What is a Clawback Provision?
Clawback provisions are clauses that specify a set of factors or situations in which money already paid to an employee must be returned to the company. Frequently, these clawback provisions are included in employment contracts, and most clawback provisions are non-negotiable. Clawbacks are typically used in response to employee misconduct, scandals, poor performance, or a drop-in company profits.
Clawbacks are typically included in employee contracts so employers can control bonuses and other incentive-based payments. Additionally, these provisions act as a form of insurance in case the company needs to respond to an employee-created crisis, and its policy may vary based on the employee’s role within the company.
Clawbacks have been on the rise at Fortune 100 companies. The Corporate Finance Institute found clawback provisions were present in less than 3% of employee contracts in 2005. In 2010, that number had risen to 82%. And, according to the Wall Street Journal, clawbacks are appearing more rapidly in employment contracts at hedge funds, investment banks, and other businesses in the finance industry.
How Do Clawbacks Work?
The following is an example provided by the Corporate Finance Institute explaining how clawbacks work.
The annual reports of a company show that the CEO worked hard to keep the company profitable. The company wants to reward her efforts and a contract is signed, stating that if the sales of the company increase by at least 10% within the next two years, then the CEO will be paid a bonus of $200,000. In the corporate financial statement, it shows that the company registered a profit of 13% in the two years and as a result, the CEO is rewarded with the promised amount.
After an audit of the company, it is found that the profits were over-reported, and the profit was actually 9.5% and not 13% as stated in the previous report. In a situation like this, under the clawback provision, the company can take back the bonus amount previously paid out to the CEO. Depending on the specific clawback clause, the CEO may also have to pay a penalty because the original financial reports submitted were flawed. Since the CEO signed the contract, there’s little she can do to contest this forced return of the money.
How Should Lawyers use Clawback Provisions in Employment Contracts?
Generally, adding a clawback provision to employment contracts is straightforward. However, complications arise when updating past employment contracts and stock plans to meet new clawback policies.
Here are the steps used to aid employers in updating their employment contract policies:
- Understand why the company wants a clawback, and what it wants to accomplish with the policy.
- Analyze existing agreements and policies in place to determine if and how they fall short of the company’s goals.
- Use expertise in the law to draft and edit clawback provisions that protect the company while simultaneously remaining within the boundaries provided by applicable laws.
Clawback Provisions in Financial Recovery
The first federal statute to allow for clawbacks of executive pay was the Sarbanes-Oxley Act of 2002. It provided for clawbacks of bonuses and other incentive-based compensation paid to CEOs and CFOs in the event that misconduct on the part of the company — not necessarily the executives themselves — led it to restate financial performance. The legislation sought to both improve the reliability of the public companies’ financial reporting, as well as restore investor confidence in the wake of high-profile cases of corporate crime.
Clawback provisions have become more prevalent since the 2008 financial crisis. The Emergency Economic Stabilization Act of 2008, which was amended the following year, allowed for clawbacks of bonuses and incentive-based compensation paid to an executive or the next 20 highest-paid employees. It was designed to prevent the collapse of the U.S. financial system during the subprime mortgage crisis, which was the sharp increase in high-risk mortgages that went into default beginning in 2007, contributing to the most severe recession in decades. The Emergency Economic Stabilization Act sought to restore liquidity to credit markets by authorizing the secretary of the treasury to purchase up to $700 billion in mortgage-backed securities and other troubled assets from the country’s banks, as well as any other financial instrument the secretary deemed necessary “to promote financial market stability.” The Act applied in cases where financial results were found to have been inaccurate, regardless of whether there was any misconduct, but was only available to companies that received Troubled Asset Relief Program (TARP) funds.
In July 2015, a proposed Securities and Exchange Commission (SEC) rule associated with the Dodd-Frank Act of 2010 would allow companies to clawback incentive-based compensation paid to executives in the event of an accounting restatement. The clawback was limited to the excess of what would have been paid under the restated results. The rule would require stock exchanges to prohibit companies that do not have such clawback provisions written into their contracts from listing. This rule has yet to be approved.