Risk & Compliance

Clawbacks Claw Their Way into Corporate Strategy

More companies are adopting provisions to recoup cash from executives involved in malfeasance.
Alan RappeportJune 4, 2008

Companies are catching onto the idea of clawback contract provisions — some of which are designed to punish executives for faulty financial statements — according to a new report from The Corporate Library.

Clawbacks came into fashion in the wake of corporate scandals earlier this decade, and were legalized as part of the Sarbanes-Oxley Act in 2002. That law established that CEOs and CFOs should reimburse their firms for any incentive payments, or profits from the sale of stock, that were awarded in the year prior to an accounting restatement that reflected misconduct. The idea was to better tie pay to performance.

In 2003, just 14 companies had clawback policies in place, according to The Corporate Library’s survey of 1,800 firms that year. The latest survey shows that times have changed. Looking at a sample of proxies from last November to May, 295 of 2,121 companies examined now have adopted clawback provisions.

“This is an enormous increase over the last time we looked at this issue,” Paul Hodgson, a senior research associate at The Corporate Library, and author of the report, said in a statement.

Clawbacks are generally either “fraud-based” or “performance-based,” with the latter considered most effective for governance purposes. Performance-based clawbacks apply to all executives who received an incentive payment, such as a bonus, based on incorrect financial statements. The fraud-based clawback applies only if an executive did something intentionally fraudulent that brought a restatement.

As of this year, 44.4 percent of clawback provisions were fraud-based and 39 percent were performance based. (A few clawback provisions fit into neither the fraud-based nor the performance-based categories.) Some clawback payments have been particularly glaring, pinching the purses of even the wealthiest executives. Last year, for example, William McGuire, the former CEO of UnitedHealth Group, agreed to repay $448 million in cash bonuses, profits from the exercise and sale of UnitedHealth stock, and unexercised options, related to his role in the company’s illegal stock-option backdating practices.

The emergence of clawbacks could be one factor in the recent decline in the number of financial restatements. As CFO.com reported Tuesday, the restatements filed by companies to correct accounting errors fell by 17 percent last year, after a record high for revisions in 2006. Moreover, through the first three months of 2008, restatements were down 21 percent from the same period in 2007, according to a study from Glass, Lewis & Co.

Allegations of financial restatements are also declining. A recent report from Cornerstone Research found that such allegations appeared in just 30 percent of settlements for accounting-related class action lawsuits.

Not only are restatements proving costly, but they have become a red flag on résumés. In a new paper to be published in the Journal of Accounting, Auditing and Finance, Manuel Sanchez and Adi Masli, of the University of Arkansas’ Sam M. Walton College of Business tracked CFOs who left their firms within 24 months after a restatement. They found that those CFOs had significantly more difficulty finding similar jobs compared to CFOs who restated prior to Sarbanes-Oxley.

“We found that executives terminated in the post-SOX period have suffered greater labor-market penalties compared to the pre-SOX period,” Sanchez said. “Clearly, a tarnished reputation was more costly for CFOs following the passage of SOX.”

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