What is a clawback?
– A clawback is a contract term that lets an employer, fund, or government reclaim money already paid out. It most often applies to incentive-based pay (bonuses, stock awards, carried interest) and can require repayment plus an extra amount (a penalty) in specified situations.
Key concepts (short definitions)
– Incentive-based compensation: pay tied to performance targets or company results (bonuses, equity awards).
– Restatement: a company’s correction of previously issued financial statements because the original statements were incorrect.
– Carried interest: the share of profits (usually for general partners) in private equity or investment funds.
– Clawback trigger: the event that permits recovery (e.g., fraud, accounting restatement, later losses, Medicaid estate recovery).
Why companies use clawbacks
– Recover pay based on faulty or misreported results.
– Deter misconduct or manipulation of performance metrics.
– Re-align pay with long-term outcomes (especially after major losses).
– Meet legal or listing requirements from regulators and exchanges.
Regulatory and market background (high level)
– Clawback provisions have become much more common since the 2008 financial crisis as part of efforts to strengthen corporate governance and accountability. Usage rose sharply among large public companies over the 2000s–2020s.
– Several U.S. laws and rules address recovery of executive pay:
– Sarbanes–Oxley (2002) created rules to recoup bonuses from CEOs/CFOs in limited circumstances.
– TARP-related rules (after 2008) required recovery of some incentive pay for bailout recipients.
– Dodd–Frank (2010) mandated policies for recovering pay tied to restatements.
– The U.S. securities regulator later finalized listing standards to help ensure companies adopt clawback policies tied to erroneous awards.
Common settings where clawbacks appear
– Executive compensation: Companies often include recovery clauses to reclaim bonuses or equity that were based on misstated earnings or misconduct.
– Private equity funds: Limited partners may require a provision that forces general partners to return carried interest if later fund losses show the GP was overpaid when profits were first distributed. Clawbacks are typically calculated at fund liquidation.
– Medicaid / government: State Medicaid programs can recover certain long-term care costs from the estates of deceased beneficiaries; federal rules require recovery in some cases (commonly for beneficiaries age 55+), with hardship exceptions in some states.
– Legal discovery: “Clawback” can refer to returning privileged documents that were accidentally produced during discovery.
– Markets: Informally, the term is used when a stock gives back part of a prior gain (a price pullback).
How clawbacks are typically structured
– Written provision in an employment contract, plan document, or fund agreement. Verbal promises are generally not sufficient.
– A defined trigger event (
– A defined trigger event (e.g., financial-statement restatement, proven misconduct or fraud, material breach of covenants, bankruptcy or insolvency, regulatory sanction, or a specific time/event such as fund liquidation). The trigger should be as objective as possible to reduce disputes.
– A clear formula for calculating the amount to be returned. Common approaches:
– Gross-return clawback: repay the full previously distributed amount tied to the trigger.
– Net-return clawback: repay only to the extent prior distributions exceed what would have been due under the final, correct accounting (typical in private equity carried-interest clams). In formula form:
Clawback = max(0, Prior_Distributions_to_Recipient − Final_Amount_Due_to_Recipient)
– Pro rata or tiered adjustments when partial faults or time-based vesting apply.
– Timing and procedure for repayment: specify when repayment must occur (e.g., within X days of final determination), whether installment plans are allowed, and any acceleration if the recipient becomes insolvent.
– Enforcement mechanics: set dispute resolution (arbitration or court), remedies for non‑payment (offset against future compensation, liens, withholding from other amounts due), and whether indemnities or security (escrow, letters of credit) are required.
– Limitations and defenses: statute-of-limitations windows, materiality thresholds (minimum dollar or percentage), good‑faith exceptions, and clawback caps tied to amounts actually received (no “double jeopardy”).
– Tax and accounting treatment: state which party bears tax adjustments if prior distributions were taxed when received. Note: tax treatment can be complex and jurisdiction‑specific—consult tax counsel.
– Integration with other documents: require consistency with employment agreements, plan documents, fund limited partnership agreements, and corporate governance policies.
Practical checklist for drafting or evaluating a clawback (use before signing)
1. Identify the precise trigger(s) and who makes the determination (independent committee, auditor, court).
2. Specify the calculation method and provide a numeric example in the agreement.
3. Define the repayment timetable and permissible payment methods (cash, setoff, escrow draw).
4. State remedies for non‑payment and dispute-resolution steps.
5. Include limitations: lookback period, materiality floor, and caps.
6. Address tax consequences and require recipient cooperation for tax filings.
7. Decide on security: escrow, holdbacks, or guarantees.
8. Ensure consistency across all related documents (equity awards, bonus plans, LPAs).
9. Build in audit and forensic procedures to detect triggers promptly.
10. Review local law (employment, insolvency, tax) for enforceability constraints.
Worked numeric example — private equity carry clawback (simple)
Assumptions: