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Jan 31, 2008

Clawing at the bank

With companies facing restatements and less than stellar returns, clawback policies are irksome but essential

Of all the various correctives to excessive executive compensation available to companies, clawbacks may be one of the least controversial. Even so, many corporate secretaries and boards fail to truly understand the issues surrounding them and their use.

‘Clawbacks’, the increasingly popular term for companies’ recovering unearned pay, typically occur when an executive has received an award based on stated performance, which later turns out to have been less stellar than once thought. Often, companies attempt to claw back money after its financials have been restated.

More than anything else, clawbacks appeal to notions of basic fairness. ‘If you didn’t earn it, you should return it. That’s the best sound bite answer I’ve heard – and it’s right,’ says Con Hitchcock, outside counsel for Amalgamated Bank’s LongView Funds. Mark Poerio, a partner at Paul, Hastings, Janofsky & Walker and head of the firm’s employee benefits practice, agrees: ‘Clawbacks are almost a no-brainer for everyone who hears about them.’

Until recently, though, most companies simply weren’t thinking along these lines and hadn’t crafted clawback policies. And so the typical response to an executive walking off with higher-than-deserved incentive pay was an exasperated shrug. Not so today. In the 2006 financial year, 42.1 percent of Fortune 100 companies had disclosed a clawback policy, relative to just 17.6 percent the previous year, says Alexander Cwirko-Godycki, research manager at Equilar, an executive compensation research firm located in Redwood Shores, California.

American Express, Pfizer and Microsoft are among those companies with clawback policies. Institutional investors are increasingly pushing for these policies as well; CalPERS, for instance, supported LongView’s 2004 proposal at Computer Associates requesting a clawback policy, which is believed to be the first shareholder proposal in this area.

Philosophical support for clawbacks is tempered by pragmatism and a growing realization that these policies can be maddeningly difficult to collect on. Charles Elson, director of the John L Weinberg Center for Corporate Governance at the University of Delaware, describes himself as ‘a big fan of clawbacks.’ Clawbacks are ‘very hard to argue with,’ he says, but ‘enforcement of a clawback is very difficult.’

Misconduct or mistake: a matter of perception
UnitedHealth Group’s December 2007 settlement deal is a perfect example of how the same glass can both be half full and half empty. Longtime chief executive William McGuire agreed to return options worth $418 million. This was in addition to the nearly $200 million in options previously forfeited after the company restated 12 years of earnings to the tune of $1.5 billion. However, a December 7 Wall Street Journal article notes that McGuire still holds options worth around $800 million, not to mention $530 million in pay earned from 1991 to 2006.

‘At UnitedHealth, there were claims of roughly a billion dollars at issue, and it got settled pretty much near the midpoint,’ notes John Coffee, a Columbia Law School professor specializing in corporate governance and securities law.

UnitedHealth’s well-publicized success will almost certainly make other companies take note. But there are other reasons why clawbacks are suddenly in the limelight. One is the high number of restatements occurring as companies finally come to grips with the stock options backdating scandals, says Brian Foley, founder of Brian Foley & Co, an executive pay consultancy based in White Plains, New York.

Last year, there were 1,301 financial restatements and during the year before there were 1,524, according to Robert McCormick, chief policy officer at proxy advisory firm Glass Lewis. Showing a tremendous increase, these restatement levels are more than twice as high as earlier in the decade. In 2004, for instance, there were only 663 restatements.

There’s some debate over what situations should spur clawbacks. Ten years ago, notes Paula Todd, a managing principal and compensation consultant at Towers Perrin, clawbacks sometimes occurred when an executive failed to honor a non-compete clause or violated trade secrets. Mike Melbinger, a partner at Winston & Strawn in Chicago, says that some companies have clawbacks for insider trading or violating a company’s sexual harassment policy.

Today, though, the two most common clawback triggers are ‘misconduct or negligence directly or indirectly resulting in a restatement,’ says Poerio. Among the Fortune 100 companies that have disclosed clawback policies, 95 percent of the policies refer to either misconduct or financial restatements, explains Cwirko-Godycki.

Poerio points out that even when a company specifies misconduct, gray areas exist. Some companies are, for instance, uncomfortable holding an executive accountable for a subordinate acting in a deceptive manner, especially if the deception was hard to detect.

Others believe that it’s fair to claw back performance-based pay whenever earnings are restated for the simple reason that the performance triggering the award never really existed. Foley sums up the argument this way: ‘If the teller runs your $1,000 deposit through as $10,000, it’s not yours. You have no right to it.’

Scott Zdrazil, director of corporate governance at Amalgamated Bank’s LongView Fund, agrees. When LongView crafts a shareholder proposal, it asks that ‘there be a policy that allows for the recoupment of any unearned benefits in the case of financial restatements regardless of whether or not there was any fraud or misconduct on the part of the person who received the performance-based payments.’ He continues: ‘It’s not a matter of personal insult. It’s simply that your compensation package was miscalculated and should be recouped.’

Although Foley acknowledges that executives at companies with financial restatements may truly be ‘innocent bystanders’, that doesn’t mean that another group of innocents – namely, shareholders – should take the hit. ‘If the payment shouldn’t have been made but was made anyway, then who’s out? The shareholders are out,’ he says. ‘And are they out for a good reason? No. Not to mention that they’re also probably looking at a dramatically reduced share price.’

Depth of coverage
This spring, corporate secretaries everywhere should be asking their compensation committees to take a long hard look at clawback policies. If your committee hasn’t considered clawbacks, ‘you run the risk of reacting like a deer in the headlights when the first problem comes along,’ says Foley. ‘Once you take the attitude that it can’t happen here, then you get burnt.’

One important consideration is who should be covered under a clawback policy. The most conservative policies apply only to the CEO and CFO, and yet many companies demand that anyone receiving performance-based grants be potentially subject to recoupment. (This is the policy that LongView advocates). 

‘There’s a fair amount of swing in how clawback policies are written,’ notes Foley. At American Express, for instance, approximately 520 executives have signed agreements with provisions requiring them to forfeit proceeds from incentive awards if they engage in conduct that’s detrimental to the company. American Express specifies that detrimental conduct includes working for certain competitors and also the disclosure of trade secrets.

Another question is whether recovery policies should apply only to future awards. Poerio notes that most clients start with prospective clawbacks because the topic is far easier to broach. That said, he’s found that retroactive clawbacks specifying misconduct rarely meet with too much resistance because of the general sense that only the guilty would protest too vigorously. ‘It makes you a bit uncomfortable,’ he says, ‘when an executive is very emotional about not having a retroactive clawback that relates to [his or her] own conduct.’

Ideally, recovery policies will appear in the plan documents, the employee handbook, and perhaps even the corporate bylaws, but it’s crucial that they’re also written into individual employment contracts. Although requiring a new recruit to agree to clawback terms may seem like asking a bride to sign a lengthy pre-nup, the terms really do need to be spelled out and a contract needs to be signed.

Finally, boards should consider how ‘hard-wired’ they want their clawback policy to be. Here, compensation committees walk a tightrope between nailing down every particular and reserving the latitude to act appropriately in a scenario that no one quite anticipates.  Foley advises compensation committees to grant themselves the authority to pursue clawbacks rather than mandating a particular response.

Poerio also warns against spelling out too many details since the company may later regret its choices. He maintains that saying that a clawback will occur following a restatement caused by misconduct is clear enough. Trying to define the term ‘misconduct’ might land you in trouble if ‘you miss something or there’s later some fact that doesn’t quite fit in,’ says Poerio.

Understanding the objective
While drafting a good clawback policy requires effort, it also helps you clarify your overall compensation strategy. Poerio points out that restricted stock payable upon an employee’s departure can work well with a clawback policy, while providing the added attraction of serving as golden handcuffs. As a practical matter, money that’s already in an employee’s pocket is far more difficult to recoup than compensation that the company continues to control.

Above all, though, clawback policies are fairly easy to implement when a company truly understands what its pay practices are designed to achieve. ‘Companies go off the rails when they have pinball-machine compensation – anything you hit rings a bell,’ says Nell Minow, corporate governance guru and founder of The Corporate Library.

‘If you don’t have a clawback policy, then you’re providing a perverse incentive for short-term gains that are not in the best long-term interests of the company,’ maintains Minow. She believes that this argument is finally gaining currency: ‘I think we’ll be seeing close to 100 percent [of companies disclosing clawback policies] in the next few years because shareholders will really be pushing for this.’

Entering the public eye
Companies’ clawback policies have suddenly come to light thanks to the SEC’s new compensation disclosure requirements. The SEC’s CD&A requirements include a discussion of a company’s policies and decisions regarding the recovery of payments if the performance measures upon which they’re based are restated in a manner that would reduce the award size. The new CD&A is ‘smoking out a lot of cases of companies that have no clawback policies,’ says Todd.

Shareholder proposals are also drawing attention to clawbacks. Companies like General Motors and Hewlett-Packard recently faced shareholder proposals on clawbacks, and more clawback proposals are likely to surface this proxy season. Amalgamated Bank’s Longview Fund, which typically sponsors one clawback proposal a year, says that it will be introducing another proposal this spring. At the time this story was written the target had yet to be named.

Zdrazil notes that clawback proposals have garnered strong support. In October, for instance, the clawback proposal at Sunrise Senior Living, a company that hadn’t released financial results in over 18 months because it was in the midst of restating earnings and was under SEC investigation for insider stock sales, received 29 percent shareholder support. Zdrazil characterizes this as a significant achievement, given the peculiarities of the situation (Sunrise shareholders had to be physically present at the annual meeting in order to cast a vote).

Finally, having a clawback proposal in place before something goes awry is simply evidence of good, solid corporate governance. ‘You want to signal to shareholders that you’re not being cavalier about compensation,’ says Foley. Increasingly, agree the experts, the absence of a clawback policy will raise a red flag about your compensation policies in general.

In the end, peer pressure and the fear of media attention might be what gets clawback policies written into practically every executive employment contract going forward. ‘At some point,’ concludes Foley, ‘someone’s going to write an article naming who has a clawback policy and who doesn’t. And do you really want to be on the list of those that don’t?’

Elizabeth Judd

Elizabeth Judd, a graduate of Yale and University of Michigan, regularly writes about investor relations, corporate governance and new fiction