Do your malus and clawback provisions need updating?
Malus and clawback provisions in incentive plans were originally introduced for financial institutions, mainly in response to the financial crash in 2008. However, they have now become common for LTIPs and executive bonuses in all sectors. They originally applied in very limited circumstances, such as misstatement of financial results or gross misconduct by the participant, but the range of events which trigger these provisions has been gradually expanding.
Meaning of Malus and Clawback
The term “malus” (except in the context of gardening) has become used broadly as an opposite to “bonus”. It refers to the downward adjustment of incentive awards before they become payable – or before they vest or become exercisable in the case of LTIP awards or share options.
In contrast, “clawback” means that participants are required to pay back all or some of an amount they have already received, for example the shares transferred on vesting of an LTIP award.
Certain companies regulated by the FCA or PRA are required to include provisions which make variable remuneration awarded to material risk takers subject to clawback.
The July 2018 version of the UK Corporate Governance Code, which applies to all companies with a premium listing, states (paragraph 37) that “Remuneration schemes …… should also include provisions that would enable the company to recover and/or withhold sums or share awards and specify the circumstances in which it would be appropriate to do so”.
The November 2018 Investment Association (IA) Principles of Remuneration (section 4) require remuneration structures to “include provisions that in specific circumstances, allow the company to:
• Forfeit all or part of a bonus or long-term incentive award before it has vested and been paid (‘performance adjustment’ or ‘malus’); and/or
• Recover sums already paid (‘clawback’)”.
Directors’ remuneration reports must set out the company’s policy on malus and clawback and, of course, the actual provisions need to comply with that policy.
The relevant regulations do not spell out the circumstances in which malus and clawback provisions should apply. The most common triggers used by companies are:
• material misstatement of the company’s results; and
• gross misconduct by the participant.
The IA now states that “remuneration committees should establish a more substantial list of specific circumstances in which the malus and clawback provisions could be used”.
In practice, the additional reasons differ depending on the companies’ sectors and individual circumstances. The ones which we see most often are:
• material error in the information on which the size of awards or the extent of achievement of performance conditions was based;
• material corporate failure;
• material risk management failure;
• serious reputational damage or material loss caused by the participant’s actions; and
• material contravention by the participant of a company’s ethics and values.
How clawback works
Malus provisions are relatively easy to implement because no amount has been paid to the participants, and so the size or nature of the existing awards can be adjusted.
In the case of clawback, however, amounts need to be recovered from participants. For those who remain employed, this may be done by reducing other amounts due to them, for example by reducing future bonus payments or the size of unvested LTIP awards. If the participant has been dismissed, it may be very difficult in practice to recover anything. Moreover, the participant must give written consent to any deductions from wages. For these reasons, it is advisable to require employees specifically to agree to the malus and clawback provisions in writing at the time when an award is first granted.
Where an amount is clawed back, it may not be possible for a participant to recover tax from HMRC for the repayment – there is still uncertainty about the tax law in this area. Many companies therefore only seek to recover the net of tax benefit received by the participants.
Period of clawback
UK financial institutions are required to make variable remuneration awarded to material risk takers subject to clawback for a minimum of seven years from the date of the award, or 10 years for certain senior managers.
For other companies, the period varies considerably. Some companies do not express a time limit, which may lead to a successful challenge based on proportionality. Where a time limit is stated, clawback periods vary significantly from three years after the original grant date of an award up to five years after an award has vested or become exercisable.
Many LTIPs now provide for a two-year period after the vesting date, during which the participant is obliged to continue to hold the shares acquired, at least the net number after deducting any exercise price or tax liability. For many companies, it would be convenient for the potential clawback period to coincide with the holding period, as implementing clawback would be made relatively easier. However, in others it may take many years for true financial performance to become certain, and in these cases the clawback period should be rather longer.
Companies should ensure that malus and clawback policies, including principles behind the use of discretion, are clearly documented. The IA Principles also state:
“It is also very important that the documentation for the LTIP and bonus rules, the remuneration policy and employee contracts are all consistent. Any communication around the payment of bonuses or LTIPs should also be consistent with and not contradict the malus and clawback provisions. Remuneration committees should develop clear processes for assessing executives against either malus and clawback criteria or how they will exercise discretionary clawback. Demonstration of process and evidence of decision-making is very important in the event that clawback is contested.”
We recommend that companies should review their current malus and clawback arrangements to ensure that they are fair and consistent and are clearly communicated to the participants potentially affected by them.
For further information contact Michael Landon.