Part 3 in a series
In this third and final article in our three-part series on adopting Securities and Exchange Commission (SEC)-mandated, Dodd-Frank-compliant clawback policies, we consider the sources of funds for when a clawback is triggered, with a focus on mandatory deferral programs.1
Under Dodd-Frank, a clawback is not required when a compensation committee determines recouping the compensation would be “impracticable” because the costs of doing so would exceed the amount to be recovered. When a clawback is not pursued under these circumstances, a company should be prepared for shareholders and proxy advisors to question how those costs were calculated as well as why the company did not have a source mechanism in place to fund the recovery of excess incentive compensation.
The source of funds in a clawback for current employees is straightforward: Future pay provides a ready source. The SEC regulations specify that after a restatement, companies must act “reasonably promptly,” and that directors and officers must “pursue the most appropriate balance of cost and speed in determining the appropriate means to seek recovery.” Options discussed in the regulations include recovering funds over time, from future pay, from incentive awards earned but not paid, or by cancelling unvested equity and non-equity awards.
As companies prepare to adopt Dodd-Frank compliant clawback policies, some may choose to outline within the policy the order in which fund sources will be pursued to facilitate fast recovery. For example, if officers must meet certain share ownership requirements, either as shareholders or beneficial owners, the company could mandate that those shares be the first source of a clawback, particularly if they are still in the company’s possession. The same could apply for shares not yet beneficially owned, such as performance shares that are not yet vested.
Alternatively, within the policy companies could list all the types of compensation available and state more generally that the fastest course of recovery will be pursued first. Another option is allowing current officers to choose a clawback source, whether it be future pay, existing stock holding or ready cash, although this can be accomplished as a matter of administration rather than being explicitly stated in the policy.
For former officers who have left the company, the source of funds may not be as straightforward or readily available. While there are exceptions — when options remain outstanding, full-value shares are not settled until a later date (e.g., the end of a performance period) or existing deferral arrangements delay payment until some future date — most companies should consider whether a mandatory deferral program makes sense. Under such a program, a portion of an officer’s variable pay would be deferred for an amount of time sufficient to cover a clawback in the event the officer leaves the company.
For a deferral mechanism to be viable under section 409A of the Internal Revenue Code, deferrals must be paid on a fixed distribution date — for example, holding a portion 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 match up the total deferrals held by the company with the potential amount required to be clawed back. Companies would need to make sure these deferrals were subject to a legally enforceable forfeiture provision in the case of a restatement. Tax advisors should also weigh in on whether these deferral forfeitures would be on a before-tax basis.
Figuring the amount to defer will be challenging, as every restatement is different and every officer compensation plan is different. Forecasting the amount needed will be an estimate, at best, based on past financial metrics and amounts; we expect many companies that go this route would choose a formula deferral, such as a percentage of the annual bonus.
Despite the challenges, a program of mandatory deferrals may eliminate the need for a hierarchy of clawback sources within a company’s clawback policy. It also may solve or mitigate the problem of 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 distributed, and arguably they wouldn’t be taxed ever if it’s determined that the amount should be forfeited due to a restatement.
There is much to consider when determining the source of clawback funds, with trade-offs and benefits to each approach. Companies should work with their tax advisors and legal counsel to determine the best course of action, as any company undergoing a financial restatement is likely to come under intense scrutiny.
