While some organizations may be planning to rely on the compensation committee to deem executive incentive recoupment costs as “impracticable” so they can avoid enforcing now mandatory clawback regulations, this is not a get-out-of-jail-free card.
Companies must disclose why recoupment is impracticable, including details about how they calculated the amounts to be recouped. There is an overarching concern that shareholders, proxy advisors and the media will question the calculation that supports not seeking recoupment. We also anticipate that these same audiences will ask why the company did not have a mechanism in place to help ensure that officer-earned compensation is within reach.
Determining the source of funds to execute a clawback for current employees is straightforward: A ready source of funds exists based on future pay. The U.S. Securities and Exchange Commission (SEC) has said that, after a restatement, companies must act “reasonably promptly” to recoup funds, and that directors and officers who are charged with safeguarding the company’s assets will pursue the most appropriate balance of cost and speed when deciding the right way to recover funds.
Until restatements happen, we will not know if companies adopted a hierarchy outlining the sources they will pursue first, but sources certainly do exist. It is just a matter of figuring out the “who” and “how.”
If officers must meet certain share ownership requirements either as shareholders or beneficial owners, companies could mandate in advance that those shares be the readiest source of a clawback, especially if they are still in the company’s possession. The same could apply for shares not yet beneficially owned (e.g., performance shares that have not vested).
Clawback policies leave the decision as to source of funds up to the compensation committee. Nonetheless, we think that the committee should have at least an informal discussion as to the source current officers would prefer to use to fund the clawback, whether from future pay, existing stock holdings or ready cash. Not only may the officer not have after-tax funds available, they also may prefer to withhold from future pay if they determine the tax impacts to be beneficial. Having a meaningful discussion about the options will help the committee act as quickly as possible to recoup the required pay.
Companies often do not have access to a ready source to fund a clawback after an officer leaves, but there are exceptions. Check to see if options remain outstanding or if full-value shares are not settled until a date after retirement (e.g., end of a performance period). It may be that existing deferral arrangements may delay payment until a future date.
In the U.S., it is rare for companies to hold back pay post-termination for its senior executives, except for non-qualified deferred compensation where payment is delayed for 6 months. We wonder if, after there are some high-profile cases where companies are unable to recoup funds from former officers, we might see a push from proxy advisors and shareholder advocates to create mandatory deferrals that are held back for a fixed time (e.g., two years) post-termination.
Assuming a company wanted a mandatory deferral mechanism, section 409A of the Internal Revenue Code requires that deferrals be paid on a fixed-distribution date that applies to all officers. This could be as simple as holding part of an annual bonus to pay out at the end of year one, two or three for every executive regardless of whether they are still employed.
The goal is to try to match the total deferrals held by the company with the potential amount required to be clawed back. Companies need to make sure the deferrals are subject to a legally enforceable forfeiture provision in the case of a restatement. Using an existing deferral program may be difficult unless such a forfeiture provision already existed in anticipation of this year’s mandatory rules.
Current officers can also benefit if mandatory deferrals are the source of funds because much of the hierarchy of clawback sources goes away – the deferrals are the source. Deferrals also solve the problem of forcing officers who pay clawbacks with after-tax dollars being forced to claim a miscellaneous deduction or seek relief under the “claim of right” doctrine to recoup paid taxes. Deferrals are not taxed until they are distributed and, presumably, will not be taxed ever if the amount is forfeited because of a restatement.
We expect that any company that issues a restatement this year (and for years to come) will be under intense scrutiny from shareholders and the regulators. Now is the time to consider exactly how the source of funds question will be answered and plan for how the committee will be best informed to work with officers to manage the process. Companies should not anticipate they should use the “impracticable” exception to explain why a clawback did not happen.
