In this article, our Partner and General Counsel Beth Hale discusses some of the key legal and practical issues for employers to consider when implementing or reviewing claw-back provisions in the compensation contracts of senior executives.
Setting the Scene
In challenging times – whether that be in the context of a corporate scandal, a financial crisis or, indeed, a global pandemic – the issue of executive compensation is brought into sharp focus. The idea that executives may take home hefty pay packages while society at large is struggling is perceived by some as unethical and this sense is amplified where the executive(s) in question may be seen (rightly or wrongly) as wholly or partially responsible for the hardship being felt by others.
This issue received particular attention following the 2008 financial crisis and the demise of major financial institutions that required partial nationalisation in order to survive, followed by the resulting public furore in response to the idea that tax-payers were having to bail out risk-taking bankers. This led to regulatory reform of the sector, including in relation to executive remuneration, one aspect of which was the requirement for claw-back provisions in relation to variable remuneration (such as bonuses) to be included the relevant contracts of certain individuals in the financial services sector.
While the concept of claw-back – that is, the recovery of variable compensation (in the form of money, shares or options) where a triggering event occurs following its award – has its roots in the financial services sector, listed companies also have duties (albeit not strictly mandatory) in this regard under the UK Corporate Governance Code, which contains best practice recommendations in relation to executive pay, including recommending bonus claw-back provisions in specified circumstances.
The idea has also gained traction in recent years outside of regulated sectors/companies as part of a broader trend towards formulating compensation packages which both deter bad behaviour and reward good behaviour (rather than exclusively the latter).
Despite the increasing prevalence of claw-back provisions in executive compensation contracts – reflecting a collective desire to avoid rewarding (and therefore disincentivise) failure or iniquity on the part of senior executives – they are neither legally nor practically straightforward provisions, particularly when it comes to their enforcement. Having a sound theoretical basis is not enough if the provisions are not also practically enforceable. It follows that careful consideration must be given to their design and drafting to ensure that (as far as possible) they are able to meet their objectives.
How can claw-back provisions be attacked?
While it may seem counterintuitive to start here, in order to understand how to design effective claw-back provisions it is important to understand how their validity might be attacked.
Under UK law, there are three key modes of attack:
1. No contractual right to claw-back
In most cases an employer will only be entitled to claw back sums if there is a clearly documented contractual right for it to do so, which the employee has expressly agreed to prior to the payment/award which is allegedly subject to claw-back being made. If there is no contractual right to claw-back a payment, a decision by an employer to do so risks claims for breach of contract and/or unauthorised deductions from wages.
2. Unenforceable penalty
Even where a claw-back provision has been properly documented, it may amount to an unlawful penalty clause if repayment is triggered by the employee’s breach of contract and the repayment amount disproportionately penalises the employee (rather than merely compensating the employer for the actual loss suffered).
3. Restraint of trade
If the claw-back provision has the effect of restraining employees’ future work (for example, it is activated by the employee breaching their restrictive covenants) it may be void and unenforceable as an unlawful restraint of trade unless the employer can show that it has a legitimate business interest and the protection sought is no more than reasonable.
How can effective claw-back provisions be designed?
While it may be tempting to draft claw-back provisions as widely as possible to maximise their deterrent effect (and board members/remuneration committees may face pressure from external stakeholders including investors and shareholders to do so), the reality is that trying to cast the net too widely can backfire. First, there are the issues of enforceability which stem from the legal constraints identified above. There can also be potentially unintended broader consequences of overly wide claw-back provisions including, for example, executives who are subject to potential claw-back of their variable compensation becoming (i) disincentivised to raise issues or concerns for fear that they may trigger a claw-back and/or (ii) overly risk averse or cautious.
It is crucial that careful consideration be given to these issues when designing or reviewing claw-back provisions, taking into account the particular context in which they operate (including any regulatory requirements that may apply).
We have set out below three key practical tips for implementing effective claw-back provisions. These should all be read in the light of any regulatory requirements that may apply (which are outside the scope of this article).
1. Avoid overly subjective triggers
One of the most important design considerations of a claw-back policy or provision is deciding what the triggering events will be. Broadly speaking, these fall into two categories:
- Errors in financial performance measures or reporting; and
- Misconduct or other objectionable conduct on the part on the executive.
The latter type is gaining prominence as part of broader corporate governance reforms, including a broader regulatory focus on corporate culture and non-financial misconduct. It is also the trickier of the two to enforce owing to the subjectivity of the criteria; deciding whether or not someone has, for example, caused an organisation serious disrepute involves far more discretionary leeway (and therefore scope for argument and in turn potential litigation) than determining the factual question of whether or not there has been a miscalculation of a figure.
It is therefore important that where “misconduct” on the part of the executive is a trigger for claw-back it is, as far as possible, very clearly defined. Individuals/committees responsible for assessing whether claw-back is triggered should develop clear processes on how to do this; both the process and decision should be clearly documented.
2. Give careful thought to all aspects of design – not just the triggers
The triggering event is clearly an important aspect of a claw-back provision. But there are multiple other considerations which ought to be carefully considered when designing or reviewing these provisions, including, for example:
- Individuals covered – some firms/companies may wish to limit this to executive directors whose compensation is subject to investor scrutiny via remuneration reports, but an alternative approach is to apply it to a much wider group (for example, all participants in the relevant incentive arrangement).
- Compensation covered – determining which types of variable pay will be subject to claw-back (and therefore the aggregate value that could be recovered if the claw-back was activated) will be a key determinant in the claw-back strength and also its potential deterrent effect.
- Lookback period – e. the period of time from payment during which a triggering event must be discovered in order for there to be authority for the claw-back provision to be enforced in relation to such payment. Related to this, companies may wish to consider if there should be a ratchet down of payment recoupment over time to add to the reasonableness of the provision, which may be helpful in a potential future debate around enforceability.
3. Inform and seek consent to any changes to claw-back provisions
As alluded to above, there has been a trend in recent years to widen the triggering events of claw-back to include compliance or non-financial misconduct issues on the part of the executive. For example, the #MeToo movement, which has led to widespread and concerted efforts to crack down on sexual harassment in the workplace, has resulted in this type of behaviour frequently being specifically included as a trigger for compensation claw-back. We are also seeing numerous companies (across all sectors) including “serious reputational damage” as a trigger for claw-back. Where changes are made to claw-back provisions -whether to triggering events or otherwise – it is important to properly document these and seek written agreement to these changes on the part of the executive to avoid challenges down the line as to their enforceability.
A final word of advice…
In view of the challenges of designing effective and practically enforceable claw-back provisions – many of which are born out of the (unavoidable) difficulties of recovering financial sums which have already been paid to award holders and the fact that claw-back remains a relatively untested tool – companies may want to also consider other mechanisms which allow them to retain payments/share awards to avoid the challenges of trying to recover it once it is in an executive’s hands. Measures such as lengthening the deferral period of future bonus payments, having adjustment mechanisms in respect of both unvested and vested (but yet unpaid) awards and more robust performance conditions can all be effective ways to bolster claw-back provisions.
If you are an employer and would like to discuss reviewing claw-back provisions in senior executive compensation contracts, you have any other questions arising from this alert, or for specific legal advice on particular circumstances, please contact our Partner and General Counsel Beth Hale who specialises in employment and partnership issues for multinational employers, senior executives, partnerships and partners.
This article was first published by Executive Compensation Briefing on 14 April 2021.