Existing rules in Europe require, and proposed rules in the U.S. would require, companies and financial institutions to have in place effective clawback policies. Under such policies, employers have the ability to recover compensation paid to employees when certain events occur or information comes to light that could have an adverse effect on the employer. The aim, of course, is to create a direct link between reward and conduct so as to promote good corporate behavior and ensure effective risk management.
Clawback provisions have been around for a number of years and they are now a fairly well-known feature in a variety of different bonus and equity incentive programs. They often complement other measures that employers can deploy to address adverse events and circumstances, the most common of which is the ability to forfeit or downward adjust unvested compensation. With executive scrutiny and accountability on the rise, the significance of these policies and their effectiveness will undoubtedly be put to the test. This article looks briefly at the legal and practical challenges companies face at each stage of a clawback policy – from design and implementation to operation and enforcement.
Design is important as it goes to the heart of what the clawback policy is trying to achieve. For example, is the idea that the policy will serve as a deterrent for bad management behavior? Or should it be a tool for the compensation committee to address poor financial or individual performance?
It is clear from existing practice that clawback policies come in many different shapes and sizes. Design features range from comprehensive policies and detailed processes to short provisions (typically in the plan documents) setting out simple employer discretion to claw back. There is no one-size-fits-all. However, a clawback policy should, at a minimum, address two important issues — first, the circumstances in which clawback can be applied (commonly known as the “triggers”), and second, the period during which compensation that has been paid will be “at risk” (the “clawback period”).
When putting pen to paper, the starting point for many companies will be the regulatory environment in which they operate. This is true in particular for financial services firms in Europe as they are subject to specific requirements as regards both triggers and clawback periods. The recent compensation rules for financial institutions proposed by federal regulators in the U.S. hallmark many of the European requirements.
Market practice and investor expectations also play an important role in terms of clawback design. Although market practice is still predominantly concerned with instances of employee misconduct and misstatement of accounts, a number of companies are now taking a more pragmatic and targeted approach. For example, clawback periods aligned to a company’s business cycle and triggers that directly address company performance (such as reputational damage, failure of risk management, and poor financial results) are starting to emerge.
Effective implementation centers around two ‘C’s — contract and communication. Without these, the clawback has no teeth.
An issue that has been examined in some detail by employment advisors and litigators over the years is the way in which a potentially punitive clawback provision is introduced into the award or employment contract. Most advisors now agree that some form of employee consent is required if the company is to have any realistic chance of successful enforcement. However, the wording of the consent and the method of obtaining it still differ from company to company and from jurisdiction to jurisdiction.
As with any policy, notoriety is the key to effectiveness. If employees don’t know about it, or they don’t understand it, how will the policy change behavior? Companies need a clear communication strategy – and although the clawback message is not always an easy one to deliver – particular care should be taken to ensure that employee communications do not undermine a company’s ability to claw back. Employers should be aware of the consequences of softening the message by giving employees comfort that “clawback will only ever be applied in the most egregious of circumstances”.
Once the clawback policy is in place, companies will then need to turn to how the policy is to be operated in practice. There is often a tendency for companies to focus more on the wording of the policy and less on the process and operation of it – particularly where the aim is for the policy to work as deterrent. This is not without risk and could lead to difficult employee relations, increased likelihood of employee challenge and, in some cases, a clawback action being rendered unenforceable.
To minimize litigation risk, employers should ensure that decisions on the application of clawback follow a clear, robust and consistent approach so that employees feel they have experienced a fair process. This will typically involve careful identification and investigation of the relevant event; predetermination of the relevant decision-making body; consideration of alternative, less draconian, compensation adjustment measures; providing a reasoned decision and timely communication; and consideration of a right for the individual to offer a defense.
In addition, careful and adequate record keeping should be put in place. This ensures consistency in application and may provide important evidence in the event of a dispute.
Easily the most challenging aspect of clawback is its enforcement. Having designed, implemented and established an operational process for a clawback policy, how does an employer then ensure that compensation is in fact recovered from the employee? What amount should be recovered? What about tax that has already been paid on the compensation? What if the employee is based in a foreign jurisdiction? And to what extent should the employer engage in expensive litigation in order to effect recovery?
Although certain steps can be taken to enhance enforcement prospects (e.g., adequate employee consent, including a power to withhold from other payments due to the employee; obtaining local employment advice; and setting up post-vesting stock retention arrangements), further complications often arise if the employee has long since left the company.
There are no silver bullets and the absence of case law leaves many enforcement questions unanswered. In practice, most actions settle without ever going to court. Yet companies can do more to prepare for the future. As more scandals emerge and the sums at risk continue to increase, early preparation is undoubtedly time well spent.