Recouping executive pay: the rise in popularity of clawbacks

May 20, 2010 - Hay Group

With the continued scrutiny of and spotlight on executive compensation, coupled with the current rage against the perceived role of C-suite executives in the financial crisis, 'clawbacks' have emerged as a seemingly attractive means of redressing 'unearned' compensation. We increasingly see corporate governance groups and shareholders advocating for the adoption of clawback provisions in executive agreements and incentive plans to enable a company to recoup bonuses and other incentive-based rewards in appropriate circumstances.

 

Clawbacks are being endorsed by shareholders and legislators as significant corporate governance tools to deter management from taking actions that could potentially harm the company's financial position; the objective is to eliminate – or, failing that, at least recapture – undeserved payouts to executives.

Due to the recent increased prevalence of clawbacks, it has become even more important for boards to understand the design and use of these policies in incentive compensation plans and executive employment agreements. While clawbacks may seem like a common sense approach to executive pay, these provisions have their fair share of complexities that companies and their boards should consider.

 

Putting clawbacks in context

 

Definition and history

A clawback is a provision in an employment agreement or compensation plan that permits a company, often in its discretion (typically exercised by the board or compensation committee), to recapture cash and/or equity incentive payments from certain employees – generally senior executives – for one or more reasons (set out in the particular program or agreement). For example, a clawback may be authorized if:

• an executive has been deemed responsible for fraudulent actions
• incentive payments were based on misstated financials, especially if the result of fraud or negligence
• an executive has violated enforceable non-compete provisions or other restrictive covenants
• an executive has been responsible for defined actions detrimental to the company.

Clawbacks first gained widespread attention when they were implemented in Section 304 of the Sarbanes-Oxley Act of 2002. This legislation provides that chief executive officer and chief financial officer of a public company be required to reimburse the company for any bonus or other incentive-based or equity-based compensation, and/or profits on sales of company stock received within 12 months of the release of financial information, if there is a restatement of that financial information due to 'material noncompliance' with any financial reporting requirement under federal securities laws. Largely due to its narrow scope, enforcement efforts related to this statutory clawback provision have been rare, with the first notable one resulting in the SEC's settlement with the former Chairman and CEO of UnitedHealth Group, Inc. in late 2007.

 

More recently, companies participating in the federal government's Troubled Asset Relief Program (TARP) are required to have clawback provisions for their 'senior executive officers' (basically the officers whose compensation must be disclosed in a public company's annual proxy statement) and for the next twenty highest compensated officers below such officers whose compensation is required to be disclosed in annual proxy statements. Under this legislation, during the period that an institution has unpaid TARP funds, it must apply clawbacks to these executives to recover bonuses or incentive compensation based on statements of earnings, revenues, gains, or other criteria that later are found to be materially inaccurate. More recently, several pieces of legislation have been proposed that would require all US public companies to establish clawback policies pertaining to inaccurate financial statements.

 

Prevalence

Recent years have seen a dramatic increase in the publicly disclosed clawback policies. According to Equilar, a compensation research firm, the number of Fortune 100 companies with clawback policies increased from 18 percent to 73 percent between 2006 and 2009. Much of this increase can be attributed to the discussion and publicity around the recapture of unearned compensation and the adoption of clawbacks by financial services companies. Many boards outside of the financial services sector are challenging their management teams to follow suit by adopting clawback provisions as a part of improving their corporate governance structure. This momentum should continue in the near future, with many boards implementing new clawback policies or refining existing provisions in reaction to the compensation risk assessments required by the enhanced proxy disclosure rules released by the Securities and Exchange Commission (SEC) in late 2009.

 

Triggers

Clawbacks can be designed to be triggered by any one of identified events; definitions of covered events and the consequences can vary considerably across companies. According to a recent study conducted by Equilar, the most common triggers among Fortune 100 companies are a financial restatement by the company or an executive's ethical misconduct. The next most prevalent event is a violation of a non-competition agreement.

 

Even when clawback provisions are included in an executive's employment agreement or an incentive compensation plan, it may be unclear whether a specific event was actually triggered or whether the clawback should be enforced. If fraudulent activity is discovered regarding a company's financial statements, the question may arise whether an executive should be responsible if he or she was unaware of this activity.

 

As an example of how a clawback might be applied, last year the SEC sued the former CEO of car parts retailer CSK Auto, demanding to recoup more than $4 million in bonuses and stock while the company was engaged in alleged accounting fraud. We note that the SEC did not accuse Mr. Jenkins of knowingly engaging in fraudulent activity. As described in The Wall Street Journal, Mr. Jenkins' attorneys argued that "The SEC's nonsensical view is that Mr. Jenkins must pay for that misconduct by others because he was 'captain of the ship,' despite the fact that under its own view of the evidence, his crew was mutinous – deceiving him, and secretly circumventing the ship's controls." The case highlights an issue that confronts many boards considering clawbacks – should the clawback apply only to those with knowledge of fraudulent or negligent actions, should it also apply to those in charge of these individuals, or should it apply to anyone who benefits from the improper action?

 

Covered compensation

With the rise in the prevalence of clawbacks, the definition of covered compensation has become more expansive. Initially these provisions focused on cash-based bonuses, but in recent years, clawbacks have broadened to include equity compensation – both vested and unvested stock awards. Equilar's research indicates that the vast majority of policies included both cash and equity incentive compensation in their definition of compensation subject to clawback. The addition of equity compensation to clawbacks increases the complexity of enforcement; both the impact of income taxes paid by the executive on the original award and the company's stock price at time of enforcement versus at time of award may be appropriate to consider in determining the value to be repaid by the executive.

 

What should boards consider in developing a clawback policy?

Before adopting clawback provisions, boards and compensation committees need to think through their possible application. At face value clawback provisions may seem straightforward, but actual implementation commonly surfaces many issues that need to be reviewed and thoroughly discussed.

• Which employees should be covered under the clawback provisions? One approach is for clawback provisions to cover the chief executive officer, the chief financial officer and the three other most highly compensated employees – the executives whose compensation is described in a public company's annual proxy statement. Other programs extend to all officers. The further down in the organization that the provision extends, the more likely the provision will be viewed favorably by corporate governance groups, particularly if it covers positions that contribute to and/or are responsible for financial reporting and accounting.
  
  
• What compensation elements should be covered in the clawback? Should the provision only apply to cash compensation or should it apply to both cash and equity? Base salary is not typically covered in clawback arrangements because base compensation is not usually linked to specific performance objectives. Many companies are adopting provisions that directly link their clawback provisions to all performance-based pay, including both cash and equity compensation. Another design consideration is whether the clawback should require the repayment of gains generated by stock sales if the stock price was impacted by misstated financial information.
  
  
• Should the board have discretion in applying the clawback provision? Or should a portion be mandated by pre-established contractual provisions? The issue of discretion in clawbacks is a delicate balancing act. On one hand, discretion allows a board to apply judgment with respect to the scope of a clawback. However, corporate governance groups may support mandatory clawback proposals by shareholders if they view a company's existing provisions as allowing too much discretion or as not being enforced sufficiently. Where the application of a clawback is discretionary, particular care is needed to make sure that its scope is carefully defined (and circumscribed) so as not to be subject to discriminatory application.
  
  
• How far back should clawbacks extend? In determining how far back in time to recoup compensation, many of the earlier clawback provisions adopted the 12-month period used in the Sarbanes-Oxley Act. As the scope of clawbacks has grown to encompass long-term incentives, some companies are extending their clawbacks to 24 and even 36 months. However, boards need to exercise caution that clawbacks do not extend so far back in time that executives view incentive opportunities and related payments as too high risk to have real value.
  
  
• Where should clawback provisions exist? A large number of companies have adopted clawback policies, and then supplemented those policies by adding clawback language to employment agreements and/or incentive plan documents. This second step provides companies with a contractual basis for enforcing the clawback in cases of actual violations. Many groups recommend placing the clawback language in the incentive plan documents, since at public companies these are subject to shareholder approval and avoid unnecessarily opening up existing employment agreements.
  
  
• What does applicable state law provide regarding the enforceability of the particular clawback provisions and their scope? Various states – most notably California – have expansive laws protecting employee rights and that apply to matters such as the employment relationship, earnings, and non-competition restrictions. Provisions that result in the forfeiture of compensation can be especially problematic in certain jurisdictions. Before developing broad clawback language and extending it across the country (nevermind globally), a company is well-advised to assess the enforceability of the provision in all relevant locations and the potential consequences of devising a program that may not be enforceable.

Looking ahead

While clawbacks increasingly are viewed as a common sense solution to 'undeserved' executive compensation, various facts and issues specific to a company's specific circumstances should be considered in designing any clawback policy or specific provision. Since US public companies likely will continue to feel shareholder and legislative pressure to adopt clawback provisions, they need to be aware of the factors that can affect the appropriate design. Companies should focus on developing provisions that address legitimate concerns while balancing the need to attract and retain executives.

 

Brian Tobin is a consultant in Hay Group's executive compensation practice. He can be reached at +1.312.228.1847 or brian.tobin@haygroup.com.

Megan Butler is a consultant in Hay Group's executive compensation practice. She can be reached at +1.312.228.1827 or megan.butler@haygroup.com.