The number of companies adopting clawback policies continues to claw its way upward.
Used to rescind CEO pay after fraud or poor management sours company performance, clawback clauses have long been a favorite of shareholder activists but loathed by corporate boards. Section 304 of the Sarbanes-Oxley Act finally put legislative teeth behind the idea, requiring CEOs and CFOs to return any bonus, incentive-based or equity-based pay, or profits from the sale of securities in the event of certain financial restatements.
Actual enforcement of Section 304 is almost nonexistent, since investors cannot sue under the law; only enforcement agencies can use it. But since 2002, the number of companies adopting their own clawback provisions has been steadily rising.
Borges
“While this was an area that didn’t get much attention before Sarbanes-Oxley, the enactment of Section 304, coupled with a string of well-publicized earnings manipulation cases, got boards thinking about the need for such protections,” says Mark Borges, principal at compensation consulting firm Compensia. “We’ve seen an increase in the adoption of these provisions each year since.”
Recent data supports that observation. A study by The Corporate Library of 2,121 company proxies filed from November 2007 to May 2008 identified 295 companies—roughly 14 percent—with a clawback provision of one kind or another. While not quite a groundswell, “it’s a significant increase” from the last time TCL looked at the issue in 2003. Then, a study of 1,800 companies turned up just 14 instances of any kind of recoupment policy, TCL senior researcher Paul Hodgson says.
Hodgson says concerns about the usability of the narrowly drafted statute led many companies to draft their own provisions. “Most people looked at [Section 304] and were unconvinced about its efficacy,” he says.
While some companies are adopting the provisions due to shareholder pressure, observers say just as many are adopting them of their own accord.
“While many companies have adopted these provisions in the face of a shareholder proposal or threat thereof, I’ve seen many situations where the board has raised the issue itself, either generally or in connection with the adoption of a new incentive plan,” Borges says.
Benderly
Danielle Benderly, a partner in the law firm Perkins Coie, agrees. She says the policies are being implemented by companies “that want to signal that they’re taking their corporate governance seriously.”
So far, most early converts are larger companies. Almost half of the companies with a clawback provision were in the S&P 500, according to TCL. Similarly, a study of Fortune 100 companies published last fall by compensation research firm Equilar showed 42 percent of those companies disclosed a clawback policy in 2006.
Benderly says that’s in line with what she sees in practice. “For a lot of small or medium-sized companies, this is something they’re still just talking about,” she says. “They don’t have the kind of pay or the institutional investor attention or pressure that larger companies do, and since there’s already a statutory provision under SOX Section 304, they don’t have the motivation to be early adopters.”
Mixed Success
Shareholder proposals demanding clawbacks have had mixed success since they debuted in 2004, when Amalgamated Bank’s LongView Fund filed a proposal at Computer Associates (now known as CA). In 2005, four proposals averaged 31 percent support, according to RiskMetrics. By 2007, 10 of 12 proposals went to a vote, winning an average of 31.9 percent support. Two of them, at Wyeth and Motorola, won majority support.
“The policies are being implemented by companies that want to signal that they’re taking their corporate governance seriously.”
— Danielle Benderly,
Partner,
Perkins Coie
This year, shareholder support at the companies that have held votes is down significantly, says Carol Bowie, head of RiskMetrics’ Governance Institute. She is tracking six proposals: One at GE received 15 percent voting support; another at Motorola garnered 11.9 percent; and a third at Wal-Mart got 5 percent.
In some cases, Bowie says support may have waned because the company has already adopted some sort of provision to address the issue. That appears to be the case at Motorola, which adopted a provision less stringent than the one called for by activist Kenneth Steiner.
The policy adopted by Motorola in November states: “If, in the opinion of the independent directors of the board … the company’s financial results are restated due to intentional misconduct by one or more executive officers of the company, then the independent directors shall use their best efforts to remedy the misconduct and prevent its recurrence. In determining what remedies to pursue against any individual executive officer the independent directors shall consider all relevant facts and circumstances.”
Forty-four percent of companies in TCL’s survey had clawback policies that applied only to executives who committed fraud or misconduct severe enough to lead to a restatement. Broader policies that would apply to all executives who received an incentive payment of some kind based on incorrect financials (“performance-based” clawbacks) were found among 39 percent. Roughly 17 percent have some other type of provision in place, often related to restrictive covenants.
Hodgson
Hodgson calls performance-based provisions “the gold standard.” Con Hitchcock, an attorney for Amalgamated LongView Funds, agrees. He says the clawback issue is “central to the whole concept of pay for performance.”
“I don’t see how companies can refuse to have a clawback policy if they want to be taken seriously on the issue of executive pay,” Hitchcock says. “How can a board justify letting an executive hold on to shareholder money that the executive didn’t earn?”
This year, Amalgamated filed only one clawback proposal on the issue, at Dell, but withdrew it when the company voluntarily adopted a policy. Dell disclosed a recoupment policy in its most recent proxy; the company did not respond to requests for comment. Dell had a significant restatement last year that coincided with reshuffling its financial reporting executives.
Borges, however, says a problem with performance-based provision is that, “invariably, a situation will arise that is covered by the provision even though everyone agrees it shouldn’t be.” Consequently, most provisions give the board the ability to act if fraudulent activity or misconduct results in a restatement, but also allow the board to decide at the time who should forfeit their compensation and how much.
Borges says he prefers provisions specifying that if incentive compensation is paid on the basis of erroneous financial information—whether the result of fraud, misconduct, or otherwise—the board “will take appropriate steps to recover the compensation if it’s in the shareholders’ best interest, and then leave it to the board to evaluate each situation on its own facts.”
For companies thinking about adopting a clawback provision, experts say drafting can be a challenge.
“The real problem is figuring out what situations to cover and how deep in the organization to apply the provision,” Borges says. For example, should all the executives have to forfeit their compensation when only one clearly has engaged in misconduct? Those types of questions “are difficult to answer in advance,” Borges says.
Benderly agrees that no single standard approach works well here. “Companies need to be careful in how these policies are put together,” she says. “They shouldn’t just pick someone else’s policy and adopt it. It has to be appropriate for the company’s program and structured to be enforceable in the jurisdictions in which they’d be trying to enforce it.”
State law, which varies widely, is also a major consideration, she says. Other issues to consider are whether the policy will provide forfeiture only, or forfeiture and recapture, which is more difficult. Another is how to define prohibited behavior: Is it misconduct, fraud, competition, for-cause termination, or other disloyal acts?
Companies must also consider how far they’re willing to “reach back,” Benderly says. “They have to think about the statute of limitations of the underlying behavior in the case of a bad act.”
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