Executive pay clawbacks: Just a shareholder pacifier?

August 16, 2012: 9:28 AM ET

Like the prospect of criminal prosecution, clawbacks can seem less like a real threat and more like a sop to public clamor for tangible punishment.

By Elizabeth G. Olson

FORTUNE -- As much as the disgruntled investing public would like to see dodgy executives thrown in jail, they may have to settle for the slower, but still painful, method of letting corporate boards wrest cash and stock from the wrongdoers.

Once an obscure concept, the right to reclaim compensation from executives who engage in ethical or financial misdeeds is becoming enshrined in corporate practices. A robust 86.5% of Fortune 100 companies have adopted "clawback" provisions that allow them to recover cash bonuses or stock from errant executives, according to data gleaned from recent federal securities filings.

Such provisions "now have become a widely accepted corporate governance practice," says Aaron Boyd, research director at Equilar, an executive compensation tracking firm. Its new "Clawback Policy Report" found that about one-third of the Fortune 100 adopted, or modified, their clawback policies in the wake of the 2008 financial crisis.

The clawback was the first thing invoked by J.P. Morgan Chase (JPM) to fend off criticism of its $3 billion, or so, in trading losses. The bank said it would restate its earnings for the first three months of this year. Restatements are a customary trigger for retrieving top-tier executive pay.

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Like other corporations, J.P. Morgan adopted a clawback policy to discourage the practice of rich rewards for short-term gains that later evaporate. The provisions -- sometimes referred to as "If you didn't earn it, you must return it" -- typically involve serious misdeeds like accounting irregularities before triggering the right to reel back compensation.

Clawback policies could get a lot stiffer once the U.S. Securities and Exchange Commission finishes developing its rules enforcing the 2010 Dodd-Frank Wall Street reform law.

"If the draft rules stay within the four corners of the law, they will not give a great deal of leeway to corporate boards," says Patrick McGurn, special counsel at Institutional Shareholder Services, which provides proxy voting services and corporate governance research.

The SEC has used clawbacks as a weapon against corporate fraud, after a 2002 law provided that the chief executive and chief financial officer could be made to repay in cases of fraudulent filings. Earlier, such payback policies focused on deterring executives from joining rival companies.

But the Dodd-Frank legislation bars companies from being listed on public stock exchanges unless they have a policy to recoup incentive-based compensation, including stock options, for current and former executives over a three-year period. Rules implementing the law will also likely broaden the range of high-level officers who could be targeted for compensation givebacks.

Still, "most boards want latitude if the company ends up in a situation of misconduct," says Blair Jones, managing principal of Semler Brossy, an executive compensation consultancy. "But it's not a formula. Boards need to consider the facts and circumstances of any situation, and the impact on the stock price."

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Yet, it is the rare wayward corporate chieftain who actually has forked over anything to compensate shareholders -- and assuage the public. The clawback, like the prospect of criminal prosecution, can seem less like a real threat and more like a sop to public clamor for tangible punishment.

Until recently, the word clawback more likely invoked thoughts of lobsters or house cats rather than Wall Street. Corporate titans hung onto their gains. The buck stopped short of the executive suite in cases like that of former Citigroup (C) CEO Charles Prince, who kept hundreds of millions in compensation and received a $68 million departure package in the midst of the financial meltdown.

Earlier this year, Swiss banking behemoth UBS (UBS) startled the banking world when it announced that it would scoop back a portion of its 2011 investment bankers' bonuses in excess of $2 million. The bank racked up more than $1 billion in losses last year due to trading problems.

J.P. Morgan has said nothing about its CEO, Jamie Dimon, paying a price for that firm's trading debacle. The bank has said that it planned to recoup two years of compensation from executives who oversaw the hedging. Ina Drew, the former chief investment officer who resigned in May, was the only person named. She earned just under $30 million in 2011 and 2012. The bank may also seize compensation from three traders in the London office.

Companies usually do not disclose the specifics when they use clawbacks. Most settle behind closed doors rather than battle over responsibility and fault in open court.

J.P. Morgan's clawback declaration is important in that it shows "how financial service firms can use voluntary adopted compensation recovery policies to discourage bad behavior and excessive risk taking," writes Ben W. Heineman, Jr., former general counsel of General Electric, in Harvard Business Review. But the bank has yet to specify the key details of how much money individuals would lose and which type, he notes.

Companies, under more scrutiny than ever, already are expanding the executive targets they can reach, and more are including stock options in their clawback policies than ever before, according to Equilar's report.

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But what triggers the clawback option varies, with numerous companies so far continuing to require that the misconduct cause financial restatements. Only about 10% of companies demand repayment based strictly on the existence of a restatement, no matter the reason. Boeing (BA) and United Parcel Service (UPS) are among the corporate giants that have registered such policies in securities filings. However, some watchdogs are complaining that some companies are taking out insurance to safeguard executives against loss.

"That's unlikely," says Doug Friske, head of global compensation for Towers Watson consulting company. "That would be like the company taking out insurance that someone is a thief."

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