Viewpoint August 13, 2010, 2:59PM EST

Making Sense of Clawbacks and Holdbacks

Here's a broad but flexible approach to holding senior managers accountable to the corporate mission: the fusion of high performance with high integrity

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The "clawback" of pay from high-level executives for malfeasance is a hot but complex topic. Designed properly, such a practice can be an important mechanism for corporate accountability.

The Dodd-Frank bill, passed last month, mandated that any company listed on a U.S. securities exchange have substantive clawback requirements if it has material financial restatements. Also in July, the European Parliament passed legislation requiring clawbacks, and the U.K.'s Financial Services Authority revised a proposed rule on remuneration, effective next January, which has a new provision that will define clawbacks. Prior to these regulatory developments, 212 companies in the S&P 500 had adopted a variety of clawback policies, but hundreds of other public companies still don't have such compensation recovery policies as required by Dodd-Frank.

For public companies that must design, or redesign, a program: many questions still persist. These include:

• Who is covered?

• What is the triggering event of corporate malfeasance or nonperformance?

• What types of compensation should be recovered?

• Is the period during which recovery can be sought limited?

• Does the board have discretion in seeking recoupment?

• What is the forum for resolving such issues?

• Is a "holdback" (cancelling unvested benefits) better than a clawback?

As companies revise or adopt clawback policies—whether voluntarily or because they are required to do so—these questions and others will be reexamined and policies reformulated. More basic questions, however, must first be addressed: What is the mission of the corporation, how is corporate action evaluated according to that mission, and in that context, what is the philosophy of executive compensation?

I believe that four such "first" principles should guide a clawback policy that companies adopt voluntarily. (For more detail, see "Restoring Trust in Corporate Governance: The Six Essential Tasks of Boards of Directors and BusinessLeaders,")

• The mission of the company is to create durable value for shareholders and other stakeholders through sustained economic performance, sound risk management, and high integrity. The most basic purpose of the corporation is for leaders to find a sound balance between risk taking (innovation and creativity) and risk management (financial and operational discipline) and then to fuse that high performance with high integrity (commitment and adherence to law, ethics, and values).

• The job description of the CEO—and executive training inside the corporation—must flow from this mission and be built on these integrated essentials of performance, risk, and integrity—and on a culture in which all are honored and exemplified. In choosing a CEO—and approving training and promotion of senior executives—the board must explicitly carry out this fundamental mission in its most important function: naming top-level business leaders.

• Companies must carefully articulate operational measurements for the three critical dimensions of performance, risk, and integrity. These metrics should express the near-, medium-, and long-term corporate goals in both financial and nonfinancial terms. They should represent clear steps that create sustainable value for shareholders and other stakeholders, such as employees and customers, essential to the company's health. They should not only guide internal action but also be expressed in a public and transparent way so that external constituencies can assess accountability against clear standards.