What Are CEO 'Clawbacks'?

(MoneyWatch) 

Capping executive compensation is one
way that boards can rein in outrageous payouts. Another form of censure,
called "clawbacks," takes pay limits one step
further. With clawbacks, boards can force executives to pay back
some of their compensation for wrongdoing. As a punitive measure, the tactic can be powerful. Executives are forced to dip
into their own piggybanks to cough up the cash.

How Clawbacks Work

There are two basic kinds of clawbacks, says Daniel
Ryterband, president of Frederick W. Cook & Co., a New York-based
executive compensation consulting firm. In the first type, an executive can
trigger a clawback by committing broad malfeasance. A criminal conviction isn’t
necessarily required; knowing and abiding in an accounting fib can be a trigger.

The second type, Ryterbrand says, has to do with
executives violating restrictive covenants such as non-compete clauses. For
example, if an executive moves on to a similar position at a competing company
in violation of his contract, the clawback provisions can kick in, forcing the
executive to pay back certain remuneration to the first firm.

The Fine Print

Enforcing clawbacks can be more difficult than it seems. “The
problem is that it is often hard to define good and bad performance, and
[determine] if the malfeasance is intentional fraud and if the CEO is
responsible,” says Ryterband.

The 2002 Sarbanes Oxley Act does little to clear up the ambiguity.
According to Section 304 of the law, an executive must pay back his or her
bonus, other incentives, equity-based compensation, or trading profits if his
or her misconduct forces the firm to restate its finances. The payback period
would encompass any compensation given within 12 months of the filing of the
financial restatement. But because the definition of “misconduct”
is left open to interpretation, Section 304 is especially difficult to enforce,
says Kevin Lacroix, a lawyer with OakBridge Insurance Services.

What’s Next

The impetus is strong for clawbacks to be included in
upcoming legislation, given the public outrage over the Wall Street meltdown,
Lacroix says, but efforts to toughen clawbacks predate the debacle. In April,
href="http://www.opencongress.org/bill/110-s2866/text">Sen. Hillary Clinton,
D-New York, introduced Senate Bill 2866 in an attempt to more clearly
define “misconduct” and to triple the payback period to 36
months. The Clinton bill also proposes a $1 million cap on the amount of
compensation that can be deferred each year, which would affect so-called “golden
handcuff” clauses for top corporate officials. “Golden handcuffs”
is an industry term for the way companies try to retain executives and encourage
their long-term performance by paying out benefits, such as cash and stock
awards, over the long term. The catch is that if the executive is fired for
misconduct or leaves and violates non-compete provisions, clawbacks can snatch
away these benefits.

Despite the current rage against C-suites in the financial
crisis, clawbacks should be approached carefully. Lacroix says he was involved in
a court case in which a bank went bust. A director who wasn’t really
involved was hit by a clawback provision and forced to come up with pay-back
funds. He had to sell his restaurant and declare personal bankruptcy —
“all because he was asked to be on the board of a local bank,”
says Lacroix.

Additional reporting by John Maas.