Revisiting the Scope of Clawback Coverage

It remains appropriate for the boards of companies to prioritize discussion of the application of executive clawbacks in their compliance and compensation agendas, regardless of the initiatives in Congress to reform the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Indeed, a series of public developments this year should be prompting boards to consider expanding the scope of existing “clawback” provisions listed in executive compensation agreements. When well-crafted, they can help prevent fraud, malfeasance, or damage to the corporate reputation.

A Short History

The concept of compensation recoupment as an executive sanction has its roots in the corporate responsibility provisions of the Sarbanes Oxley Act of 2002 and related enforcement actions by the Securities and Exchange Commission (SEC). Section 304 of the Sarbanes-Oxley Act empowered the SEC to compel public company CEOs and CFOs to reimburse the company for certain bonus and incentive-styled compensation that would not have otherwise been paid for misconduct.

The limited scope of Section 304 led Congress to include broader clawback rules for listed companies under Dodd-Frank. Generally speaking, Dodd-Frank provides for the exchanges to require companies to have a clawback policy as a listing condition. Pursuant to Dodd-Frank, proposed rules call for clawback policies to cover all executive officers, applied without respect to whether there has been any misconduct by the executive officer and extend to a longer look-back period. Proposed rules would also extend the clawback rule to more types of incentive compensation.

While these proposed clawback rules have not been adopted by the exchanges, shareholder advisory services like Institutional Shareholder Services and Glass-Lewis & Co. have taken a lack of a clawback policy into account when evaluating a public company’s corporate governance practices and making voting recommendations on directors. As a result, financial restatement-based clawback provisions are now accepted as a common public company practice, and increasingly so within large, financially sophisticated nonprofit organizations.

New Developments

The utility of clawbacks as a corporate responsibility measure has attracted renewed attention because of a series of corporate, legislative, and regulatory-related developments.

One of the most prominent of these was the decision by the board of a prominent financial services company to claw back in excess of $60 million in compensation benefits from two senior executives following a major corporate controversy involving certain sales practices. Yet in another development, the board of United Continental Holdings took a different position when it decided not to seek compensation clawback from a CEO who had been terminated in connection with a federal investigation of the company’s conduct, in which he had been tangentially implicated.

Additionally, the Department of Justice weighed in on clawbacks when it issued new guidelines for compliance program effectiveness. Under these guidelines, the use of financial incentives (such as clawbacks) to motivate compliant behavior is considered to be an important element of program effectiveness.

Also notable was a recent governance survey suggesting an increased willingness of boards to terminate CEOs for unethical conduct. Another development was the 15th anniversary of the Sarbanes-Oxley Act earlier this summer, which is prompting many boards to renew awareness of the tenets of corporate responsibility.

A Possible Response

These developments combine to keep clawbacks in the mainstream of current governance discourse, not only from the perspective of corporate responsibility, but also from that of effective corporate compliance—notwithstanding legislative efforts to repeal Dodd-Frank and questions on the related enforcement focus of the SEC.

Matters of clawback review could be delegated jointly to the executive compensation and audit/compliance committees, as matters of executive compensation recoupment fall within both of their respective committee charters.

The focus of the joint committee review would likely be on the expansion of clawbacks, from incidents of restatement of corporate financials, to executive misconduct which is implicated in such matters as a fraud-based governmental or internal investigation, material ethical misconduct, and damage to the corporate reputation.

In their deliberations, those committees may wish to consider two additional, important factors. One is the fact that expanded clawback provisions cannot fairly be considered a corporate best practice at this point. Enhanced media and shareholder attention to the concept of clawbacks is not the equivalent of a broadly accepted governance conduct. It may be, however, that these recent developments could accelerate the movement towards clawbacks as a best practice.

The second consideration is the effect that any expanded clawback coverage could have on board-management relationships, executive team morale, and on broader issues of talent development and retention. The board should anticipate some amount of resistance from executive leaders to the concept of expanded clawbacks, especially if it cannot yet be promoted as a best practice.

The Timing is Right

There may be no best practice available yet to guide the board or committee discussion about expanded clawbacks. And there may be no single right answer about how any one company should address the issue.  But the need for reasonable methods to incentivize appropriate executive behavior suggests that the timing is right for such a discussion. Indeed, the wrong answer might be to simply ignore it.

 

Michael W. Peregrine, a partner in McDermott Will & Emery, advises corporations, officers, and directors on matters relating to corporate governance, fiduciary duties, and officer/director liability issues.