Banking and Finance

Clawback Provisions: Definition, How It Works, and 2 Examples

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Companies and organizations purposely add clawback provisions in employee contracts to act as an insurance plan if they need to act against fraud, misconduct, or mismanagement from an employee.

Clawback provisions became more popular after the 2006 – 2008 global financial crises. There have been multiple scenarios where clawback provisions have helped companies to get back a chunk sum as compensation from defaulting executives or employees. This article digs deep to analyze how clawbacks work.

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Key Takeaways:

  • A clawback puts an employer in a position to legally retrieve money or compensation that is previously paid to an executive or employee.
  • Other than financial firms, more companies have continued adding clawback provisions into executive contracts.
  • Clawbacks act as an insurance plan to protect employers from huge losses caused by unethical behavior, mismanagement, or unprofessionalism of their executives or employees.
  • Clawback provisions can be structured in many different ways, and the defaulter may be required to repay the compensation with a fine. They remain an important tool for protecting shareholders and ensuring accountability.
  • Clawbacks have other meanings in different settings outside the cooperate/financial world.

What Exactly is Clawback (Claw Back)?

Clawback Provisions

A clawback is a contractual provision that puts an employer in a legal position to request a refund of bonuses or compensations paid to any of its executives or employees on the basis of mismanagement, fraud indictment, or misconduct. Clawbacks are commonly used by companies in the financial industry; its awareness and relevance grew after the 2008 financial crisis.

Mainly, clawback policies only affect incentive-based pay like bonuses, compensations, and awards, and they are typically non-negotiable. Clawbacks are not made to scare employees; the provisions only come into play when there’s a case of misconduct, scandal, or fraud from the employee.

It is important to understand that the term “Clawback” is used in other settings like “Private Equity,” “Medicaid,” and “Stocks.” In those settings, it has slightly different meanings. In private equity, it is used to refer to the limited rights of partners to reclaim part of the interest carried by the general partners, most especially if subsequent losses result in excess compensation for the general partners.

In Medicaid, a clawback doesn’t necessarily imply monetary payback; it could imply recovering privileged documents that got turned in mistakenly. While in “Stocks,” the term clawback is used to discuss the fall in an asset’s price – a “clawback” in the price of a stock market asset.

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How Clawback Works

The terms are clearly written into employee contracts, so you already know what to expect if you should be caught on the web. Clawback provisions are only triggered by certain events, which, of course, differ by organization. These events may include a restatement of financial statements, violation of company policies, or unethical behavior by an employee.

When clawback conditions trigger, a company or employer can invoke the clawback provision and seek to recoup some or all of the compensation previously awarded to the executive or employee. Clawback provisions can be structured in different ways; sometimes, the defaulter will have to pay back the bonuses and compensations along with a fine (penalty). Also, clawbacks may be compulsory or optional, depending on the organization.

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Clearly, clawbacks mean a different thing from other types of repayment or refund remitted by employees to their employers because clawbacks often come with a penalty (not interest). That said, an employee caught in a clawback scenario will mostly likely remit additional funds to the employer after paying back the initial amount they had received as a bonus or compensation from the same employer.

When an employee sees clawback provisions in their contract agreement, they know they have to handle the organization’s finances and account with great care and diligence, as any incorrect or miscalculated information could mean a lot on their own end. Clawbacks are a type of insurance plan for both big and small players in the financial industry.

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Examples of Clawback Provisions

There have been many instances where companies in the financial industries relied on clawback provisions to recover some reasonable amount from their executives. One of the most popular scenarios is the Wells Fargo scandal with former CEO John Stumpf and former head of community banking Carrie Tolstedt.

1. The Wells Fargo Scandal 2016

In 2016, there were widespread fraudulent practices by many employees of Wells Fargo bank; millions of fake and fraudulent accounts were created by employees who worked under the former CEO John Stumpf. These accounts were created to meet “meet aggressive sales quotas.” When it came to the limelight in 2016, the bank had to sack thousands of its workforce and also strip John Stumpf of his CEO position.

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The former head of community banking, Carrie Tolstedt, was also implicated in the scandal; he was in charge of the actual department where the fraudulent practices took place and failed to address the issue, which led to a significant public backlash against Wells Fargo and multiple regulatory fines.

The bank got fined $185 million for creating fake accounts to meet sales quotas – clawback provisions helped the bank recover up to $69 million in compensation from former CEO John Stumpf and former head of community banking Carrie Tolstedt.

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2. Toys “R” US Bankruptcy 2018

In 2018, Toys “R” US went bankrupt due to increased head-on competition from online retailers, changes in consumer shopping habits, and a significant amount of debt from a leveraged buyout in 2005.

The company filed for Chapter 11 bankruptcy in September 2017 to restructure its debt and continue operating, but in March 2018, it announced it would liquidate all of its US stores and go out of business. At this time, the company’s creditors resorted to clawback provisions to regain up to $16 million in retention bonuses paid to top executives before the bankruptcy filing.

Summary:

A clawback is a contractual provision that allows a company to retrieve previously awarded compensation from an executive under certain circumstances. Clawback provisions are becoming more common in executive contracts. Although these provisions have been criticized by many, they remain an important tool for ensuring accountability and protecting shareholders.

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Sources:

Samuel Odamah

We wake up to new tech innovations. All I'm doing is trying to get acquainted with cutting-edge innovations, write about them, as well as deploy them in solving my everyday problems.Follow me on Twitter @fwesh_finnest for my daily updates on Tech, Bitcoin, marketing, etc.

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