It may be time to adopt a clawback policy

Clawback policiesCompensation and Benefits Bulletin
Executives should return compensation earned improperly. That’s a statement many would find difficult to dispute. Yet clawback provisions remain one of the most controversial agenda items being addressed by compensation committees and boards of directors of publicly held companies.

The clawback provision was first passed under the Sarbanes-Oxley Act of 2002, which generally required public company CEOs and CFOs to disgorge bonuses, other incentive-based compensation and profits on the sale of company stock within a 12-month period if there was a financial restatement because of material noncompliance due to misconduct. This was an important first step. However, under those rules, companies weren’t required to take steps to provide for a clawback of executive compensation.

Clawback: Money or benefits that are distributed, then taken back as a result of special circumstances. In 2010, Congress reaffirmed its commitment to clawback provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) by requiring all exchange-listed companies to adopt a clawback policy related to executive compensation.  

These new rules, titled “Recovery of erroneously awarded compensation,” are located in Section 954 of Dodd-Frank. The rules are intended to be more encompassing than those under Sarbanes:

  • Any current or former executive would be subject to the rules.
  • The rules require the recovery of incentive compensation (including stock options awarded as compensation) in excess of what would have been paid or awarded (had the determination for such incentive compensation been based on the restated financial statements) during the three-year period preceding the date on which the company is required to prepare the restatement.
  • Dodd-Frank Section 954 does not require misconduct to trigger the clawback obligation.

The SEC was charged with drafting the new regulations and directing the securities exchanges and securities associations to prohibit the listing of any security of an issuer that doesn’t comply with the requirements of Dodd-Frank Section 954.  

However, as we approach the fifth anniversary of the enactment of Dodd-Frank, the final rules implementing Section 954, the clawback provision, remain one of only a few of the 102 Dodd-Frank regulations to be finalized and adopted.

Nevertheless, according to a study by Equilar, a provider of executive compensation data,the number of Fortune 100 companies with publicly disclosed clawback policies increased from 17.6% to 89.4% from 2006 to 2013. This clearly shows that an increasing number of companies are not waiting for the SEC and are opting to voluntarily adopt clawback policies.

However, without clear guidance and direction, these policies run the gamut of what might be included in the final regulations.

It is important that such policies start with the basic objective to align the goals of the company with the goals of its executives, shareholders and stakeholders, including boards of directors. When drafting these policies, companies should also consider important questions like the following.

  • Who should be covered by the policy? Senior executives or all employees?
  • What events would trigger the clawback policy? Should they include only misconduct resulting in a restatement or also error?
  • Should the board and/or compensation committee have discretion in seeking recovery, or should recovery be required?
  • Should all incentive compensation be subject to clawback? Are all outstanding stock options subject to forfeiture or merely the recoupment of realized gains?
  • Does the policy affect compensation awarded or earned only after the adoption of the policy, or should it be applied retroactively to existing awards?
  • Should the clawback include the entire amount of the incentive compensation or only the amount that was earned in excess of what would have been earned if no restatement had been required?
  • What role do taxes play in the amount of compensation to be recovered?
  • For what period of time should compensation be subject to recovery?
  • Will the policy be a stand-alone document? Does it also need to be referenced in the incentive plans and employment agreements?  Do these documents require bilateral agreement with the additional provisions? Would consideration be appropriate in certain circumstances?
  • How will the policy be enforced?

As with all such changes to the executive compensation regulatory landscape, we will see the intended and unintended consequences of these policies over the next few years.  What will those consequences be?

  • Will executives take extra steps to provide adequate resources for their financial-reporting and compliance departments?
  • Will companies require more-redundant review procedures to manage the risk?
  • Will compensation structures be modified to change the payout periods under certain awards to manage clawback exposure? Or conversely, will more awards include a mandatory deferral period to aid in the enforcement of a clawback if necessary?
  • Will such provisions affect the number of financial restatements?
  • Will the marketplace begin to discount longer-term incentive compensation because of the repayment risk?

One thing is clear, once the SEC finalizes its clawback rules, companies will need to review their clawback policies, incentive plans, employment agreements and severance plans to support compliance and enhance corporate governance and alignment with the interests of shareholders.

Ken Troy
+1 213 596 6770

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