Companies Getting Ahead of Coming Clawback Requirements

By this time next year public companies will face more stringent requirements for recouping executive compensation following a financial restatement—that is, if the Securities and Exchange Commission sticks to its agenda. 

The SEC is currently working on a Dodd-Frank Act rule that would require companies to put policies in place to recoup ill-gotten gains by executives. Known as “clawback” policies, the plans cover when executives must give back all or a portion of their bonuses and other compensation if it later surfaces that the executives met the goals using improper means or that the performance shown to meet the incentives is later found to be false, such as in a financial restatement.

Many companies, however, aren't waiting around for the SEC to write specific rules on clawbacks. They are revisiting existing policies and putting new policies in place that require executives to return compensation if problems with how it was earned surface later.

Trying to get ahead of the curve is no easy task, however. “Clawbacks and pay-for-performance disclosure issues are exceptionally sensitive ones for companies and boards,” says Abby Brown, a partner at law firm Squire Sanders. “They are well aware that, at some point, rulemaking will be enacted that will need to be complied with, and they struggle with what, if anything, to do in advance.”

Aside from requirements in the Dodd-Frank Act, companies already face clawback requirements under the Sarbanes-Oxley Act. There are substantial

differences, however, and those policies that comply with SOX are unlikely to pass muster with the Dodd-Frank rule.

Both pieces of legislation refer to the recovery of incentive-based compensation—such as bonuses, stock awards, and stock options—when financial restatements are needed to correct instances of non-compliance with reporting requirements.

The Dodd-Frank clawback provision, however, is stricter than the one in SOX, says Matteo Tonello, managing director of the Conference Board. Under SOX, clawbacks must be exercised only in situations where the restatement is due to misconduct. Under the Dodd-Frank provision, compensation should be recovered if a financial restatement is triggered for any reason.

Another difference is that the look-back period in the Dodd-Frank provision is three years, compared to 12 months under SOX. Dodd-Frank applies to the incentive-based compensation awarded to both current and former senior executives, while SOX refers exclusively to the current CEO and CFO.

Questions, Everyone?

Without a proposed rule from the SEC, adhering to the Dodd-Frank Act's clawback requirements raises numerous questions that still need to be addressed. What forms of compensation are covered? How should equity gains be treated? How should a clawback function when targeting former employees?

A variety of studies show that companies, as they await definitive rulemaking, are increasingly adopting or modifying clawback provisions. However, according to Tonello, “a relatively low percentage” of companies have adopted policies that would likely comply with Dodd-Frank requirements. The reason: The SEC has not yet introduced rules requiring stock exchanges to prohibit the listing of non-compliant companies.

“Companies are in a limbo,” Tonello says. Nevertheless, some have gone ahead and adopted internal policies, or tweaked existing ones, in anticipation of what will ultimately be required.

This is especially true among larger companies in financial services, where executive compensation has been subject to more scrutiny during the last few years, he says. According to the Conference Board, 57 percent of financial services companies with assets of $100 billion already have put in place stricter policies intended to align with Dodd-Frank's clawback requirements. By contrast, just 24 percent of policies in the manufacturing sector would likely satisfy the rule when it is adopted.

“There is also a bit of an industry bias. Financial services companies, due to their closer scrutiny by regulators and the public, are more likely to have made Dodd-Frank clawback adjustments.”

—Abby Brown,

Partner,

Squire Sanders

Company size is also a factor. The Conference Board says 39 percent of companies with annual revenue of $20 billion or more have adopted tougher policies that shift to expected Dodd-Frank requirements. Many are adding company-specific provisions that respond to excessive risk taking, strategic inconsistencies, and performance evaluation errors.

“The larger companies that tend to end up in the spotlight on these issues are more likely than their small- to mid-sized counterparts to have gone ahead and made adjustments to their policies to be more in line with Dodd-Frank,” Brown says.

Meeting Shareholder Demands

Some companies are adding clawback policies because shareholders are demanding them. The last proxy season, as analyzed by the Conference Board, found that investors are putting shareholder proposals on the proxy that call for companies to adopt or improve their clawback policies.

After what it calls a “drastic decline” in the volume of executive compensation related shareholder proposals following the introduction of mandatory “Say on Pay,” they rebounded in 2013—up 50 percent from just 96 in 2012. These targeted specific pay practices, including the elimination of tax gross-ups and golden coffins, the introduction of equity retention periods, and more stringent clawback provisions.

With shareholders and others focused on pay for actual performance, more companies are looking to put better clawback policies in place, even before they are required to. “A few years ago companies were taking more of a wait-and-see approach,” says Melissa Burek, a partner with Compensation Advisory Partners, an executive compensation consultancy. “Now, they recognize it is good corporate governance and it makes good business sense to do it.”

In her firm's review of 150 companies, in 2012, 30 percent either adopted a policy or made changes to an existing one. “What that tells you is that companies are saying, ‘look, it's been a few years and we are going to start making some of our own changes if this is recognized as good governance,'” she says. “I don't want to overstate that there is this massive change out there, but slowly and surely companies are making changes in a way that makes sense for their business strategy.”

CLAWBACK PROVISIONS BY INDUSTRY

Below are three charts from the conference board breaking down clawback provisions by industry and reasons for the provisions.

Sources: The Conference Board/NASDAQ OMX/NYSE Euronext, 2013.

Burek suggests moving beyond broad policy to define what the triggers are for clawbacks, because under Dodd-Frank, they are not limited to financial restatements. Other potential triggers include fraud or misconduct, materially inaccurate financial statements, non-compliance with a financial disclosure requirement.

What can be recouped is another matter to address. In the law firm Shearman & Sterling's annual survey of corporate governance practices at the 100 largest U.S. companies, of the 87 that maintain clawbacks, eight apply them only to cash, and only two apply them solely to equity compensation; 77 may recoup both.

Enforcement is also important. Of the companies surveyed by Shearman & Sterling 17 percent provide for mandatory enforcement, while 70 percent leave discretion with the board of directors as to whether to execute a clawback. Another 5 percent provide for both mandatory and discretionary enforcement depending on the triggering event; 8 percent don't specify their enforcement approach.

Where the Policy Goes

Where is the policy documented? Shearman & Sterling found that some formalize it in their corporate governance guidelines; others disclose that the policy is part of an incentive plan or agreement. Other choices were having a publicly available compensation or corporate governance policy, or as a provision in the compensation committee charter. Fourty-five of the top 100 companies describe their clawback policy in their proxy statement, but do not publicly disclose where that policy is memorialized; nine companies formalize their policy in more than one document.

Some other clawback requirements in Dodd-Frank companies are addressing, often in small ways inlcude: crafting a policy that prohibits hedging of company shares; addressing the pledging of company shares as collateral for a loan; providing the board with flexibility to clawback amid unforeseen circumstances; board latitude for accessing whether a financial restatement had implications for shareholders; increasing executive accountability; and seeking positive feedback from shareholders and proxy advisers.

Companies may also want to define how far back a clawback can go after a financial restatement. Less than a quarter of companies surveyed by Burek's firm did so. Of those that did, the most common time frame was one year from the date of restatement; a smaller number established three years as the benchmark.

JPMorgan Chase, the banking giant that has spent more time this year under a microscope than in good graces, may offer some worthy ideas for linking clawbacks to the discouragement of bad behavior.

In the aftermath of the “London Whale” trading debacle that lost at least $6 billion, the key traders involved, including retired Chief Investment Officer Ina Drew, forfeited two years of total annual compensation, the maximum established by the bank's clawback policies.