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Adjusting Clawbacks vs Deferred Comp - April 2010

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					Thinking of Adjusting Your Clawbacks?—
Consider Deferred Comp Instead
A Clark Consulting Technical Resource Group White Paper
April 20, 2010



So your company has channeled its inner Jerry Maguire and shown your executives
the money. Unfortunately, two years later the company’s financials are restated,
and it is determined that the performance metrics upon which the executives’
bonuses were paid were actually not met. Now what do you do?


Given the current public hysteria over executive compensation issues, it is axiomatic
that doing nothing (or being perceived as doing nothing) is not a legitimate option.
So what options are available?


In executive compensation circles, the traditional solution has been to seek recovery
of the excess bonus amounts through the use of a “clawback” provision. However,
companies should consider a non-traditional solution which is fast gaining traction—
using deferred compensation instead.


This white paper will first look at the applicability and challenges associated with the
use of both government compelled clawbacks and privately instituted clawbacks. It
will then focus on what is perhaps a superior alternative to clawbacks—nonqualified
deferred compensation.


“Clawback” Basics


It may be best to start with a baseline question: ”What is a clawback?” As
commonly used, the term “clawback” refers to any contractual provision providing
for the repayment of incentive compensation previously paid to an executive.
Typical situations in which the recoupment obligation may arise and the executive’s
money may be “clawed back” include:




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                                   Considering Deferred Comp Instead of Clawbacks




   1. Downward restatement of the employer’s financial results due to a material
       inaccuracy;
   2. Ethical misconduct by the executive; and
   3. Failure of the executive to comply with some provision of the executive’s
       employment agreement (e.g., breach of non-compete).


The use of corporate clawbacks is certainly not a new phenomenon, but it is a
dramatically growing practice. As noted in Equilar’s 2009 Clawback Policy Report, the
percentage of Fortune 100 companies publicly disclosing that they had clawback
policies rose to more than 70 percent in 2009.1 This represented a dramatic increase
from the 17.6 percent reported in 2006.2


Sarbanes-Oxley Clawbacks


While clawbacks aren’t new, they have typically been associated with private
agreements between employers and employees. Government compelled clawbacks,
however, are a relatively recent and growing trend.


As a practical matter, the WorldCom and Enron debacles ushered in the first
significant entry of the federal government into the clawback arena—the Sarbanes-
Oxley Act (“SOX”). Enacted in 2002, Section 304 of SOX contained a statutory
clawback provision. While much may have been made in the media regarding SOX’s
clawback provision, clawbacks under SOX are actually rather limited—and do not
represent a viable approach for most companies seeking repayment of excess
executive compensation.


Looking at SOX, it is relatively easy to see why SOX is not a complete solution. First,
SOX is only applicable to publicly traded companies. Therefore, many U.S.
companies (and the executives employed by them) would not be subject to any
provision of SOX—let alone its clawback provision.


For those companies actually subject to SOX, Section 304 provides only limited
clawback relief. Section 304 may only be used to clawback the compensation of a
company’s chief executive officer (“CEO”) and its chief financial officer (“CFO”).




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                                   Considering Deferred Comp Instead of Clawbacks




Thus, the majority of corporate employees will not be subject to clawback under
SOX—notwithstanding that subsequent developments may show the corporation
actually missed the performance metric used to determine the amount of the
employee’s incentive compensation.


In addition, SOX clawbacks are triggered only if there is a restatement of a
noncompliant financial report and such restatement results in a material change.
Also, when triggered, clawback is limited to compensation within the twelve month
period following the original filing of the noncompliant financial report. Moreover, to
date, it has not been determined that SOX creates a private right of action for
repayment—(i.e., enforcement of a SOX clawback may be limited to the SEC).


TARP Clawbacks


Following SOX, the next government foray into mandating clawback provisions came
in the wake of the recent credit crisis and accompanying government intervention to
assist financial institutions—as a result, the Troubled Asset Relief Program (“TARP”)
was born. Passed into law as part of the Emergency Economic Stabilization Act of
2008 and subsequently modified by The American Recovery and Reinvestment Act,
TARP once again mandated the use of clawbacks.


Overall, clawbacks under TARP have a narrower application than their SOX
counterpart, as relatively few public companies received federal “bailout” funds
subject to TARP’s restrictions. However, the TARP clawback, in the abstract, is a
much more viable compensation recovery tool. Where the SOX clawback is limited
to just the CEO and CFO, the TARP clawback applies to a significantly larger group of
senior executive officers and highly compensated employees. In addition, the TARP
clawback requires no misconduct on the part of the executive to trigger the
executive’s repayment obligation, and it also does not require a formal restatement
of the company’s financial results to be triggered—the mere inaccuracy of a financial
statement or performance metric criteria is sufficient to compel clawback so long as
the executive’s compensation was based upon such inaccuracies. However like
clawbacks under SOX, there is no private right to action under TARP.




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                                   Considering Deferred Comp Instead of Clawbacks




Privately Instituted Clawbacks


Due to their various limitations, corporations in this current hostile environment
clearly cannot reasonably rely on SOX or TARP to be their sole mechanism to ensure
that the incentive compensation paid is based upon actually achieved performance
results. As amply demonstrated in Equilar’s 2009 Clawback Policy Report, the use of
clawbacks is on the rise—specifically, privately instituted clawbacks.


Privately instituted clawback provisions come in every shape and size. There is not a
“model” clawback provision currently in use. However, certain shareholder proxy
advisory firms believe the TARP clawback represents the new “best practice” in the
area.3 These firms are actively pushing non-TARP publicly held companies to adopt
privately instituted clawbacks consistent with TARP’s clawback regime.


Whether by pressure or by choice, companies have certainly opted to adopt clawback
policies in increasing numbers. Companies “that want to signal that they’re taking
their corporate governance seriously” have voluntarily embraced clawbacks,
according to Danielle Benderly, a corporate governance attorney with the
international law firm of Perkins Coie.4


No one disputes the fact that clawbacks represent good “optics.” But do clawback
policies really work? Are they really the best tool a corporation has available to it to
ensure that the incentive compensation paid is matched by actual performance?
That is extremely debatable.


Clawback Limitations


In the traditional context, clawbacks are problematic and very hard to execute for
the following reasons:


   1. The executive subject to the clawback has to have the continuing financial
       wherewithal to pay the company back—(e.g., once the bonus check has been
       cashed, spent and taxes paid, will there be assets to recover?).




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                                   Considering Deferred Comp Instead of Clawbacks




   2. State creditor and wage protection issues may come into play preventing
       enforcement of the clawback (e.g., state wage payment laws may prohibit
       enforcement in certain circumstances and creditor/bankruptcy laws may
       protect the assets of the executive if the executive is or becomes insolvent).
   3. Significant cost of enforcement (i.e., typically, enforced by a lawsuit).


The extensive costs and difficulties of enforcing a clawback provision present a
significant dilemma for most companies.


Moreover, clawbacks, without a doubt, create uncertainty for the executives subject
to them. Companies should consider whether the usage of clawbacks undermines
the reason for the use of incentive compensation in the first place—to Retain, Recruit
and Reward.


An executive subject to a clawback policy might reasonably question, “When can I
rely on my bonus?” and “How risky is it for me to spend my bonus?” Using
clawbacks, there really are no good answers to these questions—spending bonus
cash is increasingly becoming a risky endeavor. Consequently, executives are
advised by New York attorney, Liam O’Brien, to “Be mindful of the fact you could be
obliged to repay some portion of the bonus and treat the money accordingly. Don’t
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squander it...”


Consider a Different Approach


Given the limitations associated with the use of clawbacks, it seems that clawbacks
represent a better optical solution than a practical one. Since businesses expect
practical solutions, a possible answer to the clawback dilemma may lie in the
nonqualified deferred compensation (“NQDC”) arena.


Subject to appropriate vesting and adjustment, NQDC can serve as a superior
alternative to traditional clawback policies: an alternative that can achieve the
objective of clawback provisions—recovery of unearned monies—but without the
difficulty and costs of collection and without continuously subjecting the company’s
executives to anxiety over the use of their incentive compensation.




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                                   Considering Deferred Comp Instead of Clawbacks




Solving the Clawback Dilemma—Nonqualified Deferred Compensation


         So what would a NQDC solution look like and what would a company need to
do to embrace this alternative to clawbacks? The first step would be for the
company to create a NQDC plan or determine that an existing NQDC plan can be
utilized for this purpose.


In lieu of making an annual bonus payment, a mandatory company contribution
would be made to the NQDC plan for the benefit of the executive. No assets would
be transferred, and the contribution would remain subject to the claims of the
company’s creditors in the event of the company’s bankruptcy or insolvency. Each
individual executive would simply receive a credit to his or her deferral account
based upon the achievement of predetermined individual and/or company
performance metrics. No company contribution would be made if no performance
metrics were met. As a practical matter, the way the annual company contribution is
calculated need be no different than the way the company calculates its existing
bonus payments.


         The NQDC plan would provide that each annual company contribution would
be subject to vesting and adjustment of unvested amounts. This is necessary to
ensure alignment between actually achieved performance metrics and the incentive
compensation amount. And let’s be clear about the motivation here—the
recalculation of unvested amounts is not about taking money away from executives
or punishing them—it’s about whether the incentive compensation was in fact fairly
earned and correctly calculated.


Essentially, the company is creating a mandatory holding period to guard against the
possibility that the executive’s incentive compensation was miscalculated as a result
of an incorrect financial statement or other comparable problem. The predetermined
vesting period would be for a set period of time which the company identifies as
adequate to judge whether the performance metrics upon which the executive’s
incentive compensation was based have actually been met. For most companies, a




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3- to 5-year cliff vesting period for each year’s contribution would be more than
adequate.


If during the vesting period, it is determined that a performance metric was not
achieved to the extent previously thought (i.e., downward financial restatement), the
NQDC plan’s “adjustment” provision would be triggered. The executive’s deferral
account balance for the year the performance metric was not achieved (or
underachieved) would be reduced to match the actual, achieved results. Since no
funds have been paid or become fully vested, the costs, difficulties and hassles
associated with enforcing a traditional clawback should not be present.


After the expiration of the vesting period, the company contribution would be fully
vested and not subject to adjustment. Each annual contribution would be subject to
the same vesting period. As a result, after the first company contribution becomes
vested, the executive could annually receive a cash distribution—just like they would
if the company directly distributed an annual bonus—but with the added benefit of
knowing that the distribution they receive is unconditionally and irrevocably theirs.
However, companies may also wish to consider leveraging off of their existing NQDC
plan, if possible.


In addition, since the goal is to put the company’s executives in the same economic
position they would have been in had the incentive compensation amount initially
been calculated accurately and had the bonus been immediately distributed when
declared, the NQDC plan should contain a provision designed to potentially
compensate the executive for the time value of money. This may be accomplished
by crediting the executive’s deferral account with hypothetical earnings and/or losses
on certain predetermined measurement funds (typically mutual funds) which the
executive is allowed to select among. This also may be accomplished by specifying
an annual crediting rate. However, gains and or losses would need to be refigured in
the event that the initial company contribution is adjusted during the vesting period.




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                                  Considering Deferred Comp Instead of Clawbacks




Corporate Governance Experts Recommended


Deferred compensation not only represents the most practical approach to dealing
with the clawback dilemma—it is also a recommended one from a corporate
governance standpoint. In fact, there is broad international support for this model.
The G-20’s Task Force on Executive Compensation had this to say about deferred
compensation:


        “If appropriate, incentive plans may incorporate some form of bonus
        banking, deferred bonus, longer-term performance periods, or other tools to
        more closely align payouts with such risks and better measurement of true
        performance. … In appropriate circumstances, all or a portion of a bonus
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        payout can be held back in a bonus account and paid out in the future …”


In setting implementation standards for the Task Force’s recommendations, the G-
20’s Financial Stability Board (“FSB”) recently recommended that:


        “a substantial portion of variable compensation, such as 40 to 60 percent,
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        should be payable under deferral arrangements over a period of years.”


Moreover, the FSB also recommended that for:


        “the most senior management and the most highly paid employees, the
        percentage of variable compensation that is deferred should be substantially
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        higher, for instance above 60 percent.”


In addition on October 27, 2009, the Board of Governors of the Federal Reserve
System (“Board”) issued proposed guidance regarding the incentive compensation
practices at banking organizations. This proposed guidance was generally consistent
with the G-20’s position. According to the Board:


        “Incentive compensation arrangements for senior executive at LCBOs [large,
        complex banking organizations] are likely to be better balanced if they




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                                       Considering Deferred Comp Instead of Clawbacks




         involve deferral of a substantial portion of the executives’ incentive
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         compensation over a multi-year period …”




Choosing the Right Solution


As the G-20 and the Board understand, deferred compensation has a significant role
to play in ensuring that your company’s executive compensation practices properly
account for risk and appropriately align compensation paid with performance metrics
actually (rather than merely temporarily) achieved. Traditional clawbacks may
continue to have a role to play. However, if the choice needs be made between an
“optical” solution such as clawbacks and a practical solution, companies should
strongly consider embracing the practical option—NQDC.




This white paper is for information purposes only; it is not intended as an offer or solicitation
for the purchase or sale of any financial instrument and is not intended to present an opinion
on legal, tax, accounting or investment matters.




Notes:
1
  Equilar Inc. 2009 Clawback Policy Report. 2009.
2
  Id.
3
  Gibson, Dunn & Crutcher, LLP. Considerations for Public Company Directors in the Current
Environment. 15 Oct. 2009.
4
  Aguilar, Melissa Klein. “More Companies Opt for Clawback Clauses.” Compliance Week. 24
June 2008.
5
  Leondis, Alexis, and Margaret Collins. “Spending Bonus Cash Becomes Risky as Clawback
Rules Increase.” Business Week 8 Jan. 2010.
6
  The Conference Board Inc. The Report of the Conference Board Task Force on Executive
Compensation. 2009.
7
  The Group of 20 Financial Stability Board. FSB Principles for Sound Compensation Practices:
Implementation Standards. 25 Sept. 2009.
8
  Id.
9
  Federal Reserve System. Proposed Guidance on Sound Incentive Compensation Policies.
Fed. Reg. Vol. 74, No. 206. 27 Oct. 2009.




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                                  Considering Deferred Comp Instead of Clawbacks




About The Technical Resource Group:

Consisting of professionals with backgrounds in law, tax and accounting, Clark
Consulting’s Technical Resource Group provides technical consulting services to Clark
Consulting’s clients, their legal counsel and other advisors, regarding the design,
implementation, informal funding and ongoing administration of nonqualified plans.
The Technical Resource Group also provides Clark Consulting’s clients and their
associates with periodic updates on legislative and regulatory developments, industry
issues and trends.

The Technical Resource Group

Scot I. Billeaudeau, J.D., LLM (Tax)          Robert W. Kaufman, J.D.
Karen Boney, J.D.                             Mark Keerbs, J.D.
Marge Hyde, CPA                               Troy M. Miller, J.D., LLM (Tax)
                                              Becky Pressgrove, CPA



About Clark Consulting, LLC:

Clark Consulting, LLC, headquartered in Dallas, is an AEGON company. AEGON N.V.
is an international life insurance, pension and investment group based in The Hague,
The Netherlands, with businesses in over twenty markets in the Americas, Europe
and Asia.

Clark Consulting is a leading source of strategic financing solutions such as bank-
owned life insurance (BOLI) and corporate-owned life insurance (COLI) for
inefficiently funded and unfunded liabilities that result from executive and employee
benefit programs.

Since 1967, Clark Consulting has helped place thousands of benefit plans and serves
as the record keeper for billions in assets for leading American corporations and
banks.

Securities products and services are offered through Clark Securities, Inc., DBA
CCFS, Inc., in Texas: 2100 Ross Avenue, Suite 2200, Dallas, TX 75201-7906. Phone:
800.999.3125. Member FINRA and SIPC.




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