Clawbacks: Grabbing more than the basics

Securities and Exchange Commission rules approved in 2022 obligated national stock exchanges to adopt listing standards requiring that companies have policies to recoup, or claw back, erroneously awarded incentive compensation from company executives. These rules implement a requirement of the Dodd-Frank Act of 2010. In accordance with these rules, stock exchange standards required companies to adopt compliant clawback policies no later than Dec. 1, 2023.

Following the initial scramble to ensure timely adoption, questions remain for many compensation committees about the scope of these policies: Is the mandatory policy sufficient for the company's approach to risk management? If not, should the company tailor the policy or adopt additional tools to manage compensation risks?

Discretionary clawback policies as risk management tools

As documented in various reports released in the last year, many companies have adopted policies that go beyond what is required by stock exchange listing rules. FW Cook reports that 80% of the 45 large-cap companies it surveyed have a clawback policy that goes beyond the stock exchange listing requirements. Similarly, Dragon GC reports that 70% of S&P 500 companies have implemented such policies.

There are multiple drivers for these "discretionary" clawback policies, which largely share the underlying theme that boards need to manage risks related to executive compensation, including by deterring misbehavior.

The final rules for mandatory clawback policies are highly specific, including regarding the executive officers subject to such policies, type of compensation covered, events triggering clawbacks, and time frame of previously awarded compensation covered. Many compensation committees are finding that the required policies do not address all situations where the committee might believe seeking recovery of compensation is in the best interests of the company.

For example, mandatory clawback policies apply only with respect to compensation that is granted, earned, or vested based on the attainment of any financial reporting measure, including stock price or total shareholder return. Awards subject solely to time-based vesting requirements are generally outside the scope of such policies. Further, the policies are triggered only in situations where a company is required to make an accounting restatement of previously issued financial statements. Many compensation committees recognize that the company may want to seek recoupment of other types of compensation and do so in situations where there is misconduct that does not trigger an accounting restatement.

Other external influences resonate with boards and support adoption of discretionary clawback policies as an appropriate and useful tool for compensation committees. These considerations include:

Department of Justice Criminal Division's Pilot Program Regarding Compensation Incentives and Clawbacks. This three-year pilot program was announced in March 2023. One part of the program provides that the Criminal Division will reduce fines for companies that attempt to claw back compensation from individual wrongdoers and those with supervisory authority over the wrongdoer or business area in which the misconduct occurred. Adopting such practices can also be a factor in establishing that a company has designed its compensation system to incentivize compliance and deter wrongdoing, which can come into play under other DOJ corporate compliance policies.

Public Pressure on Companies to Seek Recoupment in Connection with Executive Terminations. In several headline-grabbing situations involving executive misconduct in recent years, shareholders and the press have pushed companies to seek recoupment or raised questions about why they have not done so.

Proxy Advisory Firm and Institutional Investor Voting Policies. Proxy voting policies from proxy advisory firms ISS and Glass Lewis, as well as institutional investors like BlackRock and Wellington Management, set expectations that companies will have policies exceeding the minimum requirements of Dodd-Frank policies. These voting policies include expectations for clawback policies to cover all time-vesting equity awards, and policy triggers to include material misconduct, conduct that leads to corporate reputational damage, fraudulent activities, material risk management failure or material operational failure.

Implementing discretionary clawback policies

Dodd-Frank clawback policies are subject to express stock exchange listing requirements, making the policies highly consistent from company to company. In contrast, discretionary policies are far more variable. Companies updating existing policies or considering adoption of new policies, may consider these issues:

One Policy or Two? A discretionary policy can be a stand-alone policy or incorporated into the same document with the Dodd-Frank policy.

Many companies have adopted separate policies for practical reasons, including that the discretionary policy has significant differences in scope or procedure, or the company previously had a policy addressing misconduct or fraud. In addition, only the Dodd-Frank policy is required to be filed as an exhibit to the annual report on Form 10-K. For now, most companies that maintain separate policies have not made the discretionary policy publicly available, although that practice may change if institutional investors or proxy advisory firms seek access to the full policies.

Other companies have decided to maintain a single policy to simplify references to the policy in employment and award agreements, provide greater clarity and simplicity for employees subject to the policy, and reduce the need to duplicate administrative provisions.

Policy Scope. There are many scope questions for which a company may want to implement a different approach than that dictated for Dodd-Frank policies. A company may want its discretionary policy to apply to compensation paid over a longer time period or to a larger group of employees. In order to meet the requirements of proxy advisory firm and institutional investor expectations, a company would also want to cover a broader range of compensation, such as time-vested equity.

Policy Triggers. As discussed above, one of the main reasons to adopt a discretionary policy is to give the company a basis for recovering compensation in situations other than financial restatements. Companies have adopted a wide range of triggers that commonly include material misconduct, breach of company policies, fraud, and for-cause termination. Another common approach is to tie triggers to conduct that causes material reputational or financial harm to the company.

Enforcement Discretion. The stock exchange listing standards for Dodd-Frank policies provide very limited ability for companies to exercise discretion on whether to seek recovery. For discretionary policies, companies may prefer a more flexible approach permitting greater committee discretion over enforcement.