AN EFFECTIVE CLAWBACK PROVISION
Consider the Boeing Company’s voluntary clawback provision reported in its 2006 proxy statement filed on March 23, 2007:
In 2006, the Board of Directors adopted an executive compensation clawback (“recoupment”) policy, which is now a part of the Company’s Corporate Governance Principles. Under the Company’s recoupment policy, the Board must, in all appropriate circumstances, require an executive officer to reimburse the Company for any annual incentive payment or long-term incentive payment to the executive officer where: (i) the payment was predicated upon achieving certain financial results that were subsequently the subject of a substantial restatement of Company financial statements filed with the Securities and Exchange Commission; (ii) the Board determines the executive engaged in intentional misconduct that caused or substantially caused the need for the substantial restatement; and (iii) a lower payment would have been made to the executive based on the restated financial results. In each such instance, the Company will, to the extent practicable, seek to recover from the individual executive the amount by which the individual executive’s incentive payments for the relevant period exceeded the lower payment that would have been made based on the restated financial results.
The provision appears comprehensive at first glance, yet there are several unanswered questions: Who is and who isn’t “an executive officer” for purposes of the Boeing clawback rule? After a restatement is filed, how much time does the company have to activate a clawback, and from how far back can it reclaim money? What criteria need to be met for the board of directors to prove an executive intentionally engaged in misconduct, and what is the standard used to define a “substantial restatement”? If these questions are left unanswered, the board can have a rather substantial degree of discretion in determining that improper activities weren’t, in fact, meaningful enough to activate a clawback.
Accountants and auditors should be concerned about these questions because they might be consulted to provide a professional opinion about restatements and their potential impact on compensation clawbacks. Internal auditors who are tasked with auditing executive compensation and benefit plans are directly affected by clawbacks because of the relationship between corporate governance, executive compensation, and various risk factors. This can be challenging in situations when an internal auditor discovers that his or her boss’s compensation package isn’t structured in the best interests of the organization and the owners of the company.
A study by Michael H.R. Erkens, Ying Gan, and B. Burcin Yurtoglu identified several aspects that companies should include to strengthen the clawback policy, including specifically naming the executives covered by the policy, identifying the time period for how far a company can go back in time to “claw back” the incentive pay from the covered executives, detailing the types of compensation the company can recoup, and excluding words that give the board discretion to enforce a clawback, such as “the Board has an option to recoup if an executive is proven to have engaged in misconduct.” (For more, see “Not All Clawbacks Are the Same: Consequences of Strong Versus Weak Clawback Provisions,” Journal of Accounting and Economics, 2018.)
In addition, the proportion of the amount of compensation subject to a clawback relative to an executive’s total compensation is another key to a strong policy. Clearly the higher this proportion, the more effective the policy will be. Giving the board a deadline to enforce the policy is another critical element.
Here’s what the provision could look like if it included those elements (added text is in bold, and deletions are shown in strikethrough text):
In 2006, the Board of Directors adopted an executive compensation clawback (“recoupment”) policy, which is now a part of the Company’s Corporate Governance Principles. Under the Company’s recoupment policy, the Board must, in all appropriate circumstances, require the NEOs [Named Executive Officers] included in the Summary Compensation Table on page 35 of this proxy statement to reimburse the Company for any Annual Incentive Award, Performance Award, and Stock Options Award to the executive officer (up to 20% of his/her total annual compensation) where: (i) the payment was predicated upon achieving certain financial results that were subsequently the subject of a substantial restatement of Company financial statements filed with the Securities and Exchange Commission; (ii)the Board determines the executive engaged in intentional misconduct that caused or substantially caused the need for the substantial restatementthe payment was received within three years prior to the financial restatement; and (iii) a lower payment would have been made to the executive based on the restated financial results. In each such instance, the Company will, to the extent practicable, have two years from the restatement’s filing date to seek to recover from the individual executive the amount by which the individual executive’s incentive payments for the relevant period exceeded the lower payment that would have been made based on the restated financial results.
This revised version eliminates potential ambiguity related to the board’s procedures and actions in order to enforce the clawback policy in case of a restatement and, therefore, should constitute a stronger corporate governance policy.
PERFORMANCE EVALUATION
Research studies have examined the impact of adopting a clawback provision. For example, in 2012, Lilian H. Chan, Kevin C.W. Chen, Tai-Yuan Chen, and Yangxin Yu shared findings in the Journal of Accounting and Economics that the number of restatement filings decreases after a company adopts a clawback policy. They also provide evidence that auditors reduce effort in auditing clawback clients relative to clients without clawbacks.
And Mai Iskandar-Datta and Yonghong Jia found that the market responds positively to companies after they make an announcement about voluntary clawback adoption (“Valuation Consequences of Clawback Provisions,” The Accounting Review, 2013). The impact was especially noticeable for companies that have previously filed restatements, suggesting that investors as a whole view clawbacks as an effective corporate governance mechanism to curb earnings management.
Yet merely having a clawback provision doesn’t guarantee that there won’t be any errors or financial statement manipulations. Auditors must apply the same diligence when auditing a company’s financial statement whether or not a clawback provision was adopted. For instance, Diane K. Denis found that the correlation between clawback adoption and the observed subsequent reduction in restatements could be explained by executives being more reluctant to file restatements and admit mistakes after a clawback provision is adopted (“Mandatory Clawback Provisions, Information Disclosure, and the Regulation of Securities Markets,” Journal of Accounting and Economics, 2012).
In fact, in an experimental study where corporate executives were asked to decide whether they would agree with the auditors in filing a restatement, results show that executives are reluctant to do so when a high portion of their pay is subject to a clawback, especially when facing an auditor with relatively less industry specialization, training, and overall experience (Jonathan Pyzoha, “Why Do Restatements Decrease in a Clawback Environment? An Investigation into Financial Reporting Executives’ Decision-Making During the Restatement Process,” The Accounting Review, 2015).
Furthermore, in several cases, higher pay followed the adoption of the clawback provision. For instance, Ed Dehaan, Frank Hodge, and Terry Shevlin compared compensation for companies with clawbacks and those without and found that total compensation increases after a company adopts a clawback policy and that this increase is largely driven by higher base salary as opposed to incentive compensation. Such changes in the executive compensation structure counteract the effect of clawback by shifting away from the “clawable” portion bonuses and stock options and replacing them with base salaries (“Does Voluntary Adoption of a Clawback Provision Improve Financial Reporting Quality?” Contemporary Accounting Research, 2013).
Auditors should look for clues in the qualitative factors, such as how close the company is to meeting its earnings targets. Narrowly beating an earnings target could be an indicator for financial statement manipulation. Both internal and external auditors need to pay attention to the language used in a company’s clawback policy to assess whether the clawback is set up only in appearance.