What is a clawback provision?

Written by joseph nicholson
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A clawback provision is contractual language that used in writing performance-based compensation contracts. It allows a company to take back such compensation if future events show that some or all of the compensation was excessive according to the intended terms of the contract. Thus, if a bonus is earned through chicanery and a deliberate misstatement of financial results, that bonus may be taken away.

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Identification

Clawback provisions have different definitions in different contexts. Generally, a clawback provision is a stipulation within a contract that requires repayment of certain kinds of funds due to changing situations. In the most common context, that of executive compensation, a clawback provision allows a company to take back previous performance-based payment based on restated financials. (See References 1.)

Types

Clawback provisions also exist within the context of financial incentives, restructuring or economic development. To aid the development of an emerging economy or resuscitation of a struggling company, part of a loan principal can be automatically forgiven as part of the loan terms. Such terms can also be part of enticing international corporate investment in an underdeveloped region. A clawback provision here would allow the creditor to recover this forbearance amount if the future performance exceeds certain benchmarks.

Significance

Clawback provisions became an important issue in the wake of the 2007-2008 credit crisis stemming from reckless lending and the securitisation of home mortgages. (See Resources 1.) Because the financial results of the lenders were extremely positive in the years leading up to the credit crisis, executives of these companies received extremely large bonuses. When, just a short time later, the value of the lenders' portfolios had to be significantly written down, the results no longer justified the previous compensation. Where there were no clawback provisions, executives had an incentive to frontload their companies' earnings, and most have managed to keep their inflated compensation packages.

Considerations

Representative Barney Frank (D-Mass.), chairman of the House Financial Services Committee in 2009, argues that legislation to reform regulation of the financial industry should contain explicit clawback provisions to avoid a repeat of the excessive compensation that occurred prior to the credit crisis. (See References 3.) An attempt to recover compensation of AIG executives in the wake of that company's £55 billion bailout from the federal government failed in the Senate due to concerns about its constitutionality.

Effects

The Sarbanes-Oxley Act of 2002, which placed new obligations on corporate executives and accountants, included a clawback provision that has since been formalised in Title 18 U.S. Code, section 7243. In 2009, the Securities and Exchange Commission (SEC) took the unprecedented step of enforcing the Sarbanes-Oxley clawback provision against the CEO of CSK Auto Corporation, who had not been accused of wrongdoing. (See References 1.)

Both the Chief Financial Officer (CFO) and Chief Operating Officer (COO) of CSK were charged with accounting improprieties that resulted in a misstatement of the company's financials. As of September 2009, the SEC is seeking to clawback roughly £2 million in compensation to the CEO based on the misstatements. The significance of this decision is that the inability to allege wrongdoing against the CEOs who presided over the creation of the credit crisis has been seen as a major obstacle to clawing back their compensation packages.

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