Making Sense of Clawbacks and Holdbacks

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4. The act of malfeasance that can lead to a holdback or clawback should be far broader than a material misstatement of financials (which is the focus both of some existing corporate policies and of the recently passed Dodd-Frank legislation).

5. Acts of omission by an individual can trigger discipline—as well as actual intent or gross negligence (recklessness). For example, senior business leaders can, especially when they have negligently or recklessly failed to create proper culture, be held responsible for problems in their units. Given the range of possible acts and the variety of standards (and circumstances) that could trigger clawbacks or holdbacks, greater sanctions (termination) or lesser ones (demotion, being denied promotion) may be appropriate, either in concert with or instead of clawbacks and holdbacks.

6. In The Squam Lake Report (Princeton University Press 2010), 15 leading economists suggest a "collective" holdback for senior managers that would be forfeited in the event of bankruptcy or receipt of extraordinary government assistance. This provides incentives for the management team to prevent outsize and potentially catastrophic risk.

7. The inevitable, real-world variation in possible circumstances supports giving the board discretion to find the facts and make appropriate individual holdback or clawback determinations (with advice and counsel of management when it is not implicated).

8. This discretion should be applied to the appropriate amount of damages—how much unvested variable cash or equity or other long-term awards should be held back; how much vested variable cash and equity and other long-term awards should be clawed back.

9. The board should also have the discretion to determine the time when sanctions may be sought. Obviously, a holdback can occur any time when future benefits have not vested. But there is no reason to set a limit on the time for clawbacks of vested benefits, because discovery and disclosure of corporate malfeasance can be delayed. (Once there has been discovery, there should, however, be a specific time limit during which a clawback action must be brought.)

I believe that this type of broad, flexible holdback/clawback approach is a powerful mechanism for holding senior leadership accountable to the fundamental mission of the corporation: proper risk taking balanced with proper risk management and the robust fusion of high performance with high integrity. It is not a tail that wags the dog, but instead a systematic follow-on of the interrelated tasks of defining the corporate mission, CEO job specs and senior management training, appropriate operational objectives across performance, risk, and integrity dimensions, and executive compensation that promotes long-term growth and sustainability and rewards balanced senior leadership.

This voluntary approach to holdbacks/clawbacks is, in general, broader than many current voluntary corporate clawback policies and follows more clearly from necessary revisions in executive compensation that have emerged since the financial crisis of 2008 and that focus on deferral of a significant percentage of annual pay, on more intense consideration of risk, and on more detailed performance objectives (beyond stock price and total shareholder return).

Such broad, flexible, circumstance-based holdbacks/clawbacks do, however, require that government mandates be accommodated within a corporation's voluntary approach. For example, Dodd-Frank (Section 954) is narrower than the approach described above (it applies only to financial restatements due to "material noncompliance"); removes discretion from the board (recovery must be sought); does not require fault of individuals from whom monies are clawed back (both present and past employees); specifies and limits those individuals ("executive officers"); and, in general terms, specifies the amount of recovery (the percentage of incentive compensation, including equity awards, in excess of what would have been paid without the restated results). (There are many ambiguities in the legislative language that will have to be clarified in implementing SEC regulations—e.g. whether it is retroactive, how to calculate recoverable amount, the dates during which the recovery must be sought.)

But because the trigger to Dodd-Frank Section 954 is a financial restatement due to material noncompliance with reporting requirements, this is just one type of malfeasance within the broad framework suggested above. In any new or revised voluntary corporate holdback/clawback policy, such restatements will have to be treated separately due to regulatory requirements. But it does not prevent the corporation from adopting the broader approach outlined here.

Such a fact-based approach, building on prior voluntary clawback policies adopted by corporations, is far superior to the rigid, procrustean legislative mandate of Dodd-Frank, if (and it's a big if) companies take designing and implementing their own policies seriously to hold business leaders accountable.

Ben W. Heineman Jr. is GE's former senior vice-president for law and public affairs and is currently a senior fellow at Harvard Law School and at Harvard's Kennedy School of Government. He is the author of the book High Performance with High Integrity (Harvard Business Press, June, 2008).

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