Enforceability of Clawback and Compensation Penalty Provisions (Part II of II)
We often read about lucrative bonus payments made to CEOs and other senior executives. With refinements in corporate governance structures, shareholders and investors are raising concerns over executive bonuses. To bring balance to the equation, companies have to punish executives through clawbacks for misconduct.
The Wells Fargo scandal is an example of how clawbacks can be effectively used to punish wrongdoing. In the aftermath of the Wells Fargo sales incentives scandal and fraudulent accounts, Wells Fargo clawed back $75 million in compensation consisting of pay and stock grants from the former CEO, John Stumpf, and Carrie Tolstedt, the former head of Wells Fargo’s community banking business. Wells Fargo’s board found that Stumpf turned a blind eye to the fraudulent accounts incentive program and that Tolstedt was responsible for creating the sales targets program and witheld information from her chain-of-command the board.
Last year, the SEC imposed a requirement that employers establish mandatory clawbacks of bonuses where the individual engaged in conduct that required the company to issue a financial restatement of earnings, even if the restatement was relatively minor and without regard to whether the executive knew or should have known his/her conduct would result in a restatement.
Under a DOJ Criminal Division Pilot Program, DOJ will provide a credit to any fines imposes in an enforcement action equal to the amount of compensation the company is attempting to clawback from culpable executives. If successful in securing a clawback, a company will be able to keep the money it recovers.
Crafting a Clawback Program
Under deferred compensation systems, executives are often given an incentive to achieve certain performance targets, subject to clawbacks for misconduct. The common clawback scenario involves situations where: (1) a company paid a bonus on the basis of performance that was later found to be overestimated; (2) during a specific restricted period of time after the bonus was paid, a specific misconduct incident occurs, thereby triggering a clawback; and (3) an employer discovers that a bonus was paid at a time when the employee was in breach of his duties which, if known at the time, would have excluded the executive from the bonus payment.
The key determinant of clawback enforceability is the specific drafting of enforceable legal provisions as part of an employment contract. However, if the bonus payment is at the discretion of the employer, the company has to make sure to condition any bonus payment on a specific and affirmative certification that the executive has not engaged in any misconduct, and that they are not aware of any employee who has engaged in any misconduct.
Clawback provisions have to be drafted with extreme care and avoid some common pitfalls that may enable the executive to wiggle out from under the penalty. The terms of bonus clawback provisions have to be objective and reasonable. In crafting the clawback provisions, the company has to avoid that the clawback does not disproportionately penalize the executive given the nature of the misconduct or operate as an unreasonable restraint of trade. Ultimately, the enforceability of the clawback provision will depend on the clarity and lack of ambiguity.
Companies have to exercise caution in the design of a clawback program since bonus payments and deferred compensation programs are significantly important to luring talented senior executives to companies. Companies have to balance the need for appropriate accountability principles while ensuring that companies can attract and retain talent.