• Many companies pay out vast sums as performance incentives to management.
• However, unethical, fraudulent, and downright catastrophic actions can take years to come to light, with the money long gone.
• A study from Nyenrode Business University has discovered the best ways companies can ensure clawback.

The history of business is replete with stories of unethical actions and dodgy deals. From everyday insider trading to the predatory lending which brought on the Great Recession, greed and corruption have taken down companies, banks, and governments. And all too often, those who caused the collapse walk away from the wreckage with fat pockets.

To help combat and curb the wilder excesses of management, companies have, largely since the sudden, brute shock of 2008, put in place (often at the insistence of governments) measures to recoup compensation paid out to those who are found to have misbehaved egregiously and imperilled the company. This is a double-edged sword, as not only does the company reclaim cash, but it encourages management to act responsibly, morally, and lawfully. This process is known as “clawback.”

If a company awards a bonus to employees based on financial performance and it later turns out that the results were incorrect, or were achieved by improper means, a clawback clause can be used to retrieve the money.

By 2010 of the 100 largest companies in America, 71 (a new record) had clawback policies in place, a number which doubled from 2007. By 2012, Morgan Stanley had put into place clawback policies which could be “triggered for circumstances ranging from substantial losses to ethical lapses and include failure to appropriately supervise or manage an employee,” in rules which applied to all top executives.

Clawbacks need claws

After years of debate, in 2015 new rules were put in to allow for a decade of bonuses to be clawed back by banks if evidence of mismanagement or risk management failures were evident. Bankers were found trying to put their assets out of regulators’ hands, sticking their cash offshore, or finding loopholes which would “cause logistical problems that lawyers suggest will limit clawbacks in practice.”

The rules were put in place after deliberation as, “In the last crisis, many people walked away from the mess that they had created with huge rewards, well before the risks matured and it became clear that the rewards were not merited,” said Andrew Tyrie, chairman of the Treasury select committee.

In the US in 2016, a similar clawback was used to get back $41m of stock awards given to the chief executive of Wells Fargo, John Stumpf, after it revealed that its staff had opened 2m fake customer accounts. The lesson: “Clawbacks need claws.”

Clawback clauses flourished in the years following the Great Recession, but their usefulness has since been diluted. 

It still proves difficult to stop bosses and management dishing out lavish rewards to themselves for their lacklustre to devilish business actions, and then even harder to claw back these unjust rewards.

Rank abuses remain. In one such case, the 2018 collapse of British multinational Carillion plc, it was found that clawback policies had been purposefully watered down so that the boss who oversaw the destruction of the company was allowed to keep his £245,000 bonus and £346,000 share-based reward.

How to optimise clawback clauses

New research from Nyenrode Business University has uncovered ways in which companies can optimise clawback clauses, and the ways in which better clawback causes can, in turn, help business and the wider world.

Rancour against bad business remains. Studies have shown that the public continues to want senior executives to be more accountable.

One way to achieve effective clawback, the research advises, is to be precise and careful about the wording of clawback clauses.

The study looked at the nitty gritty of clawback clauses, and found that rather than there being a binary, a firm either has or does not have a clawback clause, there are instead strong and weak clauses. The finding was that firms need to be sure that their clawbacks are strong enough.

A weak clawback might say that the firm can recover bonuses from senior executives whose fraud or misconduct resulted in a significant financial restatement. With this wording, not only is fraudulent behaviour extremely difficult to prove, but it only allows for only the recovery of bonuses, not other incentive compensation, which can be significant.  

Building a strong clawback clause

A strong clawback clause would not allow for any escape hatches from which money can be shuttled. It would state that the company could recoup any and all incentive-based compensation paid for a number of years prior to the firing of an executive or a discovery of malpractice. This kind of clawback clause also doesn’t require evidence of fraudulent misconduct, nor is it limited to bonus payments, and sufficiently backdates claims.

“A strongly worded clawback means that compensation can be recovered regardless of whether fraudulent intentions need to be proven,” Professor Michael Erkens explains.

The research has already affected legislation, as the outcome of the study resulted in the mandatory implementation of effective clawback clauses in the United States.  served as input for a legislative change in SEC regulations in the US. As a result, listed US companies will have to implement and enforce strong clawback clauses from the end of 2023.

The findings, that only strongly worded clauses lead to better quality reporting and a better reward system for CEOs, will affect companies everywhere.

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