As we noted recently, the Securities and Exchange Commission (SEC) may propose regulations to guide companies in implementing Dodd-Frank clawback policies sometime this fall. (See “SEC Agenda Suggests the Latter Half of 2014 May Be Busy for Executive Compensation Matters,” Executive Pay Matters, June 3, 2014.) There are a number of unanswered questions companies should consider before they adopt clawbacks to recover incentive compensation paid erroneously following material financial restatements, as Dodd-Frank requires.
One question relates to potential state and international law hurdles that may be involved in pursuing employees and former employees to recoup previously paid compensation, not to mention the potential for ill will that could result. This has led to speculation that some companies could decide to impose mandatory deferrals on at least a portion of annual bonuses for the three-year period following the date compensation is received (i.e., the period over which Dodd-Frank clawbacks can be exercised). The thinking is that holding back a meaningful portion of executive bonuses could potentially be sufficient to cover the value of a clawback that may be required.
Incentive compensation subject to a Dodd-Frank clawback would include any element of “incentive-based” compensation earned by a senior executive. This could include the annual bonus, cash-based long-term incentives, the value of any equity gains already earned and, presumably, option value gains (even if not yet monetized). In short, the covered components run the full gamut of the types of incentive compensation used by companies today. Trying to recoup any of these elements of compensation will create practical and legal hurdles.
Consider equity compensation, for example. Executives often sell shares to cover taxes and/or exercise prices. Some executives also immediately sell the shares and reinvest the proceeds in other investments, which may be illiquid. So, there are fundamental challenges companies will face in trying to recoup these types of compensation.
Such concerns might prompt some companies to adopt mandatory bonus deferrals that could be used as an offset against other compensation elements. Not only would having a pot of cash held on the company’s books help in carrying out a clawback, executives might be happier to not have to undo their financial planning strategies by liquidating their holdings to repay compensation. This is without even considering the myriad state or international law implications of trying to recoup funds.
Many major banks have put in place arrangements under which a portion of annual compensation is held back, perhaps invested in company stock and/or subject to recoupment under a malus clause in the event of unsustainable financial results. These arrangements have been adopted largely at the insistence of federal banking regulators to address perceived risk-taking by bank executives. While the banking context may not be directly analogous to that of other organizations, their experience may offer some direction.
Of course, the annual bonus might itself be subject to a Dodd-Frank clawback. To the extent that a significant portion of the deferred bonus needs to be forfeited, less will be available to repay other erroneously awarded compensation (e.g., an equity award) to which a clawback might also apply.
DOES 409A STAND IN THE WAY?
An issue that creates some cause for concern is the potential that Section 409A of the tax code would prevent the forfeiture of a deferred bonus in lieu of a clawback.
Recall that 409A is very strict about when distributions of vested deferred compensation can take place. The rules permit distributions at a fixed date, but bar distributions upon the occurrence of events other than those specified by statute (e.g., death, disability or separation from service). The rules generally also prevent deferred compensation from being distributed sooner or later than one of those dates.
If a deferred, vested bonus is scheduled to be paid at a fixed date, could a forfeiture of that deferral to satisfy a clawback of the bonus be deemed a prohibited acceleration under 409A? We would hope this rule would not apply because this is a forfeiture of an item of deferred compensation rather than an early payment subject to the prohibited-acceleration rule. The outcome may be less certain if a deferred bonus is forfeited at least in part to satisfy a clawback of other compensation (e.g., equity gains).
For example, assume that a vested bonus payment was deferred for three years; the deferral agreement explicitly states that the bonus is subject to recoupment upon a financial restatement within the three-year deferral period and can be used to cover all forms of incentive compensation previously earned. Could this provision be deemed to create an impermissible distribution for purposes of 409A? The answer is not addressed specifically under the regulations.
To avoid any potential issues, the deferred bonus could be structured to be exempt from 409A — for example, by imposing a three-year vesting period, subject to forfeiture if the executive terminated early, and providing for payment shortly after the vesting date. As nonvested awards are exempt from 409A, the acceleration rule would not apply. However, the prolonged vesting period under which the deferral could be forfeited likely would be unpalatable to executives.
These are but a few of the legal issues and uncertainties that companies and their advisors will have to wrestle with if and when Dodd-Frank clawbacks are required. It will be interesting to see how the legal issues influencing the ability of companies to claw back compensation will affect plan design. The most important influence, of course, will be how the SEC regulations are crafted.
Steve Seelig and Russ Hall are senior regulatory advisors for executive compensation in Towers Watson’s Research and Innovation Center in Arlington, Virginia and White Plains, New York. Email firstname.lastname@example.org, email@example.com or firstname.lastname@example.org