Compensation Clawbacks

The requirement of forfeiture or clawback provisions was first introduced by the government with the passing of the Sarbanes-Oxley Act of 2002, though some employers utilized clawbacks as a tool on their own prior to 2002.  This federal statute required forfeiture or repayment obligations for bonuses paid to the CEO and CFO of public companies that would be triggered by a restatement of the company's financial statements due to material noncompliance or misconduct.

The federal bail-out program under the Emergency Economic Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009 re-introduced the concept of executive repayment of bonuses tied to inaccurate financial statements.  These programs broadened the group of executives that are covered by these repayment obligations.

The Department of Treasury recently issued an interim final rule on compensation and corporate governance, which requires that any bonus payments to executives of bail-out recipients must be subject to a "recovery" or "clawback" provision, which is triggered in certain circumstances relating to materially inaccurate financial statements or performance metric criteria.  A bonus payment is defined to include retention and incentive payments.  In this case, the rule requires that bail-out recipients mustexercise clawback rights, unless it is unreasonable to do so, i.e, the cost of enforcing the rights would exceed the amount to be recovered.

Although this recent legislation approves the use of clawbacks as a protection for shareholders, there are special legal issues and considerations that come into play. 

Potential Tax Consequences

Upon termination of employment, the employer and employee may want to negotiate repayment schedule for the bonus due back to the employer, or offset any severance payments with the amount due to be repaid.  However, Section 409A of the Internal Revenue Code appears to establish limits that would prevent changes to the terms of the bonus repayment, or allow the offset of severance or other compensation owed to the employee.  Section 409A of the Code makes clear that offsets of "deferred compensation" for an employee "debt" is limited to $5,000 per year and must be paid on the same schedule as ordinary debt payments.  Section 409A also restricts the renegotiation or offset of compensation that would result in a substitution or replacement of deferred compensation.  Severance payments could be considered deferred compensation under the Code, and thus, any reduction in severance in order to meet the bonus repayment obligation may be prohibited.

Non-Compete/Non-Solicitation

Clawback provisions are often triggered upon an employee's violation of a non-compete or non-solicitation clause that extends for a period of time beyond the end of employment.  State law determines whether non-compete and non-solicitation clauses are enforceable in a particular jurisdiction, and the same will hold true in determining whether these clawback provisions are enforceable.

State Wage and Hour Laws

Bonus compensation promised or previously paid to an employee could be considered "wages" or "earned compensation" that may not be forfeited under applicable state wage and hour laws.  The main issue under state wage and hour law is whether the compensation subject to clawback constitutes wages, particularly where the bonus was "owed" to the employee pursuant to a bonus plan or policy, rather than clearly "discretionary" on the part of the employer.  Many states do  not consider incentive and discretionary bonus compensation as "wages".  However, once the bonus has been paid, even a discretionary bonus may be considered a wage, and a clawback on a bonus already paid may be considered an impermissible deduction from wages.

Advice for Employers

Given the potential tax and legal issues in implementing and enforcing clawbacks, employers may want to consider other programs, such as a retention bonus program requiring certain services be performed before the compensation is paid, or tying forfeiture provisions to other compensation, such as severance pay.  That said, clawback provisions can be a useful retention tool and helpful in defending compensation practices to boards and shareholders.

If your company is considering drafting clawback provisions, consider the following:

• State the repayment obligation clearly in writing, signed by both parties;
• State the clawback provision in an agreement that is executed at the time the bonus is paid, rather than waiting to include it in a separation agreement at the time of termination of employment;
• Review applicable state wage and hour laws;
• Specify what compensation the clawback relates to;
• Be consistent in administering and applying repayment provisions to all employees in the same bonus plan or program; and
• Exclude the repayment obligation from any release of claims signed by both parties at termination of employment.