Clawback Provisions

Introduction

A “clawback” is a contractual clause in employment contracts authorizing reimbursement to the organization by employees of compensation, whether in the form of cash or shares of stock, already received for a specified number of years in the past. Such a provision was not common before the Global Financial Crisis (GFC) starting in 2008, even though clawbacks were authorized in Sarbanes-Oxley. ¹

Arguably, the most compelling factor pertaining to clawbacks since GFC has been the Wells Fargo marketing scandal. Clawbacks were brought to light when this bank took back compensation benefits in the form of stock options and pension benefits of two former top officers and later eight current senior executives only after the bank was prodded to do so by members of Congress.

This article focuses on the meaning and rationale for a clawback, its legal status, and recent applications. Academic research is considered. Securities and Exchange Commission (SEC) actions to enforce clawbacks under SOX and Dodd-Frank are also examined. ²

Rationale

The rationale for a clawback is to hold executives accountable to stockholders and other stakeholders of enterprises for their actions and conduct. If the executives fail to exercise due diligence in their management of the firm, then they ought to forgo incentive payments such as bonuses based on net income and share prices as well as stock awards. Should the income and stock price figures plummet as a result of their actions, those executives should be responsible and return the incentive payments previously earned based on misleading, if not downright, erroneous or even fraudulent figures.

To illustrate a clawback, a CFO is contractually granted an extra $500,000 above base compensation as an incentive to keep the firm’s net income or common stock price growing at a particular annual percentage. If such growth actually does occur, then the CFO would be entitled to the $500,000 incentive payment. Should the growth figures have to be revised downward afterwards due to errors or misconduct, then the clawback provision would be instituted. ³

Notwithstanding the rationale for clawbacks, such provisions could have unintended, collateral damage in terms of driving up executive compensation or base pay, so that executives would not be especially hurt by implementation of actual clawbacks. ⁴

Implications From Academic Research

Clawbacks, generally triggered by restatements, conceivably could influence spending on research and development, which is expensed immediately in earnings under generally accepted accounting principles, and therefore could influence long-term corporate capital investment in plant and equipment, if not also other investments by the company. ⁵ Furthermore, clawbacks could also affect companies in different stages of growth differently, as well as other expenditures and revenues of the company, including selling, general, and administrative expenses and especially sales; after all, companies want to make their earnings look attractive to the capital markets. ⁶

DeHaan and colleagues ⁷ analyzed 300 firms voluntarily adopting clawbacks along with a control group of companies that did not. They found the voluntary adopters to produce more accurate financial statements and to have increased investor trust. The researchers observed that by 2010, 82% of Fortune 100 firms have voluntarily implemented clawback clauses in executive compensation contracts. They also found that clawback provisions that required compensation repayment not only for misconduct but also for accounting misstatements were more effective than those provisions only for misconduct.

Chan and colleagues ⁸ found that accounting restatements decline after companies require clawbacks. They also found that investors relate clawbacks to higher accounting quality and that auditors view them in terms of lower audit risk. Moreover, auditors are less inclined to report internal control issues with clawbacks and are likely as well to charge lower client fees.

Iskandar-Datta and Jia ⁹ found that stockholders of firms with clawback provisions show statistically significant positive stock valuation effects. Also, firms having prior restatements had the biggest economic gains from clawbacks, which may suggest that such provisions curtail incentives for management of earnings. Examining bid–ask spreads shows that clawbacks serve to reduce reporting risk for restating firms whereas nonrestatement firms reflect no spread change.

Wells Fargo

In 2017, Wells Fargo, while relatively unscathed during the GFC, actually invoked clawbacks on the stock and pension compensation of two former top executives only after an outcry from the public and Congress about the amounts involved.

Forty-one million dollars in stock benefits was clawbacked from its ousted CEO John Stumpf, and 19 million in stock and unvested pension benefits from retail director Carrie Tolstedt after hearings on Capitol Hill about the scandal. ¹⁰ Additionally, eight current senior executives of Wells Fargo, including the current CEO and CFO, have had their stock awards from 2014 reduced by as much as 50% and their total pay and equity cut by $32 million. ¹¹

The Wells Fargo clawbacks followed the high-profile scandal at the bank involving employees signing up depositors for accounts they did not seek or desire. At least two million phony checking and savings accounts had been created. Five hundred thousand unauthorized credit card applications were processed. Wells Fargo reaped $2 million in extra fees from this fraud, which occurred starting from 2009, if not earlier, to 2016. As a result, the bank has had to pay $185 million in fines to local and federal government agencies. ¹²

The board of directors at Wells Fargo was seemingly unaware of the scandal, never mind the fact that some of the members have had significant experience in banking, and should have provided diligent fiduciary oversight of the bank’s operations and management.

Securities and Exchange Commission

The SEC has had legal jurisdiction over the enforcement of clawbacks based on SOX, Section 304, which was enacted as a consequence of the accounting scandals of the early 2000s, including Enron and WorldCom. This provision calls for forfeiture of bonus and equity grants by CEOs and CFOs within 12 months of SEC public company filings due to misconduct at the organization and restatement of the financial statements previously issued. However, the SEC was lax in enforcing this aspect of Sarbanes Oxley. ¹³

Dodd-Frank, Section 954 of Sarbanes-Oxley effectively authorizes the SEC to implement clawbacks to recoup incentive paid 3 years back with no requirement that misconduct occurred to trigger the provision.

Under a proposed 2015 provision of Dodd-Frank, Section 954 (July 1, 2015) would

prohibit the listing of any security of an issuer that is not in compliance with [Dodd-Frank]. . . . Requirements of incentive-based compensation and recovery of incentive-based compensation that is received in excess of what would have been received under an accounting restatement.

This proposal would direct national security exchanges to set forth listing standards requiring each public issuing company to develop and implement a policy for such recovery and file this policy with the company’s annual report to the SEC. ¹⁴ Furthermore, the proposal would postpone incentive pay to executives for 4 years and even for as many as 7 years, beyond typical restatement years, if involved in misconduct. This proposal would apply not only to senior financial executives but also to traders in financial firms. ¹⁵

In fact, a Ninth Federal Circuit Court panel has unanimously decided in the case of SEC v. Jensen that the SEC is authorized to pursue clawbacks despite no apparent misconduct by the CEO, CFO, or other executives and employees involved in this case. This is an appellate court ruling, the highest level of endorsement of SEC clawback actions, following successful SEC endorsements at the trial court level. The ruling should embolden the SEC to go after other public companies restating their financials to invoke clawback provisions for their top executives as well. ¹⁶

It should be noted, however, that the SEC did not invoke clawback provisions in two particular cases in 2016. With Monsanto, the SEC did not require the CEO or CFO to clawback incentive pay received for 3 years due to misstated earnings stemming from the company’s failure to adequately recognize rebate recognition costs. Monsanto did, nonetheless, pay $80 million in penalties. Additionally, the SEC pursued a biopesticide company, Marrone Bio Innovations, which consented to pay $1.75 million in damages to settle the commission’s complaint that the company inflated its accounting figures. While the SEC found Marrone’s former COO guilty of fraud, the commission did not accuse the CEO and former CFO of misconduct, but did require them to reimburse the company for some incentive pay they received. ¹⁷

In light of the Madoff Ponzi scandal, clawback litigation has become a hot topic of legal recourse in bankruptcy proceedings, as illustrated by Baker & Hostetler in the Madoff court cases. Especially since fraud has been inherently involved in those cases, clawbacks provisions have been implemented. ¹⁸

In 2012, JPMorgan Chase asserted that it would pursue maximum clawbacks against executives and traders for misconduct in connection with its London Whale security trading fiasco, amounting to 2 years of their incentive compensation. ¹⁹

Conclusion

While clawbacking incentive pay is still not a common occurrence, it is a preventive measure for banks and other enterprises to actually implement. Clawbacks are commonly found today in corporate bonus plans, stock options, restricted stock, and other top-executive performance agreements.

To refrain from invoking clawback provisions in employee contracts, it is highly advisable for companies to institute and monitor strong internal controls governing operations and management, paying careful attention to all areas of enterprise risk management in the process. Having a strong, independent audit committee of the board of directors is another related preventive measure. Maintaining a confidential whistleblowing channel is still another deterrent misleading financial statements and financial fraud.

It is one thing to have rules on clawbacks as part of SOX and Dodd-Frank, but quite another thing to enforce those rules. The SEC appears to be enforcing the rules, though not necessarily in the most consistent manner to date. There ought to be more consistency in invoking clawback provisions. These provisions are likely to be implemented and enforced more frequently in the future. They evidently do affect management decision making and earnings management.