Focus on Clawbacks

Clawback policies allow companies to recover erroneously awarded compensation from executive officers. They have increased in popularity over the past few years, and will become a fixture of executive compensation plans now that the Dodd-Frank Wall Street Reform and Consumer Protection Act has passed and is being implemented.

Specifically, Section 954 of the Dodd-Frank Act requires the SEC to adopt rules prohibiting national securities exchanges and associations from listing any company that fails to implement a clawback policy.

Although Dodd-Frank criteria are more stringent than the clawback provisions in Sarbanes-Oxley’s Section 304, many Fortune 100 companies have existing policies that meet some mandated conditions within the Dodd-Frank Act.

Research by Equilar, Inc. has found that from 2006 to 2010, the prevalence of Fortune 100 companies with publicly disclosed clawback policies increased from 17.6% to 82.1%. Many of these policies allow companies to recover compensation in the event of a financial restatement or ethical misconduct.

As one would expect, most clawbacks are triggered by ethical or financial misconduct. In 2010, 81.3% of Fortune 100 clawback policies included provisions allowing for the recovery of compensation in the event of a financial restatement. Moreover, 78% of clawback policies have provisions allowing companies to recoup pay in the event that an executive behaves unethically.

In many cases, these triggers overlap. For example, some policies trigger a clawback only when a restatement is caused by the unethical behavior of an executive. In fact, 63.7% of clawback policies within the Fortune 100 included provisions containing both financial restatement and ethical misconduct triggers.

DIGGING INTO THE DATA

As shown in Figure 1, from calendar year 2006 to calendar year 2010, clawback policies have grown from a little-known concept to a widely accepted corporate governance practice at Fortune 100 companies.

Under the Dodd-Frank Act, if a company does not disclose a clawback policy, the national securities exchanges and associations will be prohibited from listing the company’s securities.

SURGING POPULARITY

The surging prevalence of publicly disclosed clawback policies at Fortune 100 companies suggests that the majority of policies were implemented very recently. From the 56.5% of clawback policies that actually listed a date of adoption, effectiveness or amendment, the amount of disclosure available seems to support the assertion that clawback policies are a fairly new phenomenon.

In fact, among Fortune 100 companies that disclosed the implementation date for their clawback policies in their fiscal 2009 proxy statements, 95.8% adopted their policy in calendar year 2006 or later. Furthermore, 67.3% of the group disclosed clawback policy amendment and implementation dates effective in 2009 or 2010.

This data suggests that many companies have recently taken extra measures to polish or implement their clawback policy. Figure 2 displays the prevalence of clawback policy adoption dates disclosed in the Fortune 100′s fiscal 2009 proxy statements.

A TRIGGER-HAPPY PROCESS

Clawback policies are primarily used to deter management from taking actions that could potentially harm the financial position of a company. Therefore, many clawback policies are triggered by a financial restatement, especially when caused by misconduct.

In some cases, there must be a clear link between personal misconduct and a financial restatement to trigger a clawback. In other cases, a restatement, regardless of its cause can trigger the recovery of past compensation for anyone whose compensation was tied to false information.

Other clawback policy triggers include the violation of non-compete provisions, ethical violations not related to financial restatements, and the termination of employment shortly after the exercise of stock options or vesting of restricted stock.

Again, as one would expect, specific definitions for triggers vary greatly and often overlap, creating a situation where the majority of policies fall into multiple categories. In 2010, 68.1% of Fortune 100 clawback policies had triggers in more than one category. Among policies with multiple triggers, the majority had a blend of triggers relating to financial restatements and ethical misconduct.

To illustrate this point, Figure 3 displays the overlapping nature of Fortune 100 clawback policy triggers in 2010.

Under the Dodd-Frank Act, executive officers will have to reimburse their company if a financial restatement occurs, regardless of misconduct. This is a more stringent provision than that of Sarbanes-Oxley, which tied clawbacks to a financial restatement caused by misconduct.

As illustrated in Figure 3, many clawback triggers contain both financial restatement and misconduct triggers, but only 17.6% of the triggers were based solely on the occurrence of a financial restatement.

A STEADILY INCREASING SCOPE

Clawback policies have diversified from basic guidelines limited to recovering cash bonuses to all-encompassing policies that cover all performance-based pay and equity awards. This trend was evident in 2010, when more than 80% percent of clawback policies covered equity incentives and/or cash incentives.

As clawback policies reach a greater assortment of compensation elements, the areas of coverage become more difficult to classify. That said, clawback policies can be placed into specific categories based on covered compensation:

  • Cash incentives
  • Equity incentives (including performance shares)
  • Outstanding options
  • Vested options
  • Restricted stock/units
  • Other

In most cases, clawback policies fit into several of the categories listed above. Of the 78 Fortune 100 companies disclosing clawback policies in 2010, 88.5% percent had policies covering more than one key element of compensation, and 44.9% had policies covering three or more elements of pay.

Additionally, the “Other” category typically includes deferred compensation, but also includes sales commissions, flexible perquisite accounts and supplemental retirement plans.

A majority of policies included both cash and equity incentive compensation, with 70.7% falling into this category. Many policies already cover both cash and equity incentive compensation, but only 25% or so mention recovering compensation derived from or in the form of vested and/or outstanding options.

Figure 4 displays the prevalence of policies covering each of the compensation categories listed above, without regard to whether or not policies cover more than one element of pay.

WHO IS CLAWABLE?

While clawback policies often do not cover all employees at a particular company, disclosure on clawback policy coverage is usually vague.

In 2010, for example, 67.4% of disclosed Fortune 100 clawback policies were captured in the broad category of “Key Executives and Employees.” This is primarily because most companies don’t provide enough information to place examples into narrower categories, such as Section 16 Officers or Named Executive Officers.

Since many clawback policies now link to incentive plans, the number of employees covered by a compensation recovery policy in any given year can change based on incentive plan participation. Some clawback policies also cover both non-employee directors and employees.

Figure 5 provides a breakdown of clawback policy employee coverage at Fortune 100 companies in 2010. The “Other” category includes policies limited to Section 16 officers and Chief Financial Officers and/or Chief Executive Officers. The “Directors and Employee Category” includes policies for Directors in addition to Key Executives, Named Executive Officers, or All Employees.

Section 954 of the Dodd-Frank Act is fairly specific regarding employees who must be covered by clawback policies: “any current or former executive officer who received incentive-based compensation during the three-year period preceding the restatement.”

Again, this coverage is much broader than that of Section 304 of the Sarbanes-Oxley Act, which targets only the chief executive officer and the chief financial officer who receive compensation in the year after an erroneous filing.

Of the clawback policies disclosed in 2010, however, only 3.3 percent exclusively targeted the chief financial officer and/or chief executive officers, while the majority of policies cover key executives or employees, which, as the broadest category, includes executive officers.

MORE TO COME

In recent years, clawback policies have become much more likely to impact all compensation vehicles. Certainly, the design trends described here are apt to evolve, as the implications of the Dodd-Frank Act become more clear and as specific incidents trigger newly written clawback provisions.

In a time of sweeping change for the fields of executive compensation and corporate governance, all concerned parties will have a continuing need to seek data and conduct analysis on one of the most important new topics under their purview.

Want to learn more? See the full report by visiting http://www.equilar.com, calling (650) 286-4512, or e-mailing Equilar.