This is the third in our three-part series of articles detailing the steps to be taken and decisions to be made as companies adopt Securities and Exchange Commission (SEC)-mandated, Dodd-Frank-compliant clawback policies.
We are relatively certain the Talking Heads were not thinking of clawbacks when they penned this line from our title, which sticks with us as we think about this issue. This article focuses on whether and how companies should prepare in advance to facilitate their ability to claw back incentive compensation from officers by considering a program of mandatory deferrals.
This may be an overlooked consideration for companies based on the working assumption they can rely upon the rule that allows the compensation committee to determine that a clawback would be considered “impracticable” if the costs of enforcement would exceed the amount that could be recovered. This exception could apply in many cases when a company needs to pursue a former officer for a clawback.
The “impracticable” exception should not be viewed as a “get out of jail free” card, as companies must disclose its use, including the amount foregone and how the costs of pursuing the clawback would make it impracticable. Companies also must include details of how they calculated the amounts to be recouped (a future article will cover the calculation issue). Our overarching concern is that shareholders, proxy advisors and the press will raise questions about the calculation done to support not seeking recoupment of compensation. We also anticipate those same groups could raise questions about why the company did not have a mechanism in place to help ensure that officer-earned compensation is within reach if a restatement later arose.
Consider the source:
For current officers: The issue of determining the source of funds to effectuate a clawback for current employees is straightforward in that a ready source of funds exists based on future pay. The SEC regulations specify that after a restatement, companies must act “reasonably promptly,” noting that “directors and officers in the exercise of their fiduciary duty to safeguard the assets of the issuer...will pursue the most appropriate balance of cost and speed in determining the appropriate means to seek recovery.” The SEC discussed in the preamble whether companies may recover funds over time, from future pay, from incentive awards earned but not paid, or by cancelling unvested equity and non-equity awards.
It is not yet known if companies will adopt, as part of their clawback policy, a hierarchy that outlines which sources they will pursue first to show they are poised to move quickly to enforce those recoupments. For example, if officers must meet certain share ownership requirements, either as shareholders or beneficial owners, the company could mandate in advance that those shares be the readiest source of a clawback, particularly if they are still in the company’s possession. The same could apply for shares not yet beneficially owned, such as performance shares that are not yet vested. This hierarchy could be a directive to a specific type of compensation or a list of the types of compensation the company has in place, stating more generally that the fastest course must be pursued.
It also is possible that the clawback policy might permit current officers to choose from which source the clawback would be paid, whether from future pay, existing stock holding or ready cash. We would anticipate that choice would be available to executives if it meant the company would be paid back speedily; however, we wonder if any officers would use after-tax funds to pay the clawback because of the limitations in the tax code on recouping taxes paid in a prior year. Said differently, the economics suggest officers might prefer the source of clawbacks to be future compensation, which may be more tax efficient.
Former officers: Once an officer departs, the company often does not have access to a ready source of funds to effectuate a clawback within its direct reach. There are exceptions: When options remain outstanding, full-value shares are not settled until a later date (e.g., the end of a performance period) or when existing deferral arrangements delay payment until some future date. But we expect that most companies will have to confront the obvious question about whether they should defer a portion of officer compensation for a period sufficient to facilitate a clawback in the event the officer terminates employment.
Companies wishing to adopt this approach must resolve certain issues first. The predominant one is that current officers can become former officers very quickly, and often no compensation is available to defer once they leave. For example, if annual bonuses have a “must be present to win” provision so that payment happens only for a current employee, no funds will be available for a departing officer who leaves before that date or if that office leaves on that date when the bonus is paid. Similar rules apply for most, but not all, long-term incentive plans.
409A is tricky: For a company to have a viable deferral mechanism in place, section 409A of the Internal Revenue Code would require that deferrals are paid on a fixed distribution date, which would then be applied to all officers. This could be as simple as holding a portion of an annual bonus to pay out at the end of year one, two or three for every executive, regardless of whether they are still employed. The goal here is to try to match up the total deferrals held by the company with the potential amount required to be clawed back. Companies would need to make sure these deferrals were subject to a legally enforceable forfeiture provision in the case of a restatement. Using an existing deferral program may prove more difficult unless such a forfeiture provision already exists in anticipation of the Dodd-Frank clawback rules.
Figuring the amount to defer will be challenging: Every restatement is different, and every officer compensation plan is different. Forecasting what amount of compensation needs to be on hand to cover a potential clawback will require a study based on prior data as to what financial metrics tend to be adjusted in what amounts. Because the SEC will require detailed disclosure of clawback values, we expect that with several years of experience, companies will have much better data to help calibrate the value of deferral amounts. We concede that forecasting the amount needed will be an estimate, at best, so we expect companies would choose a formula deferral, such as a percentage of the annual bonus.
Some deferral benefit: If there is a silver lining, current officers having mandatory deferrals as a source of funds means that much of the above discussion about the hierarchy of clawback sources goes away; the deferrals would be the source. Deferrals also solve the problem of forcing officers who pay clawbacks with after-tax dollars being forced to claim a miscellaneous deduction or seek relief under the “claim of right” doctrine to recoup paid taxes. Deferrals are not taxed until distributed, and presumably they won’t be taxed ever if it’s determined that the amount should be forfeited due to a restatement.
This article compresses a lot of detail into what is hopefully a digestible format. There are many layers to be considered in determining the source of clawback funds, with benefits and trade-offs for each subject. Yet, we believe this entire clawback regime is one that will receive extensive scrutiny for any company undergoing a restatement, and it makes sense to work with your tax advisors and counsel to determine the best course going forward.
This is the last in the series of articles about how to get ready for Dodd-Frank clawbacks. Stay tuned for a future article that will provide insights on the challenges companies will face in determining the amount that must be recouped following a restatement.
