Clawbacks, Compliance and Incentive Compensation: A Supplemental Approach

The following post comes to us from Michael W. Peregrine, Partner at McDermott Will & Emery, Andrew C. Liazos, head of McDermott’s executive compensation practice, and Timothy J. Cotter, Managing Director at Sullivan, Cotter, and Associates, Inc. 

Governing boards should consider compliance-based incentive compensation as a supplement to statutorily mandated “clawback” provisions, and as an alternative to more aggressive proposals to recoup past compensation from “culpable” executives.  The general counsel is well situated to support the board in any evaluation of compensation-based executive accountability policies.

There is much public discourse concerning the function of clawback clauses, their structure, and their limitations.  Much of this discourse is prompted by recent corporate scandals and associated calls for executive accountability.[1]  But there are other reasons.  There is extensive discussion in anticipation of rulemaking from the Securities and Exchange Commission that is required under Dodd Frank Section 954.[2]  Notable governance commentators and shareholder advocates are encouraging boards to adopt clawback policies that go beyond the statutory requirements.[3]  Major public companies are adopting their own versions of clawback policies,[4] including some who are doing so at the behest of investors.[5]  In addition, the boards of large, financially sophisticated nonprofit corporations are considering clawback policies as a demonstration of corporate responsibility.[6]  Indeed, how best to establish a “clawback” policy continues to be a hot topic!

In advance of the Dodd Frank rulemaking, many responsible boards are evaluating how best to tie executive compensation arrangements to overall corporate accountability goals and objectives.  Some will be satisfied with meeting the letter of the Dodd Frank rulemaking — and there should be no negative connotations from such an approach.  Others will expand clawback arrangements to encompass other “triggers” (e.g., violations of corporate ethics codes, “fitness to serve” standards, and restrictive covenants).  Still others will increase the risk of forfeiture of certain benefits should an executive be terminated for ethical or compliance lapses.  The suggestion here is that compliance-based incentive compensation, as a supplement to the clawback, should be part of the board’s discussion in this regard.

Of course, the concept of the clawback clause has its roots in the seminal Sarbanes-Oxley Act.  Section 304 of the Act was intended to address the public policy goal of holding accountable corporate executives when there is misconduct with respect to a public company’s financial statements.  As enacted, Section 304 requires the CEO and CFO to “disgorge” certain types of compensation and profit-taking in the event of an accounting restatement due to noncompliance as a result of “misconduct”, with any financial reporting requirement under the federal securities laws.[7]  The limitations of Section 304 have been well-established since the Sarbanes-Oxley Act was enacted in 2002: its failure to apply to other corporate officers; uncertainty as to the definition of “misconduct”; and the absence of a private right of action — Section 304 is only enforceable by the SEC.

Congress later adopted more expansive clawback requirements in response to the financial crisis in 2008 for companies participating in the Troubled Asset Relief Program (“TARP”).  Unlike Sarbanes-Oxley, TARP provisions were applicable to a broader group of employees, did not require any misconduct, did not have any lookback period and were applicable to a participating company irrespective of whether it was publicly or privately held.  Currently, these provisions only apply to the few companies that have not fully satisfied their TARP obligations.

Section 954 of the Dodd Frank Act strikes something of a compromise between Sarbanes-Oxley and TARP.  As a practical matter it will require that public companies adopt a clawback policy relating to erroneously awarded incentive compensation paid to a current or former executive within a three year look-back period.  The “trigger” for the recoupment is an accounting restatement due to material noncompliance with any financial reporting requirement under federal securities laws, without regard to whether the individual executive was involved in misconduct that prompted the restatement.  Section 954 differs from Section 304 with respect to its scope (applicable to executive officers generally); time period (the lookback period is longer — 3 years as opposed to 12 months); platform (no finding of misconduct is required); and enforcement (by the issuer and not by the SEC).  While the SEC has not publicly stated when it will issue proposed rules, it is reasonable to expect that proposed rules will be issued at some point this year.

Some of the related challenges facing governance have to do with the vagaries and ambiguities of these statutory clawback rules.  For example, a restatement must be “required” in order for a clawback to apply under Dodd-Frank (in contrast to Sarbanes-Oxley, where there is an additional condition that the required restatement resulted from misconduct).  But who decides if a restatement is required or voluntary?  There is a three year look-back period under Section 954, but no guidance as to the specific date when it will be triggered.  And, above all else, how does one calculate the amount of excess incentive compensation for equity awards that are subject to time-based vesting requirements, as there is no direct correlation between a specific stock price and financial statement results.[8]

Yet, perhaps greater challenges arise from non-governmental developments that place increased pressure on the scope of corporate clawback provisions.  As noted above, there has been movement by some companies and industry groups to adopt clawback provisions (e.g., applicable to a broader class of executives, a lower standard of conduct for triggering recoupment, such as violation of law or corporate policy) while allowing flexibility as to enforcement based on the employee’s culpability and other considerations.[9]  Imposing these types of clawback provisions raises several issues, including concerns over enforceability, accounting complexities[10] and adverse tax consequences for the employee.[11]

Another such development is increasing advocacy by institutional shareholders, governance commentators, proxy advisory groups and other interest groups for more meaningful clawback policies.  These groups have grown weary of seeing public companies take a “wait and see” approach to taking any action on this matter in the absence of SEC rules, and consider clawback policies to be an essential part of good governance.  Institutional Shareholder Services will now take into account the lack of a clawback policy in evaluating overall corporate governance.[12]  A leading voice in this regard, the estimable Ben Heineman Jr., argues for broad, flexible and context-based corporate compensation recovery policies that would, among other things, expand the scope of covered individuals, the nature of compensation and the type of executive conduct subject to holdback, and discretion of the board in making individual holdback/clawback decisions.[13]

These and other developments have sent a strong signal to governing boards about the significance attributed by external sources to a comprehensive corporate compensation recovery plan.  The message is clear — in an era of increasing focus on corporate (and executive) accountability, compliance with statutory clawback rules may not be enough to demonstrate the board’s commitment.  As a result, close to 90% of the Fortune 100 companies have adopted a form of clawback policy in some fashion, most of which provide discretion to the board as to enforcement.  Yet, as noted above, what is largely missing from this discussion is the role that compliance based compensation arrangements (i.e., incorporating achievement of compliance related goals in the executive incentive compensation plan) have in “rounding out” the board’s portfolio of accountability measures.

Compliance-based incentive compensation is a concept that is beginning to attract increased attention, particularly as boards search for effective ways in which to assure corporate accountability.  Certainly, its use has not risen to the level of “best practice”, nor is there broad acceptance on how it is to be applied.  Yet, it is perceived by its supporters as an effective and pro-active means of promoting “tone at the top”-styled cultural enhancements and demonstrating a good faith organizational commitment to compliance.

Compliance-based incentive compensation can be structured to cover the CEO and other members of the executive leadership team.  Compliance-based compensation often includes goals related to the effectiveness of “hotline” mechanisms; assuring proper funding and staffing of compliance programs; adopting enhancements in the way risk and compliance concerns are reported “up the organizational ladder”; achievement of specific targets in terms of compliance-based training and monitoring, and other similar operational goals and objectives.  Determination of whether particular incentive goals have been met could be made by the executive compensation and audit/compliance committees of the Board, working together.

In this regard, it should be noted that compliance-based incentive compensation has a solid foundation in the highly regarded guidelines set forth in the federal Sentencing Guidelines, promulgated by the U.S. Sentencing Commission, that establish the seven essential criteria of an “effective” corporate compliance plan.  The USSC Guidelines form the core of the compliance plan of many major corporations, across industry sectors.  Chapter 8B of the Guidelines identifies as one specific criteria:

“The organization’s compliance and ethics program shall be promoted and enforced consistently throughout the organization through (A) appropriate incentives to perform in accordance with the compliance and ethics program ….”[14]

The Guidelines (intentionally) do not define what is an “appropriate incentive.”  Yet, providing additional compensation for achieving specific and meaningful objectives to enhance compliance should qualify as an “appropriate incentive” contemplated by the Guidelines.  This would also be supportive of those portions of the Guidelines that place particular responsibility on the board and executive leadership to (a) be knowledgeable about the compliance program, and (b) exercise reasonable oversight with respect to its effectiveness.  Thus, by adopting such an incentive arrangement, a board would be acting consistent with its related Caremark obligations to create and maintain an “effective” compliance-based information and reporting plan.[15]

Compliance-based incentive compensation provides other advantages to public companies.  Proxy disclosure rules require a public company to assess whether its compensation policies “are reasonably likely to have a material adverse effect” on its operations.[16]  Meaningful compliance-based incentive compensation would be helpful in many cases to demonstrate that incentive compensation is being used as part of a holistic approach to discourage excessive inappropriate risk-taking within the company related to unlawful activities.  In this regard, it should be noted that the use of incentive compensation to achieve targeted corporate goals is not limited to compliance.  For example, incentive compensation can be used in connection with achieving specific operational goals to reduce data privacy and cybersecurity risks.

Having a clawback policy is entirely consistent with the use of incentive compensation as a compliance tool.  One is a penalty, the other a reward; one is a stick; the other is a “carrot”.  One is triggered by certain negative financial developments; the other is triggered by the achievement of certain previously identified goals.  When thoughtfully applied in a consistent manner, the two approaches can offer a more comprehensive approach to encouraging ethical executive behavior.  In so doing, the combined approach may serve as a powerful demonstration of the board’s commitment to corporate accountability.


It is reasonable to anticipate increased demands for both regulatory and voluntary measures designed to hold corporate executives directly accountable for their actions, and to encourage ethical behavior by executives.  Clearly, adoption of “compensation recovery policies,” such as holdback and clawback arrangements, will be a primary responsive measure.  However, boards should also give consideration to compliance-based executive incentive arrangements as a supplement to statutorily mandated clawback policies.  Such arrangements may prove attractive because they are largely pro-active rather than punitive, and seek to motivate consistent with compliance standards as contemplated by the federal Sentencing Guidelines.  They may also allow the board to justifiably resist the adoption of more extensive compensation recovery mechanisms that are likely to create tension with executive management.


[1] Gretchen Morgenson, The Wallet as Ethics Enforcer, The New York Times, April 6, 2014

[2] Section 954 requires the SEC to issue rules directing the national securities exchanges to prohibit the listing of any security of a company that does not adopt a clawback policy meeting certain criteria.  To date, the SEC has not issued these rules.

[3] Ben W. Heineman, Jr., “Broader Clawback Policies, More Corporate Accountability”,, April 21, 2014.

[4] See, e.g., “Executive Compensation: Clawbacks-2013 Proxy Disclosure Study” (PwC, April 2014); “CFO Journal”, The Wall Street Journal, April 17, 2014.

[5] See, e.g., 2013 Shareholder Initiatives of the New York City Pension Funds,

[6] “2013 Manager and Executive Compensation in Hospitals and Health Systems Survey Report”, Sullivan, Cotter and Associates, Inc.,

[7] An issue that is not specifically addressed in Section 304 of the Sarbanes-Oxley Act is whose misconduct is required in order to trigger a clawback, and courts have ruled that a clawback under Section 304 can apply even if the misconduct is not that of the CEO or CFO.  SEC v. Jenkins, SEC v. O’Dell, and SEC v. McCarthy.

[8] Other open questions under Section 954 include (i) what is “incentive-based compensation”, (ii) whether clawbacks can be imposed retroactively against former executives and (iii) whether the Board will be required to pursue a clawback in all circumstances or will it have discretion in exercising clawback rights. See, e.g., Andrew Liazos, Clawbacks Revealed, CFO Magazine, May 12, 2011.

[9] n.5, supra.

[10] It has been suggested within the accounting profession that a clawback policy which provides too much discretion may result in adverse variable accounting (or mark to market treatment) for equity awards.  The specific concern is that the discretion may defeat the formation of a “mutual understanding” as the equity award’s terms (including the number of covered shares) between the employer and the employee for purposes of ASC Topic 718.

[11] It may not be possible for the employee to effectively recover all the taxes paid to state and local taxing authorities using a tax credit under Section 1341 of the Internal Revenue Code. In addition, recovery of amounts from a nonqualified deferred compensation plan under certain circumstances may result in adverse tax consequences for the employee under Section 409A of the Code (e.g., immediate income tax on deferred vested amounts, interest from the date of vesting at the IRS underpayment rate plus 1% and a 20% addition to tax).  These tax risks also would apply to clawback policies established solely to meet requirements under Section 954 of the Dodd-Frank Act.

[12] See, e.g., Wallace, Ted (Alliance Advisors), “Key Issues From 2013 Proxy Season”, The Harvard Law School Forum on Corporate Governance and Financial Regulation, August 20, 2103;

[13] n.3, supra.

[14] United States Sentencing Commission, Federal Sentencing Guidelines Chapter Eight, Section 8B2.1. (“Effective Compliance and Ethics Program”),

[15] In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).

[16] Regulation S-K Item 402(5).

The views expressed herein do not necessarily reflect the views of McDermott Will & Emery or its clients and are not intended to be and should not be taken as legal advice.