More than 16 years have passed since compensation recovery mechanisms, known as clawbacks, came to prominence within corporate governance, yet the application of clawbacks worldwide remains highly variable, subject to regional rulemaking and industry norms. For multinationals, it’s a maze.
In response to the financial crisis, regulators across the globe pushed for the use of clawbacks to promote financial stability and better align the interests of financial services executives, material risk takers and their employers.
The argument in favor of clawbacks is that if compensation is awarded for short-term corporate or investment performance, executives and traders are incented to pursue immediate profits, even at the expense of long-term risks. This can also motivate financial fraud as employees seek to produce results that will lead to immediate payouts and hope to either never get caught or to be long gone should the truth be revealed.
To address this, employers can structure financial incentives to include:
• Deferred compensation arrangements, contingent on future financial performance
• Malus clauses that allow for all or part of deferred compensation to be rescinded in cases of bad behavior
• Mechanisms to reclaim money already paid, in certain circumstances
Some countries, like Germany and the UK, require that financial services executives and material risk takers agree to deferred compensation arrangements. Most countries with clawback laws allow for deferred compensation to be reclaimed before it vests. Fewer, though a growing number, allow for money already paid to be reclaimed, though only under specific circumstances.
In the U.S., public companies are not yet required to work clawbacks into their executive compensation agreements, though clawbacks were written into both the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010. These proposed rules cover C-Suite executives, not traders or other investment or risk management personnel who could put a firm at risk through their decision-making. The Dodd-Frank requirements, for which the Securities and Exchange Commission proposed rules in 2015, would require companies to clawback erroneously awarded incentive compensation from executive officers of public companies in the event of accounting restatements. The clawback period would cover up to three years prior to the restatement.
The most important compliance challenge for financial services firms operating internationally is that enforceability of a clawback agreement almost always depends on patchwork local law and regulatory authority. The UK’s rules, for example, are regulated by the Prudential Regulation Authority or by the Financial Services Authority but underpinned by a plethora of contract and other legal enforceability tests. Some state laws in the U.S., for example, restrict the degree to which employers can recall money that has already been paid. The Czech Labor Code, as well as laws in Australia and Singapore, also protect workers from having to pay back money they have already received in most cases. These are all examples of how we see highly tailored situations in each region.
A Global System is Unlikely
A consistent, global system would be easiest for multinational financial services companies to navigate. It also might best serve the cause of global economic stability as it would eliminate possible regulatory arbitrage where, say, a risk-taking trader might seek employment in a country where compensation is rigorously protected. In Germany, for example, a material risk taker is required by law to accept a minimum three-year deferral, plus a two-year clawback period so that their compensation is at risk for five years. In the UK, a banker could see their variable pay packet being ‘at risk’ for at least seven years.
Implementation of any global system may run afoul of local laws. The UK moved a bit more quickly and robustly in its implementation of clawback laws, presenting multinational firms who were seeking global consistency with the challenge that the enacted provisions ran afoul of worker protection laws in France, Germany and further afield in jurisdictions such as Brazil.
Towards a level playing field
While the U.S. remains behind, the EU seems to be leading the way towards global standards that will include malus and clawback in executive compensation plans. 2014’s EU Capital Requirements Directive 4 compels relevant financial services firms to put all variable pay at risk of recovery through malus (pre-vesting recovery) or clawback arrangements. While the triggers can generally be decided by each firm, these must minimally include instances of poor financial performance, individual misconduct or failure to meet appropriate standards of fitness and propriety.
We are also seeing longer clawback periods adopted by institutions in Europe (both within the EU and those on their way out). The UK, followed by Germany, have some of the most robust laws in the world. Since 2015, UK banks have been required to make variable pay recoverable through malus and clawback for seven years after it is awarded (extendable to 10 years for some senior individuals). A more benign expectation, enforced on a ‘comply or explain’ applies to UK-listed companies who must include malus and clawback provisions within performance-related plans. Material risk takers at German banks must accept a minimum three-year deferral of bonus compensation with a two-year clawback period tacked on. German regulators are now talking about expanding these rules beyond the financial sector.
In the absence of a global standard, multinational firms can cope in part by creating universal compensation rules, compliant with the requirements of their country of domicile, to create a level playing field among all employees throughout the firm.
Multinational firms should also make these terms explicit in all new employment agreements and compensation award documents (as a pre-condition of award) and seek to amend provisions as laws change. The enforceability of clawbacks is aided, but not guaranteed, when both employer and employee have entered into an explicit contract.
In a world with differing rules and jurisdictions, a multinational’s best course is to seek consistency within their organization. A standardized corporate approach to clawbacks helps to promote fairness, create cohesion and to simplify details, while relying on straightforward, voluntary clawback provision agreements as part of employment plans and agreements.