In recent years, compensation clawbacks have made headlines, as a number of high-profile corporate scandals have prompted companies to try to recover compensation from executives who were involved in or were in charge when the scandals occurred. These companies have generally been publicly traded, but private companies would do well to consider whether compensation clawbacks could be useful to them as well.
What is a compensation clawback?
At its most basic, it is a contractual right to recover compensation that has previously been paid.
Publicly traded companies have had mandatory clawback requirements since the Sarbanes-Oxley Act was enacted in 2002. Sarbanes-Oxley imposed a relatively narrow clawback requirement that applies only to the CEO and CFO and is triggered only if a restatement of financial results occurred as a result of misconduct.
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act included a more expansive clawback requirement that would apply to all executive officers (not just the CEO and CFO) and would be triggered by restatements of financial results, whether or not they were caused by misconduct. However, the Dodd-Frank clawback requirement is not yet effective due to a delay in the publication of final rules. (Proposed rules were issued in 2015, but they have not been finalized.)
Apart from legally required clawback policies, many publicly traded companies have voluntarily adopted clawback policies in response to pressures from proxy advisory firms or investors or out of a belief that clawbacks are part of good governance. Ninety percent of the top 100 largest publicly traded U.S. companies have adopted clawback policies of some sort.
Should private companies consider adopting clawback policies even if they are not required? There are a few reasons they might:
1. Clawback Policy Goals are Private Company Goals, Too. Many of the typical goals of compensation clawback policies are desirable for private companies as well as publicly traded companies. Clawback policies are generally intended to protect the company’s and shareholders’ interests by ensuring executives will not be overpaid when the company and shareholders have been harmed as a result of financial restatement or reputational or financial harm. They are also intended to reduce potential incentives for inappropriate actions or decisions by executives. Like their publicly traded counterparts, private companies face many of these concerns as well, which clawback policies may help to address.
2. Clawback Policies May Help Address Uncertainty Over Payments Based on Unaudited Financial Results. One of the risks a compensation clawback policy guards against – overpayments based on overstated financial results – may be more pronounced for a private company than for a publicly traded company. Publicly traded companies have independently audited annual financial statements, quarterly review of financial statements by auditors and rigorous internal controls over financial reporting, all of which should lessen the likelihood of overstated or restated financial results. Some private companies, by contrast, do not have financial statements that are as rigorously or regularly audited, increasing the possibility that financial results will need to be revised or restated. A clawback policy may help address concerns about overpaying executives on the basis of financial results that could later be subject to revision.
Private companies that consider adopting a clawback policy should keep in mind some of the following considerations.
1. Design Alternatives. Any company implementing a clawback policy will need to make choices about its design, and private companies may have different considerations from publicly traded companies as they make those decisions. Some of the most important design considerations are the types of compensation covered (cash incentive compensation, performance-based equity, and/or time-vesting equity), what types of events will trigger a clawback (e.g., financial restatements or reputational or financial harm as well), who will be subject to the clawback policy (only top-level management or anyone who receives an incentive award), and the time frame (how far back in time will compensation be subject to the clawback).
2. Mechanics. In designing a clawback policy, it is important to give thought to how the policy will be enforced. For example, the policy will need to be made part of the contracts representing the incentive compensation that is subject to the policy, so that the company will have a contractual right to recover the compensation. Other mechanical considerations are whether the company will also have a right to enforce the clawback by offsetting other compensation owed to the executive (e.g., deferred compensation), whether legal fees associated with enforcing the clawback will be recoverable from the executive, and whether the clawback policy should be an exception to bylaws or other documents creating a right to the advancement of legal fees.
These design alternatives and mechanical considerations often involve legal, tax and accounting questions, so it is important for any company considering implementing a clawback policy to consult with its advisors before taking action.