Recent (and not-so-recent) federal efforts are increasing scrutiny on corporate compensation and clawback policies. A trio of authors from Shearman & Sterling explore how companies can use incentive compensation to further their compliance goals.
Katherine Stoller, Melisa Brower and Daniella Villatoro co-authored this article.
Recent years have seen federal agencies like the DOJ and SEC intensify efforts to integrate compliance into corporate compensation structures, with the DOJ’s compensation pilot program incentivizing compliance and rewarding firms that have policies permitting recovery of incentive compensation in the event of employee misconduct. This focus on compensation and individual accountability was further underlined in a McDonald’s shareholder lawsuit.
Companies have historically had the ability to adopt their own clawback policies, but details of such programs vary from company to company.
Review regulatory approaches to clawbacks of incentive-based compensation as an accountability tool, explore what public companies are doing today with respect to clawback policies, misconduct clawback triggers and compliance-promoting incentives and understand how companies should consider adopting compensation programs that incentivize a culture of compliance.
Current regulatory and enforcement landscape
In March 2023 the DOJ announced the launch of a compensation pilot program. Focused on tying employee compensation to compliance, the program is meant to “prevent corporate crime before it occurs,” and to “deter criminal conduct [and] incentivize the development and implementation of effective compliance programs.”
This three-year pilot program requires companies that enter into criminal resolutions to implement compliance-related performance criteria in their incentive compensation system, which may include (without limitation) a prohibition on bonuses for employees who fail to satisfy compliance performance requirements, as well as disciplinary measures for (a) employees who violate applicable law or (b) those who had (i) supervisory authority over the employee(s) or business area that engaged in the misconduct and (ii) knew of, or were willfully blind to, the misconduct. Under the pilot program, if a company fully cooperates, remediates and adopts or operates a program to recoup compensation, the DOJ may reduce fines for companies that seek to recoup compensation from employees who engaged in wrongdoing connected to the conduct under investigation. Specifically, the DOJ may reduce fines by up to 100% of the compensation recouped during the period of the resolution or 25% for companies that seek to recoup compensation in good faith (even if ultimately unsuccessful).
The ability to claw back incentive compensation is not a new area of focus for federal authorities. Since the enactment of the Dodd-Frank Act in 2009 and the SEC’s proposed rules implementing Section 954 of the Dodd-Frank Act in 2015, the commission has been focused on the importance of clawback policies as a tool to recoup compensation erroneously paid to so-called “covered individuals.” The DOJ goes a step further than the SEC by rewarding companies for seeking to claw back incentive compensation paid to employees who have engaged in wrongdoing. There may also be additional incentive compensation regulations on the horizon: the SEC’s fall 2023 regulatory agenda indicates that the commission intends to reopen the comment period on a 2011 proposed rule under Section 956 of the Dodd-Frank Act that would prohibit incentive-based compensation arrangements for individuals identified as material risk takers at certain qualifying financial institutions.
Further, it is not just the DOJ and SEC that are pressing for individual accountability. In a 2023 Delaware stockholder derivative suit against a former McDonald’s executive, the Delaware Chancery Court found him personally responsible for breaching his oversight duties by “consciously ignoring” warning signs pointing to pervasive misconduct.
What are companies doing today?
To understand how public companies are linking compliance with incentive compensation, we surveyed executive compensation disclosure and equity plans of 100 of the largest U.S. public companies. Proxy disclosures for fiscal year 2022 showed that 22 of the top 100, primarily in the financial services and manufacturing industries, state in their compensation discussion and analysis disclosures that compliance is one of the performance metrics in a company’s executive annual bonus or long-term incentive plan.
For companies in the financial services sector, the compliance metric most often included in incentive compensation plans relates to establishing and maintaining risk controls related to compliance with applicable financial regulations. Conversely, companies in the manufacturing sector that included compliance metrics in their incentive compensation plan typically focused on compliance with safety regulations.
Individual performance metrics related to compliance are mainly included in incentive programs for C-suite level compliance and legal roles. Among the top 100 companies, 18 expressly include compliance or compliance-related metrics in the menu of performance metrics from which a compensation committee or plan administrator may draw to design performance-based equity awards under their equity plans. Other plans are designed to allow plan administrators discretion to choose any performance-based metric, rather than picking from a finite list.
Most listed companies have adopted Dodd-Frank-compliant clawback policy as of the Dec. 1, 2023 deadline. Although the final SEC clawback rule does not require companies to have recoupment levers in the event of individual misconduct or fraud, proxy disclosure filed by the top 100 with respect to the 2022 fiscal year indicated that 82 of them have a clawback policy that authorizes recoupment in the event of individual fraud or misconduct without a financial restatement. Additionally, while the companies’ proxy disclosure with respect to the 2022 fiscal year reflected that 93 companies have a clawback policy that would require compensation to be recouped in the event of a financial restatement, 49 require fraud or misconduct related to the financial restatement, whereas 44 do not.
What’s right for your company?
In light of enhanced enforcement engagement around individual accountability, companies should assess whether compensation programs are appropriately designed to incentivize corporate compliance and provide companies with the mechanisms to hold employees accountable in the event of a compliance breach.
Identify your need
To ensure your company is positioned to mitigate against DOJ sanctions in the event of a compliance breach, companies should assess employment contracts, clawback policies and incentive compensation programs to see if there are any gaps between current practices and the circumstances that may arise under the pilot program. Adding compliance as a performance metric in an annual incentive program or ensuring that discretionary clawback policies include both direct and indirect misconduct triggers (i.e., failure to supervise), can increase a company’s likelihood of recognizing all benefits under the program. It can also empower leaders who are not directly responsible for compliance to ensure proper oversight and sufficient resources are allocated to avoiding and detecting compliance breaches or misconduct. Below are a list of items for companies to consider when assessing whether changes are needed to a company’s compensation program:
- Who is responsible for directly and indirectly overseeing the compliance function?
- Do those overseeing compliance have sufficient expertise?
- Are there appropriate internal controls for identifying compliance breaches and levers to hold responsible parties accountable?
- How is compensation tied to compliance, not only in the compliance function but also in other functions?
- Is there a greater need for cross-company collaboration regarding compliance oversight?
- Has your Dodd-Frank clawback policy been approved by your board and filed as an exhibit on your company’s 2023 Form 10-K?
- Do you have a misconduct-based clawback policy that is not tied or connected to a financial statement error?
- Does your board agenda include sufficient updates and discussion about corporate compliance and internal controls and is the person tasked with facilitating that discussion from management the right person?
- Has the compensation committee of your board been briefed about the compensation pilot program?
- Has your company had a compliance breach before that has triggered DOJ scrutiny?
Address your need
Compliance risk management is intersectional and must be managed from the top down. For companies with a dedicated chief compliance officer (CCO), it may be necessary for a board committee or manager responsible for setting compensation to ensure that the CCO and their team have compensation incentives that are sufficiently tied to ensuring corporate compliance. It may also be appropriate to analyze whether the CEO and other members of senior leadership should have a portion of their compensation tied to compliance.
Companies should consider whether the board or board committees, such as the audit committee, risk committee or compensation committee, should be briefed on the compensation pilot program and the benefits to the company of tying compensation to compliance.
Regarding clawback policies, by now listed companies should have adopted a clawback policy that complies with the final SEC clawback rule and listing exchange clawback rules. Companies may also consider reviewing any additional clawback policies that they have (whether as standalone policies or recoupment provisions in agreements with employees) to determine whether they have methods to reclaim compensation previously paid to employees, whether the policies include conduct-related triggers in the event of a compliance breach, and whether such recoupment mechanism covers a majority of the workforce. Be mindful that having a clawback policy alone without individual contractual commitments may present enforcement challenges in the event of criminal resolutions. Companies should consider having their executive officers and management execute contracts that acknowledge their compensation is at risk and may be subject to forfeiture or recoupment if there is a triggering event under the clawback policy.
When entering into new employment agreements or making an equity grant, companies may also wish to review termination triggers (including the definition of “cause”) to see whether the contract addresses failure to supervise. Be mindful that changes to compensatory arrangements and clawback policies applicable to named executive officers will be reflected in proxy disclosure and, depending on the change and who is impacted, may necessitate filing a Form 8-K.
Monitor your need
The SEC clawback rule and compensation pilot program are new initiatives. Companies should monitor how peers are implementing their SEC clawback policies and whether companies decide to modify their discretionary clawback policies to enhance conduct-related clawback triggers (including clawback triggers that are not connected to a financial restatement). Companies should also monitor how the pilot program is implemented to see if particular industries are impacted more than others, and the status of proposed SEC regulations on executive compensation at financial institutions, to see whether further changes are appropriate. Finally, companies should continue to ensure compensation committees are briefed on market trends around implementing compliance-promoting compensation metrics in incentive compensation programs.
Conclusion
Compensation can be an effective tool to drive management performance. Both Congress and the DOJ have signaled an intent to use incentive compensation, along with the threat of clawback, as a way to encourage companies to prioritize compliance and hold individual executives accountable for misconduct and reduce the impact on shareholders. Although the pilot program is in its early stages and not immune to challenge, establishment of the program signals greater focus by the DOJ on using compensation as both an incentive and means to hold individual employees accountable for wrongdoing in the event of a compliance breach. (There is a risk that U.S. state and international employment laws may prohibit lawsuits seeking clawbacks of compensation that is determined to be earned wages.)
Companies must ensure they are well positioned to comply with new rules surrounding SEC clawbacks, but also to ensure their incentive compensation and recoupment programs will fit the company’s needs. Proactively laying the foundation now to be able to mitigate against potential future liability is prudent and, increasingly, expected by enforcement agencies. Closely monitoring enforcement priorities, engaging in frequent assessments of internal controls surrounding compensation and compliance and ensuring appropriate policies are in place to hold wrongdoers accountable are ways in which companies can stay current on whether such systems are adequately addressing a company’s needs.
