Structuring Discretion for Clawbacks

The continuing stream of corporate wrongdoing and risk failures—at Wells Fargo & Co., Volkswagen AG, Equifax, Uber Technologies, Mylan, and others—gives new urgency to two questions: Should boards have broader policies for triggering compensation adjustments, forfeitures, and repayment of past compensation—generally referred to as recoupments or clawbacks—when corporate harm is demonstrated? How should boards exercise discretion when they implement such policies?

Regulators today require relatively narrow clawback policies, triggered mainly in the event of a restatement of financials. But a strong business case can be made that corporate harms of many kinds should qualify as triggers for clawbacks.

Many harms have little relation to financial restatements. In the months after Wells Fargo was found to have set up over 1.5 million unauthorized deposit accounts and another 560,000 unauthorized credit card accounts, the stock plunged over 20 percent. Market cap fell $30 billion and the loss of business, legal fees, and exposures continue to mount. The company did not have to restate earnings, but its actions tarnished its brand and hurt shareholders financially. In the aftermath, shareholders and the public at large called for some action to be taken against executives who caused or benefitted from these wrongdoings.

Shareholders expect that highly-paid executives are responsible for stewarding and protecting the company, and for creating value. No new logic is needed for shareholders to make the case to broaden today’s clawback policies since a broader policy purview would stem from normal clawback objectives:

• to protect company and shareholder interests during significant corporate damage;
• to avoid bad optics for the company and board;
• and to reduce the temptation of executives to make inappropriate decisions driven by potential compensation gains.

Harms that cause financial impacts from this broader purview can strike just as quickly as those that might cause financial restatement, and can cause greater and more long-lasting harm. A loss of brand loyalty, for example, will hurt revenues or earnings and may be long lasting. Additional harms will almost certainly surface—even if more slowly—from indirect costs related to public relations disasters, operational breakdowns, human resources scandals, environmental failures, or other errors. And they will eventually hurt earnings, asset values, market value, or other dollar measures.

The real challenge may be in determining when, whether, and how a board should exercise its judgment to trigger a clawback. Two factors should govern decision making:

• Whether the company or its stakeholders have suffered harm—that is, the harm could be financial, reputational, or nonfinancial initially, affecting employees, customers, suppliers, the environment, the community or other stakeholders.
• Evidence of culpability by an executive, or the employees for whom the executive is responsible to supervise.

Weighing these factors demands discretion adequately structured so that directors make principled and defensible decisions. As a best practice, that discretion should be guided by a process created in advance. A pre-established process increases the transparency of the board’s decisions, improves the deterrent effect of clawback policies, and may improve the company’s case in the event of lawsuits.

Clawback decisions involve risk, of course. They expose the company to shareholder lawsuits if the board decides against taking action, or takes insufficient action. They may increase legal exposure if a clawback could be construed as an admission of corporate guilt. Legal liability notwithstanding, directors charged with good governance are obliged to make a clawback decision when they document material harm.

Material Harm

How do you determine material harm? One direct way is to sum financial harms, which could manifest as lost business, fines, recall costs, legal expenses, or other costs directly incurred to mitigate the damage. In calculating materiality, a clawback threshold could be based on monetary losses exceeding a minimum amount, which could be expressed as a dollar figure or a percentage of corporate earnings (e.g., EBITDA, EBIT, or net income). Alternatively, it could be a loss in market value above a threshold (e.g., 5–10% of market capitalization).

Even if the event does not cause material and demonstrable financial harm, the board could decide it caused—or is causing—material indirect or long-term harm. GAAP accounting rarely captures the total financial impacts—in either the short or long terms—especially if they involve loss of life, severe injuries, damage to the environment, violation of human rights, damage to the brand, lost opportunity, and other effects. The “long tail” of costs, including expenses from litigation long after the initial harm, do need to be taken into account.

Culpability

The decision-making element that requires the most discretion is the determination of executive culpability. A structured decision-making process should weigh the five factors discussed below.

Nature of action or inaction, or decision

Executives may be deemed culpable if they take direct wrongful or grossly negligent actions or make decisions that cause harm, fail to act to stop or prevent harm, or withhold information from others responsible for acting to prevent or stop harm. Culpability may stem from either a single significant decision or a series of lesser ones.

Even if executives are not always directly responsible for a harmful act, there may be situations where they could be culpable as supervisors from failing to identify, escalate, monitor, or manage events as they have been charged to do.

Company policies, procedures, and codes of conduct

Executive culpability would increase if the company had policies, procedures, or codes of conduct to govern the situation and the executives deliberately chose not to follow them. If the risks were identified in the company’s enterprise risk assessment, culpability would stem from executives being alerted to risk factors.

If executives unintentionally deviated from company policy, the board should examine the facts and circumstances of the situation. If policy was not appropriately disseminated, culpability may decrease to the extent that executives could not have reasonably anticipated harm.

Board involvement

If risk from the offending action was anticipated in the company’s enterprise risk assessment, and policy required directors to be notified, culpability would increase if notification was not made. Culpability would exist in any case if executives should have understood the material consequences and chose not to inform the board.

Adjudication

Although a clawback should not require adjudication, action by the courts or regulators may bolster the case for executive culpability. Even though third parties might find the corporation responsible, the board would establish individual culpability and apply its clawback policies. Needless to say, companies should consider applying their clawback policies even before courts or regulators act, to mitigate their legal and reputational damages.

Termination of employment

Termination of an executive’s employment, with or without cause, usually itself demonstrates the board’s decision that an executive is culpable and can result in the forfeiture of unvested compensation and severance benefits. Although an executive’s firing might be viewed as adequate punishment, effecting a further clawback may be its natural extension.

Implementation

Boards can implement clawback decisions by using a matrix to rate each culpability factor. The rating would increase with intention, knowledge of expected consequences, clarity of policies and procedures, and the degree of inaction or cover up by executives up the chain of command. Importantly, companies should consider setting up a cross-functional team to walk through the material risks they face and a range of situations they have previously faced and potential scenarios to test the application of a broader clawback policy. The clawback policy adopted by the board and communicated to executives should be consistent with and should permit the discretion contemplated by the proposed framework.

At many companies today, clawback policies are extremely limited. When a board is faced with misconduct or a management failure, especially in an ethical gray area, directors need established guidance to act. A clear definition of materiality—financial and otherwise—and a clear set of rules for exercising discretion about tabulating losses, assigning blame, and executing a clawback is then an important guide for good governance.