The Sarbanes-Oxley Act included provisions that called for clawbacks of CEO and CFO compensation in the case prior period financial statements had to be restated. Many companies have "noncompete" clawbacks, which require an employee to return some amount of compensation if he or she leaves to work for a competitor. Other actions that commonly trigger clawbacks include fraud, malfeasance, and the violation of a nonsolicitation agreement (prohibiting a former executive from recruiting other employees for their new employer).
The Dodd-Frank Act requires national security exchanges to require any listed company to include clawback provisions in their incentive compensation plans for current and former executive officers. The clawback provision must indicate that, in the event of certain accounting restatements, the issuer will recover the excess of what was paid over what would have been paid to executive officers based on the restated amounts during the 3-year period prior to the restatement. The provision applies to cash-based incentive compensation programs as well as stock-based compensation arrangements. This requirement is broader than the clawback provision in the Sarbanes-Oxley Act, which permits the SEC (but not the company or its shareholders) to recoup monies for the company from only the CEO and the CFO extending back 12 months, and is applicable only in cases involving the restatement of the financial statements caused by misconduct.
The SEC proposed regulations to implement the Dodd-Frank requirement, but they have not been finalized. Even so, many companies have enhanced their employment contracts to allow for clawbacks in the event the executive:
- Engages in conduct that is detrimental to the company;
- Takes actions that result in restatement of the financial statements or other financial harm to the company;
- Achieves performance-based targets, although expected profits were not actually achieved when considered in hindsight;
- Violates established risk management policies, considered from both a quantitative and qualitative perspective; and
- Demonstrates behavior that, in the discretion of management or the compensation committee, is improper.
These clawback provisions are intended to help companies better align compensation and risk. However, there are a number of challenges in implementing clawbacks. Because some of these clawback provisions are vague, it may be difficult to determine whether they have been triggered. In addition, even when a provision has clearly been triggered, it might not always be clear who triggered it. For example, if a company needs to restate its financial statements, it might not be obvious whether the clawback would apply only to the individual who directly caused the restatement, or should also apply to that person's supervisor who failed to catch the error.
As discussed in SC 2.4
, the accounting guidance for many clawbacks is generally straightforward. However, the new breed of clawback features may pose accounting challenges. For example, some provisions may require stock-based compensation awards to be clawed back if certain operating or performance metrics are not met. Because such provisions are linked to the performance of the entity or individual, they would likely be considered "performance conditions" for accounting purposes. The accounting for awards with performance conditions is different from the accounting for awards with clawback features. Further, the company may need to determine whether those measures will be based on the performance of individuals, business units, or subsidiaries. Assessing performance at the individual level may seem like the fairest approach, and it is certainly possible in some cases (e.g., for a trader in a financial services firm). In many cases, however, tracking such measures may be impossible or cost-prohibitive.
The accounting for clawbacks presumes the company and employee mutually understand the key terms and conditions of the clawback feature when the award is issued. A grant date may not be established at the time of issuance of the award if there is subjectivity or discretion regarding the triggering event of the clawback feature. If there is no grant date, variable (i.e., mark-to-market) accounting may be required (if a service inception date is established) for the fair value of the award until settlement or the date that a mutual understanding of the terms and conditions is reached.
To ensure that these performance-type clawback features will result in the establishment of a grant date at inception, the metrics should be clear and objectively determinable. Conditions based on the operations of the employer must be based on metrics that are established up-front at the grant date. These metrics might be based on financial metrics (e.g., revenue, earnings, or EPS targets), operating metrics (e.g., number of accounts opened, new customers or loans signed), or specific actions of the company (e.g., change in control, IPO).
Conditions based on the employee's individual performance will also need to be clear and objective. If metrics are based on employee evaluations and performance ratings, the evaluation process should be well controlled and understood by the employee, be reasonably objective, and serve as a basis for promotion and other compensation decisions.
Some companies provide themselves discretion to claw back compensation awards. This discretion might be related to the contingent event itself (i.e., what triggers the clawback), or to the consequence of the clawback (i.e., what action will the company take as a result of the clawback). This discretion may result in an inability to establish a grant date for accounting purposes upon award issuance, as a grant date can only be achieved when the employer and employee mutually understand the key terms of the award. If the company has discretion to decide when a clawback is triggered, the employee may not be in a position to understand what is required in order to earn and retain the award.
Finally, since clawbacks entail recovering compensation that has already been awarded, enacting a clawback may result in litigation.