Thanks to actions taken by the G-20 at its Pittsburgh Summit in September and the U.S. Treasury’s special pay master last month, the term “clawback” will reverberate throughout the board rooms of companies worldwide in 2010. While it’s certainly not a new idea, the financial crisis has led some companies to institute such policies for poor performance or irresponsible risk-taking that go beyond the disgorgement rules of the Sarbanes-Oxley (S-O) Act. Some U.S. public companies are adding executive compensation recovery, or clawback, policies in addition to executive compensation advisory, or Say on Pay, vote policies as a response to the financial crisis fallout. Many shareholders were angry about the awarding of bonuses at companies where companies posted lower earnings or even net losses. What is making the idea of such policies a big issue for the coming proxy season is that the G-20 has included them in its newly approved Financial Stability Board Principles for Sound Compensation Practices and U.S. Pay Master Kenneth Feinberg is mulling over such action for the seven Troubled Asset Relief Program (TARP) recipients under his aegis.

Second Generation of Clawbacks

With the TARP and American Recovery and Reinvestment Act, a second generation of clawback policies were created that are limited to those companies that received federal bailout funds. Unlike the S-O clawback provision, the trigger under TARP and ARRA are not tied to a financial restatement. Instead, they are tied to financial statements that are later found to be materially inaccurate but not necessarily due to misconduct or fraud (i.e. if a company pays an executive a bonus when receiving TARP or ARRA funds that may have been included as income during that period). Under S-O, the CEO and CFO of a company that, as a result of misconduct, files a restatement due to noncompliance with accounting and financial reporting standards must reimburse the company for any bonus or incentive received in the 12 months prior to the original financial statement filing. See The Conference Board’s newly released Corporate Governance Handbook: Legal Standards and Board Practices (Third Edition) for more information on this and other S-O requirements as well as their application by U.S. boards. The law firm Morgan Lewis has a thorough presentation on executive compensation clawbacks that you can look at. (See page 14 of the presentation).

Aligning Compensation Policy with Performance Measures

The Conference Board CEO Jonathan Spector told members (See SIFMA meeting video.) of the Securities Industry and Financial Markets Association (SIFMA) at its annual meeting last week that clawback policies need to be aligned with executive performance measures. “The principle is to pay the compensation after performance has been delivered,” he said. “That phrase is a concept that isn’t fully prevalent in companies’ management systems and in board room discussions. Companies have used the accounting system to say performance has been delivered when it hits the balance sheet.” He thinks there needs to be more sophisticated measures of executive performance that are linked better to compensation, although he doesn’t necessarily think there needs to be accounting standard changes. Spector said he was asking SIFMA members to do two things: to endorse the Task Force principles and to go back to their companies and figure out how to apply the principles to their compensation policies. The Conference Board Task Force on Executive Compensation states that “companies should adopt clawback policies allowing them to recoup compensation from executives under certain circumstances, such as later discovered misconduct or a subsequent restatement of financial statements.” In the United Kingdom, the HM Treasury announced shortly after the G-20 Sept. 25 release of the compensation principles that the top five banks in that country – Barclays, HSBC, Lloyds, RBS and Standard Chartered – had agreed to implement the G-20 reforms effective Jan. 1, 2010. Feinberg on Monday told an executive compensation conference at the University of Maryland Robert H. Smith School of Business that he would determine by the end of next month how he will use his power to claw back pay at those TARP companies although he is not in negotiations to do so (See Reuters story.) If that wasn’t enough to get boards’ attention, Valero Energy Corp. announced Friday that its board has adopted policies that allow for executive compensation recovery, an advisory vote on executive compensation and disclosure of compensation consultant fees in order to determine their independence. Valero’s actions are similar to what other companies have done over the past year as they approved Say-on-Pay measures, such as Microsoft, Verizon, MBIA, H&R Block, Blockbuster, Tech Data, Aflac and TIAA-CREF. Consider Microsoft’s clawback policy, which focuses on executive performance measures and not so much on misconduct. “The Company will seek to recover, at the direction of the Compensation Committee after it has considered the costs and benefits of doing so, incentive compensation awarded or paid to a covered officer for a fiscal period if the result of a performance measure upon which the award were based or paid is subsequently restated or otherwise adjusted in a manner that would reduce the size of the award or payment...” The policy does leave open the possibility of taking additional action if an executive is found to be guilty of misconduct that led to the awarding of the bonus. As for the second generation of clawbacks, research shows a much slower pace than the first generation policies that really just reflected the S-O Act. The Corporate Library in its recent 2009 Governance Practices Series: Clawbacks (fee required) found that “the spread of clawbacks is progressing at a snail’s pace absent any legislation or regulations.” (Among the S&P 500, only 13.2 percent in 2009 had filed proxies in the first half of the year calling for clawback policies compared to 10 percent in the same period last year. That figure did not include the large number of TARP recipients subject to Treasury clawback regulations.) According to The Conference Board Task Force on Executive Compensation Report, 64.2 percent of the top 95 companies in the Fortune 100 in October 2008 had first generation clawback policies, up from 17.6 percent in 2006. The report cites a January 2009 article in Financier Worldwide, which used data from Equilar’s 2008 Clawback Policy Report.

New Best Practice

In an Oct. 15 publication Considerations for Public Company Directors in the Current Environment, Gibson, Dunn & Crutcher LLP cites a RiskMetrics 2009 proxy voting policy that clawback provisions applicable to companies receiving TARP funds is a new “best practice.” Under most clawback provisions, companies receiving such funds must seek back bonus or incentive compensation that was based on materially inaccurate financial statements or materially inaccurate performance metric criteria. Basically, RiskMetrics will tend to support clawback shareholder proposals if a company’s compensation policy does not align with that of TARP recipients, Gibson, Dunn wrote. Law firms like Gibson, Dunn are advising companies to assess their compensation disclosures and have their compensation committees be aware of executive compensation practices that institutional investors and proxy advisory firms advocate, such as clawback policies and “hold-through-retirement” provisions.