On Boards, Disclosures, and Corporate Ethics

The Securities and Exchange Commission dropped a subtle hint this week about its latest expectations for corporate boards and what they disclose to investors. Corporate governance professionals might want to take a look, since I suspect we’ll be hearing more on this issue in the future.

The case involves McDonalds and its former CEO, Stephen Easterbrook. McDonalds fired Easterbrook in 2019 for having an improper affair with a subordinate, which violated the company’s code of conduct — and as part of the separation agreement, McDonalds gave Easterbrook a severance package worth $40 million. Then came news in 2020 that Easterbrook actually had numerous affairs while leading McDonalds, and had lied to the company about that during its first investigation. So McDonalds sued Easterbrook, and in 2021 he agreed to return $105 million to settle the dispute.

This week, the SEC brought charges against Easterbrook for misleading the company and investors. While neither confirming nor denying the charges against him, Easterbrook agreed to pay $400,000 to settle the case.

More interesting for the rest of us, however, is that the SEC also charged McDonalds for failing to tell investors the full details of that separation deal with Easterbrook. Specifically, the SEC said, McDonalds failed to disclose that the company exercised discretion in treating Easterbrook’s termination as without cause, when the company had clear grounds to fire him for cause: he had violated the code of conduct.

The SEC didn’t seek any financial penalties against McDonalds, although the company did agree to a cease-and-desist order. 

Why does this matter for the rest of us? Two reasons. First, both the SEC and the Justice Department have been talking a lot lately about the importance of compensation clawback policies, and how prosecutors will consider a company’s exercise of clawback policies when assessing the company’s culture of compliance. Now we have this case, where decisions to award a huge severance package and then to claw it back are the heart of the matter. 

Second, companies send errant executives packing all the time, allowing those executives to keep huge severance packages to avoid the risk of unwanted, public litigation.

So what is the SEC trying to tell us here? 

What ‘Exercise of Discretion’ Really Is

To little surprise, Republican commissioners Hester Peirce and Mark Uyeda both opposed the sanction against McDonalds. They released a statement that zeroed in on Rule 14a-3 of the Securities Exchange Act. One part of the rule — Item 402(j), for those securities law nerds who want to keep score — requires disclosure of “material factors regarding agreements that provide for payments to a named executive officer in connection with his or her termination.”

The question is whether the company’s use of discretion is itself a material factor that should be disclosed to investors. The SEC Enforcement Division has now said it is. Peirce and Uyeda say it shouldn’t be.

“We have concerns that this action creates a slippery slope that may expand Item 402’s disclosure requirements into unintended areas — a form of regulatory expansion through enforcement,” they said in their statement. 

The Enforcement Division sees things differently. Its settlement order cites Item 402(b) of the rule, which instructs companies to address “specific decisions that were made or steps that were taken that could affect a fair understanding of the named executive officer’s compensation.” That includes “factors considered in decisions to increase or decrease compensation materially.”

Hold up, everyone. Let’s remember what “using discretion” actually means. It means the board is exercising judgment — and judgments are based on values and priorities.

So when McDonalds’ board used its discretion in 2019 to declare Easterbrook fired without case and let him depart with a super-sized severance package, that was a reflection of the board’s thinking. The board decided it was better to ignore Easterbrook’s clear violation of the Code of Conduct and avoid the risk of costly, embarrassing litigation; rather than fire him for being a lout, keep that $40 million of shareholder money, and let the litigation chips fall where they may.

That tells investors something about the board’s values and priorities. Don’t investors have a right to know what that is? Doesn’t the board act as their representative, and shouldn’t shareholders be able to understand how the board’s values and priorities do or don’t align with their own? I’m hard-pressed to see how shareholders don’t, and I’m sure most investors, both retail and institutional, would feel the same way.

I’m not entirely sure Rule 14a-3 is the perfect vehicle to give investors that window into the board’s collective mind, but the language is enough to get the job done. That brings us to our next point: How often will the SEC (or other regulators) take this view against other companies? 

Boards Using Clawbacks

First we can look to the Justice Department. When deputy attorney general Lisa Monaco announced sweeping new corporate enforcement policies last year, she expressly said prosecutors “will evaluate what companies say and what they do, including whether, after learning of misconduct, a company actually claws back compensation or otherwise imposes financial penalties.” 

McDonalds didn’t do that. It knew Easterbrook had an indiscretion, which violated the Code of Conduct; and then didn’t dock his severance package anyway. Only when new allegations surfaced a year later — allegations that made the board look bad for missing them the first time around — did the company then decide to pursue Easterbrook in court.

What ethical conclusion are we supposed to draw here? That a company should always be a stickler in every instance? That seems harsh because it removes the board’s ability to exercise judgment. Then again, that brings us right back to the SEC’s point: that it’s OK to exercise judgment so long as you disclose that fact to investors. 

We also have a proposed rule from the SEC (presumably to be adopted later this year) that would require companies to exercise clawbacks for incentive-based pay that later is called into question because of a financial restatement. If the SEC wants to see clawbacks for faulty financial reporting, it would logically follow that the SEC wants to see clawbacks exercised more often in other circumstances, too. 

And why not? Deciding to clawback improper and undeserved compensation is a reflection of the very common-sense value that we shouldn’t reward bad behavior. Isn’t that what good ethical values are all about?

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