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Clawing Back Compensation

Executive compensation plans have become trickier to design under legal requirements that seek to avoid premature payouts.

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September Cover

When executives get paid based on company performance and, much later, that performance turns out to be illusory, does the executive have the right to keep that money?

According to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the answer is no. Just how companies are going to deal with Dodd-Frank's requirement that they "claw back" executive pay following a financial restatement remains to be seen, however.

In general, Dodd-Frank requires publicly traded companies to adopt executive compensation provisions that allow the company to recover any incentive-based pay that was paid out during the three years prior to any financial restatement, if it would not have been paid out under the restated financials. This so-called clawback provision applies to all of a company's executive officers.

While this broad outline of the clawback provision is included in the law itself, several questions remain. At least some of these questions will be answered by regulations the U.S. Securities and Exchange Commission (SEC) plans to release this year.

Until then, it is up to HR executives to prepare for this change while they await answers to some important questions surrounding the clawback requirement.

What They Are

Clawbacks are a relatively new phenomenon. A clawback is a mechanism included in an executive's employment contract that allows the company to recover payments made through performance-based incentives under certain circumstances. When Congress passed the Sarbanes-Oxley Act of 2002 in the wake of the Enron and WorldCom scandals, the clawbacks required in that law affected only the chief executive officer and chief financial officer, and only if these individuals were found to have profited as a result of misconduct, such as lying about or manipulating company performance.

"The original concept of clawbacks under Sarbanes-Oxley was more punitive to prevent executives from doing bad things to enrich themselves," says Steve Seelig, executive compensation counsel in Towers Watson's Center for Research and Innovation in Washington, D.C.

Clawbacks are also required for the top 25 executives in any company participating in the Troubled Asset Relief Program (TARP).

The Sarbanes-Oxley and TARP requirements have been the primary drivers of more widespread use of clawbacks, according to a review of the 2010 proxy disclosures of 85 Fortune 500 companies in a variety of industries. The review, conducted by New York City-based executive compensation consultants Compensation Advisory Partners, found that 80 percent of the companies have some type of clawback provision. The Dodd-Frank requirements are likely to increase the use of clawbacks.

But there is nothing to say that companies cannot go beyond what is required by law, and many companies already are. The Compensation Advisory Partners review found that companies with clawback provisions often seek recovery of pay and benefits beyond incentives. For example, IBM has expanded provisions that allow recovery of company contributions to IBM's Excess 401(k) Plus Plan for executives. McDonald's holds the right to recover severance awards if an executive "engages in willful fraud that causes harm to the company or is intended to manipulate the performance measures that determine award payouts." And JPMorgan Chase & Co. can recover equity awards from its management committee members if they fail "to identify, raise or assess, in a timely manner as reasonably expected, risks and/or concerns with respect to risks material to the firm or its activities."

Changes from Dodd-Frank

The Dodd-Frank requirements differ from the Sarbanes-Oxley and TARP requirements in that they are much broader and include all executive officers. Moreover, the clawbacks required under this new law extend to any executive who benefits from incentive payouts based on erroneous performance data, whether or not the error was deliberate. For example, if a company finds an accounting error that requires a restatement that lowers company earnings under generally accepted accounting principles (GAAP), the executives who benefited from the incorrect higher numbers would have to pay back enough of the payout to bring their compensation in line with what they would have received under the correct numbers. The executives in question do not have to be caught in any wrongdoing for this new clawback requirement to apply.

Although Dodd-Frank provides a broad outline of the clawback requirement under the law, the devil, as they say, is in the details. "Without regulations, there is no certainty about how this will play out," says Charlie Tharp, CEO of the Center on Executive Compensation in Washington, D.C.

Indeed, many questions remain that may or may not be answered by the new regulations. For example, how should companies deal with the local, state and federal income tax implications of taking back incentive payouts? How far back will the clawback provision extend if a restatement does not involve recent results? Will any existing compensation arrangements be "grandfathered" in?

If equity compensation is involved in a clawback, the questions are even more difficult. For example, how should companies calculate clawback amounts given the fluctuating nature of stock prices? "If an executive has exercised stock options for a gain, only to have the company make a restatement, can you calculate what this stock would have been worth had [the company financial statements been correct] and that restatement not occurred? Probably not," says Daniel Laddin, a partner with Compensation Advisory Partners. "There is a lot of uncertainty around that."

Although questions will remain until the regulations come out, some things are clear. "The Dodd-Frank requirements raise practical questions about plan design," Tharp says.

Many, if not most, executive incentive plans are based on shareholder value creation, not financial statement numbers or GAAP financials. "If a company has a material restatement on net income of 22 percent from the previous period, how do you take that 22 percent change in income and equate it to a cash flow measure or a return measure or some other discretionary measure in the incentive plan?" asks Steve Cross, managing partner with Cogent Compensation Partners in Houston. "Long-term incentive plans may need to have a tail on the payout." This way, the executive will not have received the payout while there is any possibility for a clawback.

Although companies could shift compensation design toward more discretionary measures that do not impact company financials and, therefore, may not be subject to clawback, such a shift could introduce corporate governance issues. After all, shareholders want to know what financial targets executives are pursuing and expect pay designs to back that up. In fact, prior to Dodd-Frank, shareholders themselves pushed for clawbacks as a sign of stronger corporate governance.

"HR executives are going to face a lot of work and a lot of policy decisions once the regulations are out," Seelig says. "Organizations have been in a holding pattern this year, and even those companies that want to implement a clawback provision are deciding to wait and see what the regulations say."

Once the regulations are out, companies can focus on how to adapt executive compensation designs to ensure that the program meets its goals and that the company complies with the rules. For example, will it be necessary, practical and even make sense to defer some amount of compensation in case the company has a restatement? If so, how much and for how long?

Many of these issues will take time to work out. Companies, or executives themselves, might look into whether it makes sense to purchase some type of insurance product to indemnify themselves against a future clawback. The key will be whether the SEC rules permit such an approach. "These are the technical issues that need to be addressed," Seelig says. "Once the regulations are out there, smart lawyers are going to look for ways to get around these things."

Most experts believe, however, that executive compensation programs are likely to need at least some restructuring to meet the Dodd-Frank requirements. "I do not think past practice is going to be any indication of what is to come," Seelig says.

Challenges Ahead

A key concern about clawbacks is their potential impact on the relationship between public companies and their executives. Even when clawbacks are required by law, there is concern that these provisions will create an adversarial relationship between the two parties. "It is going to create a chasm in the relationship between senior managers and the board," Cross says. "Clawbacks are looked at by senior managers as a punitive measure with the possibility that they could be the big losers even if they had nothing to do with or no control over a restatement."

The challenge for HR is to find ways to adhere to Dodd-Frank requirements while maintaining a strong relationship with executives. The first step is to get familiar with the law by talking to the company's general counsel or outside attorneys and reviewing incentive plans in light of those rules. It is unclear whether the SEC will grandfather in existing compensation contracts and plans. Therefore, HR and legal counsel should be looking for any situations that might arise under the incentive plans that would make these plans difficult to administer under the rules.

Then, HR professionals can begin to communicate the law's provisions. Once the regulations are out, employers will be in a better position to discuss potential changes with executives.

This communication is particularly important in situations where employers need consent to change individual employment contracts. They may want to move away from negotiating incentives into such contracts. Instead, employers can manage compensation through broader plans for specific groups of executives. Otherwise, they will find themselves negotiating terms individually with 20 or 30 executives.

Whatever the regulations say, HR executives need to be ready to incorporate the new clawback provisions into executive pay programs. Even though clawbacks have the potential to create challenges, employers still need to develop executive incentive structures that drive desired performance and provide rewards for increasing shareholder value. The clawback cannot become the tail that wags the dog.

The author is a New Jersey-based business and financial writer.

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