Clawback:
Definition, Uses, Types & Comparison

A clawback is a contractual provision that requires money or benefits already paid to an employee to be returned to an employer or benefactor under specific circumstances or events. These circumstances typically include fraud, misconduct, poor performance, financial restatements, or a drop in company profits. Clawbacks differ from standard refunds or repayments because they often include penalties in addition to the repayment requirement.

Clawbacks function as a form of insurance for companies, allowing them to respond to crises such as fraud, misconduct, or unexpected profit declines. To enforce a clawback, companies must include a written clawback provision in employee contracts or agreements at the time the relationship is established. Without such a provision, companies cannot legally seize employee funds.

Related terms: clawback provision, clawback clause, executive compensation, carried interest

Clawback provisions in executive compensation are contractual clauses typically included in employment contracts by financial firms that require executives to return bonuses and other incentive-based payments under certain conditions. These provisions tie bonuses specifically to the long-term performance of financial products or the overall health of the firm.

The Sarbanes-Oxley Act of 2002 was the first federal statute to allow clawbacks of executive pay, providing for recovery of bonuses and incentive-based compensation from CEOs and CFOs when company misconduct leads to financial restatement. The Dodd-Frank Act of 2010 expanded these requirements, mandating that the SEC require U.S. public companies to include clawback provisions triggered by any accounting restatement, regardless of fault. This rule was finalized on October 26, 2022.

The prevalence of clawback provisions among Fortune 100 companies increased from lower than 3% prior to 2005 to 82% in 2010. By 2021, 81% of Fortune 100 companies and over 90% of S&P 500 companies used clawback policies. Research shows that managers subject to newly implemented clawback provisions often attempt to offset their increased risk by demanding higher base salaries that cannot be clawed back.

Companies use clawback provisions for 4 primary strategic purposes:

• Protect against liability: Clawbacks mitigate risk associated with potential fraud or misconduct by providing contractual protections that allow companies to recover inappropriately distributed funds, particularly important in the finance industry where they prevent abuse of accounting information
• Respond to unexpected circumstances: Companies can reclaim funds when facing unexpected profit drops, employee misconduct, or misrepresented performance reports, experiencing less risk and public scrutiny as a result
• Provide assurance to investors: Clawback provisions offer guarantees to investors and the public, providing increased credibility to large businesses and helping restore confidence after instances of widespread misconduct or unstable financial performance
• Deter fraud and specify consequences: Many clawback provisions include penalties that accompany fund retrieval, deterring fraudulent behavior and providing consequences for employees who misrepresent company performance or commit fraud

Academic research finds that voluntarily adopted clawback provisions are effective at reducing both intentional and unintentional accounting errors. The same studies show that investors have greater confidence in a firm's financial statements after clawback adoption, and that boards of directors place greater weight on accounting numbers in executive bonuses after a clawback is in place.

Clawbacks can apply to 6 different types of payments and benefits:

• Executive-level bonuses: Companies initiate clawbacks during poor financial performance or in response to undesirable executive behavior
• Company pensions: In cases of fraud, pensioners might have to return part of erroneously claimed pension payments
• Medicaid payments: Medicaid sometimes uses clawbacks after liquidating a fund if payments were issued to someone deceased
• Life insurance policies: Canceled policies might include clawback provisions dictating when payments need to be returned
• Government contract payments: Contracts might contain clauses allowing clawback of payments if services or products don't meet the contract's terms
• Shareholder dividends: Companies might clawback dividends if their reserves or profits can't support the payments

Clawbacks are most prevalent in the financial industry, but insurance companies, governmental organizations, and large corporations also use them. Most clawback provisions are non-negotiable and typically apply only to employee bonuses and incentives rather than base salary.

In private equity, clawbacks allow limited partners to reclaim a portion of the general partners' carried interest when subsequent losses mean the general partners received excess compensation. Carried interest refers to the profit share that general partners receive beyond their typical partner share.

Clawbacks in private equity are calculated when a fund is liquidated. If the fund experiences unexpected losses after general partners have received carried interest distributions, the limited partners have the right to recover the excess amounts paid. This mechanism ensures that general partners only retain carried interest that reflects actual long-term fund performance rather than early gains that are later offset by losses.

Under the faithless servant doctrine, an employee who commits a crime in their work or fails to follow the company code of conduct or code of ethics is subject to having all of their compensation clawed back by the employer. This doctrine goes beyond standard clawback provisions by potentially requiring repayment of all compensation during the period of faithlessness, not just bonuses or incentives.

In the landmark case Morgan Stanley v. Skowron (989 F. Supp. 2d 356, S.D.N.Y. 2013), applying New York's faithless servant doctrine, the court held that a hedge fund's portfolio manager engaging in insider trading in violation of his company's code of conduct must repay his employer the full $31 million his employer paid him as compensation during his period of faithlessness. The court called the insider trading the "ultimate abuse of a portfolio manager's position" and noted that the behavior damaged the firm's reputation, a valuable corporate asset.

In the United States, clawbacks were rarely used until 2006. Major cases include a $600 million clawback affecting William W. McGuire of UnitedHealth Group, $500 million affecting Dennis Kozlowski of Tyco, and in 2019 clawbacks of compensation for the former CEO of Wells Fargo John Stumpf as well as a colleague.

The yearslong clawback undertaken after the Madoff investment scandal is notable both for its size and success. A team of lawyers headed by Irving Picard recovered over $13 billion, or about 75%, of the estimated $19 billion collectively lost by investors in Bernie Madoff's Ponzi scheme. This was a far higher percentage than the usual recovery rate for investor clawbacks, which typically ranges from 5 to 30 percent. Of the recovered money, $7.2 billion came from the estate of just one investor, Jeffry Picower, representing the largest civil forfeiture payment in U.S. history.

In sales, a clawback occurs when a company has paid representative commissions on a sale and then the customer abruptly ends the contract within a certain period of time. The clawback itself is when the employee pays back the commissions per the sales commission plan.

HubSpot has a clawback policy in effect for the first four months of the customer's contract. If a customer cancels their plan one to four months after signing up, the salesperson who sold it to them is required to return their commission payment. This ensures representatives focus their time and attention on businesses that can truly benefit from the product and encourages them to vet the best opportunities and build long-term relationships with their customers.

Clawback policies in sales can affect attainment, compensation, or both. The most common approach is to only collect the commissions back when a clawback takes effect, rather than also impacting the representative's quota attainment, as the latter can be discouraging for sales teams.

State Medicaid programs are required to claw back payment of costs for nursing facilities, hospitals, prescription drugs, and home- and community-based services, but this rule applies only to recipients who are age 55 or older. This money is typically recouped from their estates after death, though there are provisions for undue hardships imposed upon surviving family members.

Medicaid clawbacks can also occur when payments were issued to someone deceased or when someone fraudulently collected Medicaid payments on behalf of a deceased relative. In these cases, the clawback might include penalties beyond the basic repayment requirement.

The availability of defenses against clawback provisions depends on the nature of the provision and the circumstances. A clawback that is not supported by a written, signed agreement at the time a business relationship is entered into can be argued as being unsupportable. State wage and hour laws can also support or defend against clawback enforcement in employment matters.

It might help to establish that a clawback was never initiated against anyone else under the same circumstances, indicating that some level of prejudice exists. Seeking legal help is recommended when facing a clawback to ensure you understand all your rights, options, and obligations, particularly when the government is involved or retirement provisions are threatened.

Clawbacks and buy-backs both involve reclaiming assets or benefits, but they differ significantly in 4 key areas:

Clawback vs. Buy-Back

A clawback aims at rectifying past issues related to compensation or benefits due to misconduct or errors, often involving recovery of funds already disbursed in response to adverse events. A buy-back aims at achieving strategic financial goals, such as enhancing shareholder value or consolidating ownership, involving purchase of shares from shareholders and often seen as a positive move to enhance shareholder value or reduce share dilution.

Legal Framework Differences

Clawbacks are governed by specific terms outlined in contracts or company policies, with regulatory frameworks influencing clawback policies, especially in publicly traded companies. Buy-backs are governed by corporate laws and regulations, including securities laws and stock exchange rules, with companies required to comply with specific disclosure and procedural requirements when conducting buy-backs.