A clawback is a clause in a contract that requires money paid to employees to be returned to their employer or benefactor. Sometimes, there may be a penalty.

 

Companies often use clawback policies to give bonuses and incentive-based pay. These policies are most commonly used in the financial sector. Clawback provisions are usually non-negotiable. Clawbacks can be used to address misconduct, scandals, or poor performance.

 

Takeaways:

  • A clawback is a contractual provision that obligates an employee to return money paid by his employer. Sometimes, it comes with a penalty.
  • Clawbacks can be used as insurance in the case of fraud, misconduct, a decrease in company profits, or poor employee performance.
  • Provisions are usually only incentive-based, such as bonuses or other benefits.
  • Clawbacks are primarily used in the financial sector, but they can also be found on government contracts, pensions, and Medicaid.

 

 

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What is a Clawback Clause?

A clawback clause in an employment or business contract allows the organization to claim any bonus or incentive funds previously paid to employees. Clawback clauses can provide some assurance in cases where an employee’s misconduct, poor job performance, or a general decline in revenue needs to be addressed.

 

Sign-on bonuses may be offered to employees upon their employment. This could include a clawback clause that states that the bonus must return in the event of an employee’s early departure. These and other bonuses may include clawback clauses that incentivize employees who perform well to stay longer.

 

Contracts that include clawback provisions are often non-negotiable. They may also include a fee or penalty.

 

Understanding Clawbacks

After 2008’s financial crisis, clawback clauses became more popular. They allow companies to recover CEOs’ incentive-based compensation if they are found guilty of misconduct or have discrepancies in their financial reports.

 

Employers can also include clawbacks in employee contracts to control bonuses and other incentive-based payments. Clawbacks are forms of insurance that the company can use to address a situation such as fraud or misconduct or to protect its profits in the event of a loss. If the employer is unhappy with their performance, the employee must repay the money.

 

Clawbacks can be different than other repayments or refunds in that a penalty often accompanies them. Clawbacks require employees to pay additional funds to their employer to be effective.

 

Clawback provisions are designed to prevent individuals from misusing incorrect information. They also help to balance community development with corporate welfare. They can be used to help prevent employees from misusing accounting information in the financial sector.

 

Clawbacks are integral to a business model as they restore investor confidence and trust in the company or industry. Banks have implemented clawback provisions after the financial crisis to correct future errors made by their executives.

 

Take Note

Clawbacks and executive compensation

The Sarbanes–Oxley Act 2002 was the first federal statute that allowed for clawbacks on executive pay. This law allows for the clawback of bonuses and incentive-based compensation to CFOs and CEOs in the event of misconduct by the company, but not necessarily the executives.

 

The 2008 Emergency Economic Stabilization Act, later amended, allows for the clawback of incentive-based bonuses paid to executives or the 20 highest-paid employees. This applies to financial results that are inaccurate, regardless of any misconduct. This law applies only to companies that have received funds from the Troubled Asset Relief Program.

 

A proposed rule by the Securities and Exchange Commission (SEC), part of the Dodd-Frank Act (2010), would allow companies to recover incentive-based compensation paid to executives if an accounting restatement occurs.

 

The amount of clawback allowed is the difference between what was paid and what was paid according to the restated results. Stock exchanges would be required to ban companies from being listed if they do not include clawback provisions in their contracts. The rule is still being approved.

 

Private Equity Clawbacks

Other settings may also include clawback. It refers to limited partners’ rights to reclaim a portion of the general partners’ carrying interest in private equity in cases where the general partners have suffered additional losses.

 

Clawbacks can be calculated when a fund liquidates. Medicaid may recover the costs of care from the estates of deceased patients. Sometimes clawbacks do not refer to money. In other cases, lawyers can recover privileged documents accidentally lost during electronic discovery.

 

Clawback Provisions: Examples

A number of federal laws, both proposed and enacted, allow executive compensation to be clawed back if there has been fraud or accounting error. Employers may also be allowed to include clawback clauses in their contracts.

 

Companies, insurance companies, and the federal government can use clawbacks in many ways. Here are the most popular clawback provisions in place today:

 

  • Executive Compensation: Clawbacks are available if an executive violates an agreement, misuses the information, or works for a competitor.

 

  • Life insurance – A provision could state that the policy has been canceled and that payments must be returned.

 

  • Dividends can be reclaimed under certain conditions.

 

  • Government contracts Contracts could be subject to clawbacks if specific requirements are not met.

 

  • Medicaid: Medicaid may recover all monies that were paid for Medicaid recipients after their death.

 

  • Pensions – Companies can recoup pensions if the pensioner is found to have committed fraud or misappropriated information.

 

Clawback examples

To better understand this concept, let’s take a look at these clawback examples:

 

Example 1

Yahoo published a disclosure in 2014 stating that hackers had stolen data from 500 million users. In December 2016, Yahoo revealed that data theft could have affected more than one billion accounts. The shareholders lost more than $350 million due to these breaches.

 

The United States Securities and Exchange Commission (SEC) investigated whether Yahoo employees had hidden data breaches from shareholders and customers.

 

Yahoo had a clawback clause that covered Marissa Mayer’s salary. Yahoo only implemented the policy in the reporting of incorrect financials. It did not apply to accounting fraud. It implied that the clause didn’t cover hack incidents and Marissa Mayer may be safe.

 

Example 2

Wells Fargo was fined $185 million in September 2016 for fraud committed over many years.

 

The fraud included opening credit cards without customers’ consent, creating fake email addresses to sign up for online banking services, and forcing customers to pay late fees on accounts they didn’t even know they had. Wells Fargo also fired 5,300 employees as a result of the scam.

 

Clawback Rules

Sarbanes-Oxley Act 2002 was the first law to create the federal clawback clause. The provision allowed employees and beneficiaries to recover bonuses or other rewards. Penalties would be imposed for staff misconduct and discrepancies in accounting records. The beneficiary would be required to repay the rewards or bonuses.

 

The following law was the Emergency Economic Stabilization Act of 2008. This law made it possible to recover in the event of business reporting errors, either intentionally or unintentionally. However, this law only applies to firms eligible for the Troubled Asset Relief Program.

 

After the 2008 Financial Crisis, renowned US banks needed to provide a mechanism for clawing back their losses. It was necessary to ensure that executives were accountable.

The UK passed laws allowing banks to recover bonuses from bankers who acted recklessly for ten years.

 

The Standard Chartered Bank created the law to reclaim bonuses from 150 top employees who had violated clawback rules. This included bank employees who could not pay but could be held responsible for legal and financial actions.

 

Bank requirements may dictate that the rules are different. They allow banks to claim rewards and bonuses for misconduct, unreasonable risks, or poor performance.

 

Bottom line

A clawback is an obligation in an agreement that requires an employee to return money paid to them by their employer. Sometimes, it comes with a penalty. Clawbacks are used as protection in the event of fraud, misconduct, or poor performance.

 

Most provisions do not refer to incentives pay, such as bonuses, rewards, or other compensations. Clawbacks are most common in the financial sector but can also be found in government contracts and used to pay for Medicaid or pensions.

 

To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.

 

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