When news breaks of scandals in the corporate world, you may hear the term “clawback.” It refers to the taking back of employee compensation, either as punishment for misconduct or company scandal, or in response to worsening profits. If you’re curious about the term or considering signing a contract that includes a clawback clause, here’s what you should know.
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How does a clawback work? Say a company executive is at the helm of a business when allegations of fraud are made against that business. Even if the executive was not personally responsible for the fraud (or other business practices damaging to the company’s reputation), the business may decide to “claw back” some of the executive’s compensation.
Why would a clawback occur when an executive’s personal responsibility for misconduct couldn’t be proved? For one thing, a clawback might help restore the trust that the public and the government have in a company that has admitted to wrongdoing. For another, clawbacks can help restore lost profits. And, in a general sense, clawbacks might improve business practices in other companies if they deter other executives from sanctioning or ignoring bad business practices.
That’s why the federal government, in the 2002 Sarbanes-Oxley Act, began allowing companies to claw back incentive-based compensation for CEOs and CFOs in the case of misconduct resulting in restatement of financial reporting. So if a company, say, engages in fraud and has to re-file its financial reports with the SEC, its CEO and CFO could be subject to a clawback.
If a company received TARP funds in 2008, its senior executive officer and 20 highest paid employees are all subject to clawbacks if the company statement of earnings is found to be inaccurate. That was a provision of the 2008 Emergency Economic Stabilization Act.
The 2010 Dodd-Frank Act added on to U.S. clawback law. According to Dodd-Frank rules, executive officers can have their incentive-based compensation above what would have been paid under the accounting restatement clawed back. In other words, if a company has to submit an accounting restatement and revise compensation down (due to error or misconduct), the difference between the executive’s original compensation and the revised compensation is subject to clawback. To be clear, regular salary and things like 401(k) contributions aren’t subject to clawbacks. It’s only incentive-based pay like bonuses and incentive stock options.
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Could You Face a Clawback?
If you’ve climbed the corporate ladder and you’re signing on as an executive at a company, bank or hedge fund you might be offered a contract that includes a clawback cause. Many of the country’s largest and most successful companies have clawback policies in place and some of these policies are publicly available. Analysts say that clawback provisions are increasingly common. You might not be able to negotiate your way out of a clawback provision.
If you are subject to a potential clawback, it’s all the more reason to maintain squeaky-clean accounting practices. It’s also a reason to live below your means in case a portion of your compensation is clawed back. Most clawback provisions give the company board discretion when deciding whether or not to take back executive compensation. However, the SEC has proposed tightening clawback rules and requiring all publicly listed companies on national securities exchanges to have publicly disclosed clawback policies that provide for recovery of erroneously awarded incentive-based compensation for executives.
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The executives whose clawbacks you might hear about in the news probably aren’t going hungry as a result of the clawback. Because only bonuses and other incentive-based pay are subject to clawbacks, even executives punished for company misconduct can maintain a comfortable lifestyle. But as clawback provisions become more common, advocates of the clawback hope the trend will dissuade fraud and accounting mistakes and lead to better financial practices across the board.
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