Are Clawbacks Coming Back?

After Wells Fargo forced two senior executives to pay back $75 million in compensation, other companies are rethinking clawback clauses—which experts say are effective governance mechanism.

Clawbacks are in the spotlight again. Recently, two former senior executives of US bank Wells Fargo were asked by the bank’s board to pay back $75 million, due to their involvement in the bank’s recent financial fiasco. Companies can take back employees’ payments and bonuses following incidents of financial fraud or similar activity—based on federal legislation and often provisions included in employees’ contracts.

The Wells Fargo case highlights the importance of clawbacks in improving corporate governance. Yet there have not been very many to date. The largest corporate clawback took place in 2007, when a UnitedHealth Group executive gave back $618 million following an options-backdating case. While most public companies do have clawback provisions, their implementation is challenging due to the technicalities of enforcement.

US president Donald Trump has announced plans to deregulate markets and reverse Dodd-Frank, the financial regulation that followed the meltdown of 2008.The Dodd-Frank Act of 2010 mandated the Securities and Exchange Commission (SEC) to require that US public companies include a clawback provision in their executive compensation contracts that is triggered by any accounting restatement, regardless of fault. The existing SEC rules only apply to CEOs and CFOs when the companies themselves have been involved in financial misconduct. Consequently, the SEC has brought very few cases against corporate executives, with only $17 million aggregate paybacks as of September 2016.

Corporate directors are reluctant to use clawback provisions due to their limited scope, which is usually applicable to cash payments and in cases where accounts are restated based on incorrect financial statements attributed to fraud or executive misconduct.

Business professors Mai Iskandar-Datta from Wayne State University in Detroit and Yonghong Jia at Governors State University in Chicago recently concluded in a joint paper that “a clawback provision in executive compensation contracts is an effective governance mechanism” and that “shareholders of adopting firms experience statistically significant positive stock-valuation consequences.”

Better financial performance, they argue, is driven by reducing financial reporting risks through a clawback mechanism, which does not necessarily lead to higher executive compensation.