Designing Compensation Clawback Policies: A Few Issues to Consider
The purpose of this Post is to highlight issues that compensation committee members should consider when designing an effective "clawback policy" for compensation paid to certain executive officers.
Background
A clawback policy (also known as a "recoupment policy") generally refers to a company's ability to recover compensation it paid to an employee (or former employee) due to a specific triggering event. Effective clawback policies can provide positive CD&A disclosure, are generally considered shareholder friendly by shareholder advisory services such as RiskMetrics, and can help negate "materiality" under the new SEC risk assessment disclosure rules (Prior Post).
Section 304 of SOX May Not Be Sufficient
Under Section 304 of the Sarbanes-Oxley Act of 2002 ("Section 304"), the CEO and CFO of a public company are required to reimburse the company for certain cash and equity compensation received (and any profit realized) during the 12-month period following the company's first issuance or filing of erroneous financial statements. However, Section 304 has a number of deficiencies, including:
- Only the CEO and CFO are covered.
- Clawbacks are mandated only when the company is "required" to restate its financial statements (it is not always clear whether a restatement is required, e.g., consider whether a restatement to follow advice of a new accounting firm would be considered voluntary or required).
- Clawbacks are triggered only as the result of "misconduct," which is not defined.
- Only the SEC can bring an action against the CEO and/or CFO (i.e., private plaintiffs such as a company or its shareholders cannot bring a claim under Section 304 against the CEO and/or CFO).
In light of these possible deficiencies, compensation committees should consider implementing a more robust clawback policy.
Issues to Consider When Designing a Clawback Policy
The following are a few issues compensation committees should consider when designing a clawback policy:
- Which employees should be subject to the clawback policy? Minimally, it should include one or more employees who have influence on critical business issues. For example, the policy could be designed to cover: (i) the CEO and CFO (comparable to Section 304), (ii) all named executive officers (though this could become burdensome if NEOs change from year to year under the new SEC disclosure rules), (iii) all Section 16 officers, or (iv) all executive officers.
- Should it cover current and/or former employees?
- Which events should trigger a clawback (e.g., restated financial statements, fraud, misconduct, negligence, poor performance, and/or violation of non-competes or other restrictive covenants)?
- Should the policy require the executive to have some culpability or should the culpability of a subordinate be sufficient?
- What compensation should be subject to clawback (e.g., cash payments, equity, etc.)? Should it include profit (e.g., recover any profit arising from sale of stock options)?
- Who should be responsible for enforcement (e.g., a risk assessment officer, the compensation committee, the full board of directors)?
To conclude, increased compensation governance standards, public outrage over perceived compensation abuses and prospective say-on-pay mandates are just a few of the reasons compensation committees should discuss implementing or bolstering clawback policies prior to their upcoming annual meeting.
