Give It Back

Clawback policies, requiring errant executives to return undeserved compensation, make sense on many counts, not the least of which involve reputation and morale. Drafting and overseeing them can be tricky, however.

Saturday, December 1, 2007
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Fraud. Backdated options. Accounting scandals.

These terms increasingly blare from the business pages and the actions behind them are causing company after company to restate their earnings. But the salve doesn't end there. As pressure mounts to implement better corporate-governance practices, more boards are also requiring their chief executives, chief financial officers and, sometimes, other top executives to return bonuses and other incentive awards in response to restatements.

How is that possible? By instituting a type of recapture known as a clawback, a provision in a chief executive's contract -- and disclosed in a proxy filing -- that spells out the circumstances under which a board has the right to demand compensation is returned. The purpose is clear: A clawback serves as a warning that financial wrongdoing or poor managerial oversight has consequences.

"A clawback is a no-brainer," says J. Mark Poerio, an employment partner in the Washington office of the Paul, Hastings, Janofsky & Walker law firm. "How do you defend a decision to allow a CEO to keep a bonus or award after behavior that led to a financial restatement?

"A company that tries to resist implementing a clawback is making an argument that they don't have any credibility," Hastings says. "And management needs to have credibility with the board. And so the clawback is the evolving standard in the industry."

In an analysis of 2005 proxy statements, 17.6 percent of Fortune 100 companies disclosed some form of recovery policy for their executive officers, according to Equilar, a compensation consulting and research firm based in San Mateo, Calif. Of these, recovery policies for two-thirds -- or 12 of those top 100 companies -- refer specifically to financial restatements or ethical conduct. Others refer to noncompete arrangements.

The list of companies that have implemented clawbacks in the recent past includes American Express, Microsoft, Citigroup, Monsanto, Eastman-Kodak, Bristol-Myers Squibb, General Motors, the Interpublic Group of Cos. and Pfizer.

"The prevalence is certainly increasing," says Alex Cwirko-Godycki, an Equilar senior analyst, who notes that new Securities and Exchange Commission regulations for compensation disclosure require discussion of compensation-recovery policies. "Shareholders view clawbacks favorably, so it's to a company's benefit."

The concept of recapturing some form of compensation when things go awry isn't actually new. But the passage of the Sarbanes-Oxley Act of 2002 prompted many more companies to impose stricter controls and accounting standards, which has also resulted in more disclosure of financial problems tied to fraud or financial miscues.

In turn, more shareholder groups and large investor funds are becoming more aggressive in criticizing CEO performance and demanding greater accountability for executive compensation.

"We call the clawback the 'Bad Boy' or 'Bad Girl' clause," says Patrick McGurn, executive vice president and special counsel at Institutional Shareholder Services, the corporate governance organization.

"And we think the [Sarbanes-Oxley Section 304] language about returning compensation due to misconduct will become de rigueur. As for misstatements, in general, the rule is: 'If you didn't earn it, you must return it.' "

In other words, a clawback policy is increasingly becoming part of the compensation landscape. That's because without such provisions, a company is likely to have a very difficult time trying to get an executive to return a bonus, options or some other form of compensation, says Myrna Hellerman, senior vice president at Sibson Consulting in Chicago. Just imagine cajoling a CEO to return a huge incentive reward without the legal means to do so.

Adopting a clawback policy is more than a matter of saying yes or no, however. As Poerio explains, a board of directors or compensation committee should decide what type of event would trigger a giveback, which executives are subject to the policy, what type of compensation may be recaptured and whether a clawback extends to past compensation, not just future pay.

For human resource professionals, this is where the rubber meets the proverbial road. Working alongside the compensation committee, the chief financial officer and members of the legal team is not only wise, but necessary, say experts. By doing so, the human resource executive has an opportunity to shape policy, providing a uniform approach to these issues on a broader basis.

If HR is going to be a strategic player, which is where the profession is going, it needs to be involved and build programs going forward, Hellerman says. "The role," she says, "should be to help design the plan, advocating for certain ideas with the comp committee and working collegially with the top executives involved in this process."

Defining Misdeeds

This is more than conceptual. As Poerio points out, there are several key decisions to be made when it comes to adopting a clawback policy. This is where human resource executives can make a difference: How should misconduct be defined? What is the argument for including executives beyond the chief executive and chief financial officer? Conversely, are there good reasons not to do so? What kind of precedents do we want to set? What messages do we want to send?

Definitions, in particular, are extremely important because, as Hellerman notes, Section 304 of Sarbanes-Oxley doesn't define what qualifies as misconduct that could be used to trigger a clawback.

At MDU Resources, an energy conglomerate headquartered in Bismarck, N.D., Cindy Redding says that to be successful, a human resource professional should know the various financial, legal and cultural issues at play. For instance, she suggests making sure annual and long-term measures are understood, which, of course, makes it easier to gauge the impact of a financial restatement.

"If total shareholder return is a measure, there may not be a direct link to an accounting restatement, depending on how you measure shareholder return," she says. "There can be a disconnect."

Redding also advises it's best to know what she calls a company's tolerance level. In other words, would the board most likely feel more comfortable implementing a clawback that covers two or three years? And would board members line up behind requiring an executive to forfeit all or only part of an award? Would it be a struggle to convince board members to rescind vesting?

"Ultimately, you want to ask yourself how much or how little structure does your board need? And what type of guidelines they may be looking for," says Redding, whose employer opted for a clawback policy that covers a three-year time horizon and encompasses top leadership, not just the chief executive and the chief financial officer.

"Do they want something conceptual that has more flexibility, or do they want you, as the human resource person, to think of a number of different scenarios so they have plans in advance with a strictly structured guideline on policy that supports that?"

With boards under increasing pressure to address corporate governance practices, human resource professionals can play an important role by providing information and advice about practices and policies companies are pursuing elsewhere. The idea is to be forward-looking, so that no one is later accused of being reactive to a fraudulent episode or embarrassing scandal.

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As an example, Bristol-Myers Squibb has clawback provisions relating to stock options, restricted stock and long-term performance awards. According to the proxy, executives that violate non-competition or non-solicitation agreements, or otherwise act in a manner detrimental to the company's interests, forfeit any outstanding awards as of the date a violation is discovered, as well as any gains realized in the previous 12 months.

Two years ago, though, after an embarrassing accounting scandal, the Bristol board decided it would seek reimbursement of annual incentives paid to an executive if the executive engaged in misconduct that caused or partially caused a restatement of financial results. In such an event, the company will seek to claw back the executive's entire annual incentive for the relevant period, plus a reasonable rate of interest.

A Good Sign

Human resources plays an even more critical role when embarrassing headlines appear due to fraud or a financial scandal morphs into a closely watched criminal trial. During an era of anger over CEO pay and job insecurity, morale can easily suffer when an entire company is tainted by the blunders committed by only one or a few top executives. Healing those wounds usually takes a lot of work, not just time.

By having a clawback, however, a company can more easily point to the policy in hopes of convincing not only investors, but employees that the board takes such violations seriously and is willing to respond accordingly. And human resource professionals are the ones who must be relied on to transmit the message internally, which is another reason they should be involved in shaping the policy.

"The HR person does have to balance a lot of things," says Harry Graham, mid-Atlantic compensation and benefits partner at Smart Business Advisory and Consulting in Tysons Corner, Va. "There are contractual legalities [such as] deciding the key purposes to be served by a clawback. But I think the big thing HR must do is to ensure they're in alignment with a board's compensation committee."

Sometimes, however, it can be difficult for a human resource executive to get heavily involved in some aspects of the process. For instance, a chief executive or some other top executive is much more likely to negotiate a contract with board members, for instance, and not the human resource executive. But if the input was provided to the board, then the HR professional is actually very much part of the process.

"I think today more companies want to be more proactive and human resource professionals can be very involved in framing the issues and outlining the alternatives," says Mark Borges, a principal at Mercer Human Resource Consulting in Washington. "By doing so, they can protect the organization against embarrassment, and much more."

At the end of the day, the effort is something of a subtle, high-wire act, requiring diplomacy and a willingness to be alert to the interests of different constituents simultaneously, says Hellerman.

"There are tens of thousands of companies in the United States, and most aren't bad," she says. "But human resources has to focus on building integrity in these plans. And they have to balance what's good for the executives with what's required for shareholders and what's good for the company.

"You want someone who's demonstrated integrity, knowledge and a balance of what's right. But HR has to step up their game. There's no one else in the company who can do what HR can do. With that said, HR shouldn't be a solo act. Work with the chief legal counsel and the chief financial officer. Too often, HR tries to do this sort of thing by itself, and the world is too complicated these days."

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