The Business Case for Clawbacks.

Author:Neel, Kathryn

In the world of corporate governance, a string of recent corporate scandals has highlighted the criticality of effective risk management and the potential financial and reputational harm that can result from inappropriate actions or ineffective oversight (see Figure 1).

The executives of these companies received large pay packages for their stewardship and leadership, largely provided in the form of performance-based compensation under the mantra of "pay for performance."

This raises two questions:

* What should happen if pay is delivered for performance that collapses after the payout is made, and the collapse was a consequence of actions taken when pay was earned?

* Under what conditions is it appropriate to enact a clawback, essentially a reclaiming, of incentive pay, or the cessation or recoupment of severance, and how should it work?

In response to the 2008 financial crisis, the 2010 Dodd-Frank Act tried to address these questions by requiring the recovery of incentive-based compensation when a company must restate its previously issued financial statements due to a material error. However, with two recent Wells Fargo and Equifax scandals the proposed regulations would not have applied, and yet the companies incurred major damage through reputational harm, fines and/ or legal settlements.

Accordingly, a strong business case often exists for thinking about clawbacks more broadly than regulators require. This case is derived from the typical objectives for clawback policies: protecting company and shareholder interests in the event of significant damage to the company, avoiding bad optics for the company and the board, and reducing potential motivation for inappropriate actions or decisions by reducing financial gain to be realized by executives.

Many companies already maintain clawback policies that go beyond financial re-statements to cover detrimental conduct more broadly, particularly in industries where the potential for reputational or economic harm is high, such as financial services.

Figure 2 provides four examples of detrimental conduct policies. Some of the triggering factors not found in the typical clawback policy include general fraud or misconduct, gross negligence (even in a supervisory role), and "seriously poor judgement" if the company suffers extraordinary damage.

Accountability in these companies goes beyond intentional actions/decisions to encompass other failures, so that their clawback policies support a broader...

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