Now that they are mandatory, it may be tempting to assume that identifying which parts of your executive compensation plan are vulnerable to clawbacks will be a straightforward endeavor. However, you may be surprised by the places where executive pay elements are hidden among other plan documents and written communications.
Run through this list of places where clawback triggers may be hiding to avoid being caught off-guard in the event of a restatement.
Financial reporting measures are determined and presented in accordance with the accounting principles used in your financial statements, whether in whole or in part, according to the U.S. Securities and Exchange Commission (SEC). This includes non-GAAP financial measures as well as other measures, metrics and ratios apart from non-GAAP measures (e.g., same-store sales).
It’s important to remember that financial reporting measures might be included in an SEC filing, but they also may be outside of financial statements (e.g., performance graphics, management’s discussion and analysis of financial conditions). Examples of what the SEC considers financial reporting measures include:
Clearly, identifying the elements of pay that are considered financial reporting measures is time-consuming. After all, a complete review requires looking at multiple documents that pertain to particular pay elements. When it’s time to gather your documents, include:
Next, begin understanding which pay elements use financial reporting metrics that can be subject to clawbacks and what needs to change in the future.
The final regulations don’t consider salary as incentive-based compensation. However, if an executive officer receives a salary increase that is earned wholly or in part based on attaining a financial reporting measure performance goal, that increase is subject to recovery.
You need to determine if any salary increases meet this standard, either entirely or in part. When the reason for an increase isn’t discernable, the compensation committee will need to clearly articulate those reasons and ensure they are detailed in the meeting minutes.
In short, your executive pay plan needs to explain precisely why salary adjustments take place. And if an adjustment was based on a financial metric, the entire increase might be subject to clawback for multiple years.
While 162(m) no longer applies specifically to named executive officers, non-equity incentive-based pay – commonly known as annual bonuses – in the summary compensation table (SCT) may still have holdover designs from prior years. Plans usually take one of two designs:
In either plan, the question of which financial metric is used should be easily discernable from the documents you review. But a detailed description of why bonuses have been adjusted may be missing, and that’s the part that’s used to determine which portion might be subject to non-financial factors.
For bonus pool plans, guidance in the pay vs. performance realm suggests that the entire bonus based on a restated financial metric is subject to clawback (i.e., allocation based on non-financial factors doesn’t change the fact that funding is based on a financial metric).
Identified in the bonus column of the SCT, there often are specific reasons provided as to why the special bonuses are in the CD&A as well as the compensation committee’s minutes. Don’t be lulled to believe that because a bonus is paid to a single executive it isn’t tied to financial performance.
Specific examples of stock and option awards – incentive-based compensation – include:
However, equity awards where some grants aren’t contingent on achieving any financial reporting measure performance goal and is vested solely based on reaching a specific employment period or attaining one or more nonfinancial reporting measures also are included.
Companies that use an economic-value approach so that the number of grants made for the annual cycle is based on stock value might have made grants in the past that were considered incentive-based pay because the grant levels were tied to share price.
However, if the year before a grant has a restatement, it likely depressed the share price that was used to determine the number of shares granted. This could mean that more shares should have been granted. All of this is to say: How grant levels are calculated should be explicitly documented to remove any questions about the potential impact of a restatement on grant.
Recently, we have seen compensation committees adjust grant levels when stock values are down, particularly those that use an economic-value approach, based on concerns that executives would receive a windfall if share values bounced back.
Examples like this make it important to review the compensation committee’s documentation for making downward adjustments to shares granted so that you understand if there is a connection to prior-year financial reporting measures. Additionally, if performance-based options are issued, the metrics used also must be documented.
Often, not all financial measures that apply to a performance share grant are disclosed in the grants of plan-based awards table, so scrutinize grant agreements and other communications. Similar issues regarding discretion (as noted in the prior section on annual bonuses) may apply, although it is more likely that most performance measures and adjustments that are made are still incentive-based.
However, there often are performance measures within these grants that are awarded based on discretion using non-financial reporting measures, a portion of which should not be subject to clawback. This makes it important to review compensation committee minutes to understand why discretionary decisions are made.
Total shareholder return-based programs will always need to be examined to determine the extent to which the market-based measures used to calculate their return would have changed had the financials been accurately stated in the first place. Retention grants also need to be examined to determine the extent to which they are time- or service-based – so not subject to clawback – with their details recorded.
Clawbacks are not required if recovery would likely cause a retirement plan (like a 401(k)) to lose its tax-qualified status under the Internal Revenue Code. However, and at least for 401(k)s, if incentive compensation is deferred, it may be appropriate for the company to recoup amounts from other sources. A review of the documentation requires identifying whether the source of deferrals includes annual bonuses, as many plans permit.
Qualified pension plans have different nuances; if the plan accruals are based on incentive pay, that would be a company-funded contribution. Yet, the company could still decide to recoup the value from other sources even though it couldn’t recoup accruals from the pension. Of course, determining the value of any accrual for a particular year is a complicated analysis best performed by actuaries. And for supplemental executive retirement plans (SERPs), the restrictive rules of 409A may limit a company’s ability to claw back any accruals funded because of incentive compensation.
Once you have reviewed your existing documents and executive pay elements, you will need to meet with all stakeholders to ensure they understand the importance of documentation and to assure officers of which dollars are at risk of recoupment upon a restatement. Compensation committee members also need to understand their role in creating those assurances and ensuring that the process functions as it should and without ambiguity.
