UK: Is clawback the new market standard?

"The inclusion of clawback and malus provisions in scheme designs and executive contracts is a recognised way to prevent executives receiving rewards that are undeserved. Shareholders expect to see such provisions included in relevant arrangements and for them to be enforced when appropriate." ABI Principles of Remuneration, September 2011

Clawback provisions are becoming increasingly common in employees' share schemes, and companies across all sectors should be considering whether it would be appropriate to introduce such provisions. This briefing discusses what is meant by "clawback", why companies need to be considering the issue, and how clawback can be implemented.

What is clawback?

The term "clawback" is used to describe a variety of mechanisms aimed at preventing participants benefiting from rewards that later prove to have been undeserved. Clawback provisions generally fall into two categories:

• "hard clawback" refers to provisions that require the participant to return shares and/or to repay value to the company after the award has been paid or released; and

• "soft clawback" refers to provisions that allow for negative adjustments to be made to outstanding awards (including by way of forfeiture).

Why do we need to be considering clawback?

There has been an increasing focus on clawback provisions both by regulatory bodies and by shareholders.

The 2010 revision of the UK Corporate Governance Code states that "consideration should be given" to including provisions that allow for variable components of remuneration to be reclaimed in exceptional circumstances of misstatement or misconduct. The next reporting season will see companies publishing their first reports under this revised version of the Code (which applies to accounting periods starting on or after 29 June 2010), and we can expect an increased focus on clawback as a result.

The latest ABI guidance on remuneration published on 29 September 2011, quoted above, goes further than the Corporate Governance Code and states that shareholders "expect" companies to include clawback provisions in their reward arrangements for executives, and to operate the provisions where appropriate.

Potentially going even further, a September 2011 discussion paper on executive remuneration issued by the Department for Business, Innovation and Skills is currently inviting views on: "whether all UK quoted companies should be required to introduce a claw-back policy". The paper suggests that 20% of FTSE100 companies already provide for clawback.

The response to the BIS consultation from the CBI welcomes the trend of increasing use of clawback, and the November 2011 responses from both the Institute of Directors and NAPF support making clawback provisions compulsory.

The increasing focus on clawback provisions is also not limited to the UK. In the US, the Dodd-Frank Act, passed on 21 July 2011, introduced a requirement on listed issuers to implement a policy to claw back overpaid incentive-based compensation in the event a company has to issue an accounting restatement within 3 years of the vesting of an award.

The FSA Remuneration Code has already introduced requirements on financial services firms to operate risk adjustment provisions similar to soft clawback in respect of deferred portions of variable remuneration. Firms subject to the Remuneration Code should have already considered how these provisions apply to them, and further information can be found in our briefing here.

How does clawback work?

There are many different ways in which clawback provisions may be structured, but generally clawback provisions include two elements:

• the right for the employer to set off the excess value that has already been paid or released against future vestings of other awards held by the participant, whether under the same or a different plan; and

• to the extent that set off against future vestings is not possible, a contractual agreement by the participant to transfer shares back to the company and/or to repay the excess value.

Clawback could also be introduced in conjunction with an extended holding period following vesting, as this makes operating the clawback easier: during the holding period the employer may be able to direct a nominee to return shares without recourse to the individual.

Hard clawback provisions (including in respect of vested awards subject to a holding period) are often operated so that the participant is required to repay the excess value calculated net of income tax and social security (as such amounts may already have been paid to the revenue authorities). This means that although the employer will not recover the full excess value that was paid, the participant will not be put in a worse position than if the award had vested at the correct level in the first instance, and the objective of preventing the executive receiving undeserved remuneration is still met.

Can a clawback provision be tailored?

Clawback provisions can be tailored to reflect the specific circumstances of the employer and any particular risks which the business faces, as well the structure of the company's incentive arrangements.

One factor that needs to be considered is when the clawback will be triggered. Provisions often apply in cases of a misstatement of results or misconduct on the part of the participant: both the Corporate Governance Code and the FSA Remuneration Code state that clawback should be operated in cases of misconduct, and in the US the Sarbanes-Oxley Act gives the SEC a right to enforce clawback from Chief Executives and Chief Financial Officers where an accounting restatement has to be made due to misconduct. There is, however, a range of other circumstances in which a clawback could be applied, each of which may be appropriate, but which could raise additional legal complications.

Another consideration is the period for which awards should be subject to clawback following vesting. Market practice on this point is still evolving, with periods ranging from one to five years, and again this will be determined by the circumstances of the employer, as well as the expectations of both employees and shareholders.

How is clawback enforced?

Operating clawback as a set off against future vestings of awards should rarely be problematic in practice, but will not always be possible, particularly where the participant has ceased employment and consequently has no outstanding awards. Seeking to enforce hard clawback as a debt owed by the participant is likely to be more difficult, and Remuneration Committees often retain discretion as to whether or not to apply clawback in the specific circumstances. The committee may decide not to operate the provision where the difficulty and expense of doing so would be disproportionate to the excess value that vested, although companies will need to bear in mind the ABI's guidance that "Shareholders expect to see such provisions …  enforced when appropriate".

What else should be considered?

Hard clawback is generally seen as a mechanism of last resort, albeit an important one, but should not be considered in isolation.  Soft clawback provisions and holding periods, mentioned above, can reduce the risk of an award vesting at an artificially high level in the first place, and either or both can be used in conjunction with a hard clawback provision.  Similarly, using appropriate performance metrics can also reduce the risk of overpayment: for example, NAPF suggests that measuring performance against realised, rather than unrealised, profits can eliminate some of the risk of payments being made on the basis of misstated information.  More broadly, ensuring executives are subject to suitable shareholding targets can be part of a strategy of ensuring remuneration is linked to an accurate assessment of mid- to long-term performance.  Clawback therefore forms an important part of scheme design, but should not be seen as the only mechanism to address risk.

What do you need to do?

Neither the Corporate Governance Code nor the updated ABI guidance currently make clawback compulsory for UK listed companies, but they do represent increasing shareholder focus on the issue, and companies should therefore consider whether clawback would be appropriate. Some companies will take the view clawback is not necessary, although listed companies should be ready to justify that view to shareholders if challenged. However, for an increasing number of companies across all sectors, introducing clawback will be appropriate, in which case existing incentive plans can be amended to include clawback, without the need to seek shareholder approval. Market practice on clawback also continues to evolve, so companies should monitor whether their existing clawback provisions (or lack of them) continue to be appropriate.