Clawback – a comparison of alternative approaches
14/03/2012
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The Australian government has indicated that it will legislate to require clawback of executive remuneration for financial misstatements (see HERE). In addition to the fact that financial misstatement is an undefined term in Australian corporate law, many other difficulties abound.

This article compares and contrasts recent “clawbacks” of executive remuneration in the UK with statutory remedies available under United States securities laws.

This February, two British financial institutions, Lloyds banking Group and HSBC, announced the clawback of previously awarded executive short-term incentive (STI) remuneration. In these cases the clawback was a forfeiture of a deferred STI, “returning” the money to the bank. Presumably, each of these clawbacks was facilitated by employment agreement provisions, and the terms of the STI arrangements.

The Lloyds and HSBC remuneration clawbacks were each preceded by exposure to a scandal. After the discovery of a consumer fraud scandal, Lloyds Banking Group stripped its former CEO and a number of current and former directors of a portion of their 2010 deferred bonus remuneration, totaling £2m in aggregate (mind you, the company lost £3.2 billion!). The former CEO’s bonus award was reduced by 40 percent. Four executive directors’ bonus awards were reduced by 25 percent. Eight lower-seniority directors’ bonus awards were reduced by 5 percent. Lloyds stressed that the “decision is based entirely on the principle of ‘accountability’ and in no way on culpability or wrong-doing by the individuals concerned.”

HSBC was also involved in a consumer fraud scandal. The bank was fined £10.5m by the FSA, Britain’s financial regulator, and ordered to pay £29.3m in restitution for its involvement in defrauding the elderly between 2005 and 2010. The size and scope of its executive pay clawbacks is not known, although they would appear to be on a smaller scale than those of Lloyds.

US security laws also provide for executive remuneration clawbacks through provisions of Sarbanes-Oxley and Dodd-Frank. Sarbanes-Oxley §304 applies to the current CEO and CFO, and liability depends on “misconduct” resulting in material noncompliance with financial reporting requirements under securities laws.

Liability for misconduct may not require a showing of intent or knowledge of wrongdoing. SEC v. Jenkins, 718 F.Supp.2d 1070 (D. Ariz. 2010) held that misconduct related to the issuer could be imputed to its top executives.

Damages under §304 includes all incentive remuneration received for twelve months after the earlier of filing financial documents with the SEC or making such disclosures publicly. Damages can also include any profits from the sale of those securities. Dodd-Frank §954 applies to certain “control persons,” essentially current or former executive officers.

In a hint for Australian legislators, liability depends on the re-filing of financial documents due to material noncompliance with securities laws.

Damages under §954 look to the three years preceding the date of the restated financial documents and are based on the excess of actual remuneration over hypothetical remuneration if a misstatement had not been made. This is workable in the US because most companies’ incentive payments are highly formulaic. This is less so in the UK and Australia. §954 implementation has been held up by the absence of regulation and guidance from the SEC.

Dodd-Frank §954 and Sarbanes-Oxley §304 each provide for clawbacks without a necessary showing of fault. Dodd-Frank §954 reaches a broader class of executives and also covers former executives. Sarbanes-Oxley §304 encompasses up to 100 percent of incentive remuneration, while Dodd-Frank §954 is not limited based on remuneration type, but only encompasses hypothetical excess remuneration.

The clawbacks at Lloyds may have covered a class of executives even beyond those covered by Dodd-Frank §954. The remuneration reduction at Lloyds was, like Sarbanes-Oxley §304, limited to bonus remuneration. Further, the clawback was a forfeiture of previously awarded deferred bonus remuneration, rather than a full elimination of incentive remuneration as Sarbanes-Oxley §304 provides.

Assuming the recently announced clawback awards are a consequence of agreed employment arrangements, the UK method may provide a better path for Australia than relying on statutory remedies. This implies that it may be better to restrict Australian laws to “comply or explain” requirements than to prescribe tightly defined circumstances and formulaic clawback. This could be accompanied by a requirement for companies to disclose clawback policies in their annual remuneration report.

All the major Australian banks now volunteer clawback policy disclosure. Some US disclosure examples oriented to the “financial misstatement” approach proposed by the Australian government can be found HERE and HERE.

Reducing or eliminating deferred bonus remuneration via contractual clawbacks can cover a broader class of executives while maintaining a no-fault standard for reducing remuneration. One consequence, though, could be that companies could be reluctant to clawback as much remuneration from employees as US statutory provisions currently require.

Clawback of remuneration that has been paid can be a much more complicated issue than forfeiture of deferred incentives. In the US it currently requires the company to take legal action to recover the amounts at issue from the executives. Few companies are likely to attracted to this approach, even with the assistance of specific enabling provisions under the Corporations Act.

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