks closely at a series of recent corporate scandals, which each raises the same jaw-dropping question: What were those guys thinking? Did Volkswagen really believe that its “defeat device” would go undetected indefinitely?  Did Wells Fargo think that it could fire 5,300 employees for the same fraudulent practice without someone noticing?  Did major pharmaceutical companies—most notably, Valeant Pharmaceuticals International and Mylan N.V.—really expect they could buy an established drug and spike its price 600 percent or 700 percent without protests occurring and Congress investigating?

Although no one link connects all these cases, many share a common denominator:  the use of extreme incentive compensation.  Simply put, extreme incentive compensation formulas can motivate reckless corporate behavior.  In a recent article, posted on SSRN and available here, I consider several examples to support my thesis that high incentive compensation underlies most recent corporate debacles.[2]  Let’s here consider three.  First, Valeant Pharmaceuticals has been everyone’s favorite whipping boy over the last year, and it remains the subject of a serious grand jury criminal investigation in the United States.  Its business model was to acquire a drug (or a drug company) and then spike its price by 25 times or more.  For example, it acquired Cuprimine and moved its price over two years from $888 for one hundred 250 mg capsules to $26,189.

Standing alone, this behavior is not unlawful.  But Valeant did more.  It used a captive online retail pharmacy, Philidor Rx Services, to place orders for its drugs at these inflated prices in order that insurers think that an independent decision had been made to choose the more costly drug rather than a cheaper generic substitute.  Until late in 2015, Valeant hid the fact that it controlled Philidor and was consolidating Philidor’s results with its own on its financial statements.

Even if this behavior was not criminal (which remains an open question, as a grand jury investigation continues), it was certain to elicit public outrage and regulatory attention.  So why did Valeant take this risk?  Now, we get to the heart of the matter.  Valeant’s CEO (until he was replaced this year), J. Michael Pearson, had been given a compensation package (designed by a hedge fund that had a seat on Valeant’s board) that paid him only $1 million in cash annually, but also offered him an assortment of incentive compensation awards (basically stocks and options) valued at $16 million.  In particular, Pearson stood to receive performance stock units that would vest if Valeant achieved the following three-year compounded total shareholder returns:[3]

Shareholder Returns Award
(1) 3-year Total Shareholder Returns (“TSR”) < 15% 0
(2) 3-year TSR from 15% to 29% 407,498 shares vest
(3) 3-year TSR from 30% to 44% 814,996 shares vest
(4) 3-year TSR > 45% 1,272,494 shares vest

In short, returns of under 15 percent netted him nothing, but returns of over 45 percent paid him an extraordinary equity award of over 1 million shares.  Incentivized to take risk, Pearson responded predictably.

Now, let’s look at a second example: Mylan, N.V., a major generic drug company.  Even after Valeant imploded and its stock price fell by over two-thirds last year, Mylan opted to follow a similar strategy.  It raised the price of its key product, EpiPen, an emergency treatment for persons with life-threatening allergies, from $100 to $600, thereby making the drug prohibitively expensive for persons without insurance.  The public reaction was easily foreseeable, and outrage and congressional hearings followed.

Why did Mylan take this risk in the wake of Valeant’s experience?  Again, one only has to connect the dots.  In 2014, the Mylan board approved a one-time stock award that was conditioned on Mylan more than doubling the company’s adjusted per share earnings over a five-year period ending in 2018.  Because Mylan was in the mature and low-growth generic drug business, this had seemed an unattainable goal.  Still, the company’s top five executives stood to gain an estimated $82 million collectively if this target could be achieved.[4]  So incentivized, they spiked the price of EpiPen, their leading product, and attempted to ride out the storm.  But, in October, Mylan settled alleged regulatory violations with the U.S. Department of Justice relating to EpiPen for $465 million, and the dispute still continues.

A final example this year of incentive compensation producing ethically dubious risk-taking and fraudulent behavior is supplied by Wells Fargo & Co., until recently the largest U.S. bank.  At least 5,300 of its employees were terminated over a five year period for opening an estimated 2 million bogus accounts or credit cards for customers, without the customers’ knowledge or consent.  Employees did so apparently to satisfy ambitious, but arguably unrealistic, sales quotas imposed by senior management.  Under pressure, lower echelon employees opted to cheat to avoid losing their jobs.  But why did senior management persist in insisting on high cross-selling quotas once it became evident that the resulting pressure had produced systemic fraud?  Again, the answer appears to lie in the incentive compensation that the senior executives could earn.  Carrie Tolstedt, the executive vice president who supervised Well Fargo’s “community banking” operations, made up to $1.7 million in annual salary, but up to an additional $9 million in some years in incentive compensation.[5]  Given this disparity, her motivation in imposing high cross-selling quotes on lower-level employees becomes more understandable.  Although such a formula paid her extraordinary compensation, it ultimately subjected her company to a reputation-shattering scandal.

Incentive compensation is, however, the norm today.  The days when senior management was paid primarily in cash are long gone.[6]  Equilar, a leading compensation specialist, reports that, in 2015, CEOs of companies in the S&P 500 received on average 60 percent of their total compensation in equity.[7]  If enough incentive is created, it produces risk-preferring behavior.

So what should a reasonable and prudent board or compensation committee do?  Obviously, one answer is to avoid the kind of extreme equity award that Valeant used to motivate its former CEO.  But another answer is to counter-balance the impact of incentive compensation with an appropriately designed clawback.  Clawbacks mandate the forfeiture of incentive compensation (including unexercised stock options and equity awards) on the occurrence of specified trigger events. Section 10D of the Securities Exchange Act of 1934 only requires a clawback in the event of an accounting restatement that reduces the earnings that produced the incentive award.  Still, a responsible board can design a broader clawback that does not require a restatement to trigger it.

In this light, let’s take a closer look at Wells Fargo & Co’s policy, because, in this one unique respect, Wells Fargo may supply a model for other companies to emulate.  Wells Fargo’s 2016 Proxy Statement indicates that the triggers for clawbacks and recoupments include (with respect to restricted stock awards and performance shares):

  1. “Misconduct which has or might reasonably be expected to have reputational or other harm to the Company or any conduct that constitutes ‘cause’;”
  2. “Misconduct or commission of a material error that causes or might be reasonably expected to cause significant financial or reputational harm to the Company or the executive’s business group;”
  3. “Improper or grossly negligent failure, including in a supervisory capacity, to identify, escalate, monitor or manage, in a timely manner and as reasonably expected, risks material to the Company or the executive’s business group;”
  4. “An award was based on materially inaccurate performance metrics, whether or not the executive was responsible for the inaccuracy;” and
  5. “The Company or the executive’s business group suffers a material downturn in financial performance or suffers a material failure of risk management.” [8]

These are broad provisions that go well beyond financial restatements (but do leave business judgment discretion in the board as to whether to implement them).  In reality, most boards will stonewall and not impose clawbacks when they have discretion.  Still, the real lesson of Wells Fargo may be that pressure can mount to the point where the board will be compelled to invoke a clawback.  Also, shareholders can sue derivatively, and Wells Fargo has been sued in a derivative action in California, which may prove hard to dismiss.[9]

In the approaching Era of Trump, clawbacks may be the last line of defense for shareholders.  Clearly, incentive compensation is here to stay, but it should be reasonable and needs to be counterbalanced by broad clawbacks.  If activists lobby Institutional Shareholder Services, using the Wells Fargo clawbacks as their model, the proper design of clawbacks could move to front and center on the corporate governance stage.


[1] Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act added Section 10D to the Securities Exchange Act of 1934, which provision requires that stock exchange listing rules must require a clawback of “incentive based compensation…during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on erroneous data, in excess of what could have been paid to the executive officer under the accounting restatement.”

[2] See John C. Coffee, Preserving the Corporate Superego in a Time of Activism: An Essay on Ethics and Economics (available at SSRN: https// (2016).

[3] See David F. Larcker and Brian Tayan, “CEO Pay at Valeant: Does Extreme Compensation Create Extreme Risk?” Stanford Closer Look Series, CGRP56 (April 28, 2016) at p. 1.

[4] See Mark Maremont, “Mylan Tied Pay to Tough Targets,” The Wall Street Journal, September 2, 2010 at B-1.

[5] See Matt Egan, “$124 million payday for Wells Fargo exec who led fake accounts unit,” The Buzz, September 13, 2016. In a September 19, 2016 letter to five Democratic Senators, Wells Fargo Chief Administrative Officer Hope Hardison details the unvested and unpaid equity awards owed to Ms. Tolstedt and estimated a “current target value of approximately $18.9 million.”

[6] For a detailed review of the trend away from cash compensation and towards equity, see Carola Frydman and Dirk Jenter, CEO Compensation, 2 Ann. Rev. Fin. Econ. 2:75-12 (2010).

[7] See Equilar “2015 CEO Pay Strategies” at p. 9.

[8] See Wells Fargo & Company 2016 Proxy Statement (March 16, 2016) at p. 47.

[9] A derivative action, captioned “Vladimir Gusinsky Revocable Trust v. Carrie Tolstedt,” was filed on September 21, 2016 against the Wells Fargo board and Ms. Tolstedt in San Francisco County, California. Although a derivative action brought under Delaware law would likely be dismissed for failure to make demand, California derivative actions are far harder to dismiss, and demand futility is easier to plead and establish. No view is here expressed as to this action’s merit.

This post comes to us from Professor John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance. The post is based on his recent article, “Preserving the Corporate Superego in a Time of Activism: An Essay on Ethics and Economics,” available here.

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