Executive pay clawback policies enable companies to recover compensation from their current and former executives under certain circumstances. Clawback situations often arises in the context of significant accounting scandals. They can also occur when companies underperform or when executives cause reputational harm. Companies may require executives to reimburse prior compensation or forfeit future payments.
Clawback provisions have become increasingly common in the past decade. This is partly attributable to the Dodd-Frank Act, enacted in 2010, which has a broad set of clawback rules. A 2017 study found that over 92% of S&P 500 companies publicly disclosed a clawback policy. This coincides with the general trend toward adoption of more robust corporate governance policies.
Clawback and Company Underperformance
Incentive-based pay constitutes a large component of executive pay packages. It usually includes either an annual incentive payment or long-term incentive payment. A company may require certain financial metrics to retain executive pay. If a company fails to achieve certain financial targets, the company may require executives to reimburse the company or forfeit compensation.
Sarbanes-Oxley and Dodd-Frank
Companies have had mandatory clawback requirements since the passage of the Sarbanes-Oxley Act in 2002. Sarbanes-Oxley created broad changes to the financial regulation of both public and private companies in the United States. The executive compensation clawback rule under Sarbanes-Oxley narrowly applied to the CEO and CFO. But it did not apply other types of executive officers. It specified that if a material restatement of financial results occurs as a result of misconduct, then the executive should return incentive pay to the company.
The Dodd-Frank Act, passed in 2010, further expanded financial regulations with respect to executive clawbacks. The SEC has not yet finalized rules with respect to clawbacks under Dodd-Frank. Nevertheless, many companies have adopted voluntary clawback policies since Congress passed Dodd-Frank.
The Dodd-Frank executive compensation clawback rules also address awards of incentive pay near retirement. The rules state that current and former executive officers should return incentive pay awarded within three years of a material accounting restatement. Unlike Sarbanes-Oxley, the Dodd-Frank rules specify that the clawback should occur regardless of whether or not executive misconduct occurred. This is known as a “no-fault” clawback regime.
Clawback for Executive Misconduct
Companies are increasingly taking measures to demand clawback of compensation they previously paid to former executives. This is particularly true when executives exit a company due to misconduct. They also are taking actions to forfeit unpaid compensation.
McDonald’s Corporation filed a lawsuit against its former CEO Steve Easterbrook for repayment of severance and equity awards. McDonald’s dismissed Mr. Easterbrook as CEO in 2019 after allegations surfaced that he had sexual relationships with several employees. Reputational harm triggers can allow a clawback for misconduct not directly linked to financial performance. Such triggers are an increasingly common part of clawback policies.
Tax Consequences of Clawbacks for Executives
The federal income tax consequences of executive compensation can be steep, with the individual tax rate often edging toward 50%. This poses interesting questions about the tax treatment of repaid compensation. Complications arise when an executive included the amount as part of their taxable income in a prior year.
The short answer is that the tax laws are complex on this point. Under a provision of the Internal Revenue Code (IRC), IRC Section 1341, taxpayers can receive a deduction or tax credit for the repaid compensation. However, executives can only apply IRC Section 1341 under certain conditions. There is also a significant risk that Congress will amend the tax laws if executives succeed in employing Section 1341 too frequently.
Risks for Companies
Imposing executive clawbacks can pose legal risks and embarrassment for companies. If an executive sues the company due to a clawback, the executive may require the company to advance any legal fees and other costs that will arise over the course of the lawsuit.
In the case Hertz Corporation and Hertz Global Holdings v. Frissora, the car rental company brought a lawsuit against its former CEO, CFO, General Counsel and group president seeking recovery of $70 million in incentive payments. Hertz claimed that these executives caused the company damage due to improper financial statement disclosures. The series of decisions made by these executives led to a fine by the Securities and Exchange Commission (SEC) for violations of securities laws.
Legal Fees at Issue
The former executives being sued requested that, under the company’s indemnification policies, Hertz should advance any legal fees to pay for their legal defense. The court ruled in favor of the former executives on the advancement of their legal fees. Since the clawback lawsuit stemmed from their work as executive officers of Hertz, the court concluded that the company was required under its bylaws to advance money for the legal fees. However, if the executives are found negligent or lose the lawsuit under certain other conditions, they could be required to pay back those costs.
In addition to hefty legal fees, companies and their boards can also suffer from public embarrassment if they lose a lawsuit against an executive. This is particularly applicable in situations where executives are terminated for cause and then asked to return incentive payments. In order to protect against this risk, companies should invest resources in legal counsel that can conduct a thorough investigation. There is also a risk of shareholders raising a challenge against the board of directors for the termination decision, which can amplify public scrutiny.