Making Sense Out of “Clawbacks”

The “clawback” of pay from high-level executives for malfeasance is a hot but complex topic. Designed properly, such a policy is a significant mechanism for corporate accountability.

The Dodd-Frank bill, passed last month, mandated substantive clawback requirements for any company listed on a U.S. securities exchange if it has material financial restatements. Also in July, the European Parliament passed legislation requiring clawbacks , and the UK’s Financial Services Authority revised a proposed rule on remuneration, effective next January, which has a new provision that will define clawbacks. Prior to these regulatory developments, 212 of the S&P 500 had adopted a variety of “clawback” policies, but hundreds of public companies still don’t have such compensation recovery policies as required by Dodd-Frank.

But, despite this flurry of activity, there are still many questions, especially for the hundreds of public companies that do not have such a program and now must design one. These include:

• Who is covered?
• What is the triggering event of corporate malfeasance or non-performance?
• What types of compensation should be recovered?
• Is the period during which recovery can be sought limited?
• Does the board have discretion in seeking recoupment?
• What is the forum for resolving such issues?
• Is a “holdback” (cancelling unvested benefits) better than a clawback?

As companies revise or adopt clawback policies – whether voluntarily or because they are mandated to do so – these questions, and others, will be re-examined and policies reformulated.

But, there are more basic questions that first must be addressed: What is the mission of the corporation, how is corporate action evaluated according to that mission and, in that context, what is the philosophy of executive compensation?

I believe that there are four such “first” principles that should guide a clawback policy that companies adopt voluntarily (for more detail see “Restoring Trust in Corporate Governance: The Six Essential Tasks of Board of Directors and Business Leaders,” available here.

• The mission of the company is to create durable value for shareholders and other stakeholders through sustained economic performance, sound risk management, and high integrity. The most basic purpose of the corporations is for leaders to find a sound balance between risk-taking (innovation and creativity) and risk-management (financial and operational discipline) and then to fuse that high performance with high integrity (commitment and adherence to law, ethics and values).
• The job description of the CEO – and executive training inside the corporation – must flow from this mission and be built on these integrated essentials of performance, risk, and integrity – and on a culture in which all are honored and exemplified. In choosing a CEO – and approving training and promotion of senior executives – the board must explicitly carry out this fundamental mission in its most important function: naming top-level business leaders.
• Companies must carefully articulate operational measurements for the three critical dimensions of performance, risk, and integrity. These metrics should express the near-, medium-, and long-term corporate goals in both financial and non-financial terms. They should represent clear steps that create sustainable value for shareholders and other stakeholders, such as employees and customers, essential to the company’s health. They should not only guide internal action but be expressed in a public and transparent way so that external constituencies can assess accountability against clear standards.

  For example, economic performance metrics should minimize short-term stock market performance and focus on such areas as efficient use of capital; operational excellence through, e.g. cash flow or productivity increases; strong connections to customers; employee motivation, satisfaction and individual productivity; how new technologies, new products, new acquisitions and new geographies impact economic performance; and how the company performs relative to peers on these measurements.

  Similar operational measurements are necessary for risk (proper expertise for each area of risk; independence of risk-assessors; appropriate voice for “risk assessors” in important debates at the highest level of the company; processes for evaluating and mitigating both discrete and systemic risk) and integrity (adoption by senior leaders of appropriate principles and practices; evaluation through surveys or 360s of “performance with integrity” culture; annual integrity goals and objectives; comparisons against other company divisions or peers on critical integrity dimensions).

• A corporation can properly design its compensation system only when the corporation properly defines its fundamental mission, when it promotes the CEO and top leaders according to their experience and capacity to carry out that mission, and when it defines its operational goals across the performance, risk, and integrity dimension at the core of that mission.

  The purpose of compensation is, of course, to attract and retain talent but to do so within a balanced framework that incentivizes short-, medium, and long-term value creation. Although top business leadership will receive cash compensation in a particular year to sustain a decent standard of living, a significant proportion of the compensation in that one year should be variable cash and equity which will be paid out or held back over time as performance, risk, and integrity objectives are met, exceeded, or missed. Deferred cash has the advantage of avoiding stock price manipulation and providing necessary liquidity to individuals. Deferred equity has the advantage of tying employees to the long-term creation of shareholder value.

  There should be an end to “naked” cash bonuses which turn on a simple metric that does not take into account risk and integrity, and an end to “naked” stock options that turn on simple increases in the broad market Indices regardless of actual company performance.

With these first principles in view, a company’s voluntary clawback policy should have these essential characteristics (I will discuss how Dodd-Frank fits into this framework in a moment):

• 1. Covered individuals should be the executive officers (defined by the SEC as certain named officers and others with “policy-making” authority) but also other important, highly-compensated employees who have the capacity to injure the corporation with regard to performance, risk, or integrity. Current and past holders of positions with the company should be covered to advance the goal of accountability.
• 2. The clawbacks/holdbacks should cover both variable cash and equity earned in a particular year as well as long-term incentive and executive deferral programs.
• 3. In any contract or other documents related to a covered executive’s hiring or reception of benefits over time, there should be a section describing the clawback and holdback powers of the board of directors. There should also be a clause that stipulates that any disputes will be resolved in arbitration, which is far preferable for these sensitive matters. Such an explicit provision, when explained to covered individuals as a condition of their employment and in the context of an integrity culture, can serve as an important deterrent to future malfeasance.
• 4. The act of malfeasance that can lead to a holdback or clawback should be far broader than a material misstatement of financials (which is the focus both of some existing corporate policies and of the recently passed Dodd-Frank legislation).
• 5. Similarly, although actual intent or gross negligence (recklessness) should generally be the behaviors that trigger discipline, acts of omission on the part of an individual can give rise to sanctions. For example, senior business leaders can, especially when they have negligently or recklessly failed to create proper culture, be held responsible for problems in their units. Given the range of possible acts and the variety of standards (and circumstances) that could trigger clawbacks or holdbacks, greater sanctions (termination) or lesser ones (demotion, being denied promotion) may be appropriate, either in concert with or instead of clawbacks and holdbacks.
• 6. In the Squam Lake Report (Princeton University Press 2010), fifteen leading academics suggest a “collective” holdback for senior managers that would be forfeited in the event of bankruptcy or receipt of extraordinary government assistance. This provides incentives for the management team to prevent outsized and potentially catastrophic risk.
• 7. The inevitable, real-world variation in possible circumstances supports giving the Board discretion to find the facts and make appropriate individual holdback or clawback determinations (with advice and counsel of management when it is not implicated).
• 8. This discretion should be applied to the appropriate amount of damages – how much unvested variable cash or equity or other long-term awards should be held back; how much vested variable cash and equity and other long-term awards should be clawed back.
• 9. The board should also have the discretion to determine time when sanctions may be sought. Obviously, a holdback can occur any time when future benefits have not vested. But there is no reason to set a limit on the time for clawback of vested benefits because discovery and disclosure of corporate malfeasance can be delayed. (Once there has been discovery, there should, however, be a specific time limit during which a clawback action must be brought.)

I believe that this type of broad, flexible holdback/clawback approach is a powerful mechanism for holding senior leadership accountable to the fundamental mission of the corporation: proper risk taking balanced with proper risk management and the robust fusion of high performance with high integrity. It is not a tail that wags the dog, but instead a systematic follow-on of the interrelated tasks of defining corporate mission – CEO job specs and senior management training, appropriate operational objectives across performance, risk and integrity dimensions, and executive compensation – that promotes long-term growth and sustainability and rewards balanced senior leadership.

This voluntary approach to holdbacks/clawbacks is, in general, broader than many current voluntary corporate clawback policies and follows more clearly from necessary revisions in executive compensation that have emerged since the financial crisis of 2008 and which focus on deferral of significant percentage of annual pay, on more intense consideration of risk, and on more detailed performance objectives (beyond stock price and total shareholder return).

Such broad, flexible, circumstance-based holdbacks/clawbacks do, however, require that the government mandates be accommodated within a corporation’s voluntary approach. For example, Dodd-Frank (Section 954) is narrower than the approach described above (applies only to financial restatements due to “material non-compliance”); removes discretion from board (recovery must be sought); does not require fault of individuals from whom monies are clawed back (both present and past employees); specifies and limits those individuals (“executive officers”); and, in general terms, specifies the amount of recovery (the percentage of incentive compensation, including equity awards, in excess of what would have been paid without the restated results). (There are many ambiguities in the legislative language which will have to be clarified in implementing SEC regulations, e.g. is it retroactive, how to calculate recoverable amount, the dates during which the recovery must be sought.).

But, because the trigger to Dodd-Frank Section 954 is a financial restatement due to material non-compliance with reporting requirements, this is just one type of malfeasance within the broad framework suggested above. In any new or revised voluntary corporate holdback/clawback policy, such restatements will have to treated separately due to regulatory requirements. But it does not prevent the corporation from adopting the broader approach outlined here.

Such a fact-based approach, building on prior voluntary clawback policies adopted by corporations, is far superior to the rigid, procrustean legislative mandate of Dodd-Frank, if (a big if) companies take design and implementation of their own policies seriously as an important method of promoting balanced business leader and employee behavior and holding them accountable.