In competitive business environments and industries, it is becoming increasingly common for employers to incentivise their employees by offering additional remuneration in return for good performance and achievement of targets. Such “variable pay” can take various different forms, including cash bonuses, commission or profit share, and awards under long-term incentive plans (LTIPs) (for example share options, restricted shares or phantom options or shares).
LTIPs, by definition, effectively “lock in“ employees by measuring performance over time, so that awards will only vest or become exercisable once specific performance targets and conditions have been met. However, other forms of variable pay are not retained or withheld for such lengthy periods. This is to ensure performance is as good as initially thought and that there are no nasty surprises. In some cases, variable pay is not only awarded on retrospective performance but by way of forward payment (for example signing–on bonuses or awards made before performance has been verified and accounts audited).
While variable pay can be highly useful in motivating employees, it can sometimes pose a significant risk to businesses. This is particularly the case where awards are made as forward payments or where the employer includes insufficiently robust performance conditions and other protections.
The shareholders of the London-based PR giant, Bell Pottinger, are all too familiar with variable pay representing a risk. Bell Pottinger went into administration in 2017 following an exodus of clients after its embroilment in a political scandal in South Africa. It subsequently became apparent to the administrators at BDO that partners had received substantial payments before it was placed into administration. The variable pay here amounted to a forward payment of profit drawings in respect of anticipated profits (which, of course, never materialised). With a view to recouping the excessive profit drawings paid to partners in order to settle outstanding debts with creditors, BDO found itself seeking to rely on clawback provisions.
A clawback provision can be viewed as an “insurance policy“ for businesses, often found within contracts of employment or ancillary documentation (such as contractual bonus schemes or LTIP rules and award agreements). A clawback provision amounts to a contractual agreement between the employer and the employee, which requires the employee on the occurrence of a specified event (or events) to return an amount of their variable pay. This can be because either the performance of the business is later found to be not as good as initially reported, or because the participant has committed some kind of misconduct which is uncovered after vesting.
Clawback provisions can be contrasted with malus provisions. This is where all or part of a variable pay award is kept in escrow for a period of time and can be retrospectively reduced in cases where it is subsequently discovered the employee‘s performance is not as good as initially reported or the employee is guilty of misconduct.
A clawback provision can be used in respect of any employment relationship. The UK does, however, have two specified regimes which require a clawback provision to be enforced by businesses in a specified manner.
The first regime is applicable to financial institutions regulated by the Financial Conduct Authority (FCA) or the Prudential Regulation Authority (PRA). These impose rules requiring regulated financial institutions to ensure that any variable pay awards are subject to deferral, malus and clawback provisions. Specifically, in relation to clawback, variable pay awards made to material risk takers (that is, those individuals who might have a material impact on the risk profile as a result of their role or activities) can be clawed back for a minimum period of seven years after the variable pay was made. The requirement also extends to senior managers for a period of ten years. If required, a clawback can be made provided there is reasonable evidence of misbehavior or material error, or the financial institution suffers a material failure of risk management.
The second regime relates to listed companies, which are subject to the UK Corporate Governance Code. This requires that clawback and malus provisions are contained within any incentive schemes for executive directors. The Code imposes a “comply or explain” requirement on listed companies. The Investment Association’s principles of remuneration also state that share plans should include malus and clawback provisions. The Financial Reporting Council (FRC), which sets the Code, has indicated that most FTSE 350 companies have put in place malus and clawback arrangements to enable them to withhold or recover variable pay.
While the use of clawback provisions has become more widespread, they remain one of an employer’s options of last resort. Clawback provisions are often considered draconian and so may be drafted only to apply in cases where there has been serious misconduct by an employee or the business has suffered significant underperformance. Employers may also face both legal and practical challenges in recovering awards once they have been paid.
Clawback provisions need to be carefully drafted to maximise the likelihood that they are enforceable. The employer will have to take into account the following considerations:
- The employee must have clearly consented to the clawback provision. A court will take into account the unequal bargaining power in the employment relationship when determining this.
- The clawback provision must be enforceable either by way of statute or under the terms of the employment contract (or ancillary documentation) to comply with section 15(1) of the Employment Rights Act 1996. This provides that an employer cannot receive payment from a worker employed by them unless the payment is required or authorised by statute or a relevant provision of the worker’s contract, or the worker has previously signified in writing his or her agreement or consent to the making of the payment.
- The clawback provision must also be reasonable and not amount to a penalty clause (that is, a contractual provision which levies an excessive monetary sum unrelated to the actual harm caused, rather than a genuine pre-estimate of loss).
The drafting of the clawback provision is therefore fundamental to its enforceability. In contrast to Bell Pottinger, administrators of Patisserie Valerie, which collapsed in early 2019, found themselves unable to recover profits paid to directors in the form of share options awarded under an LTIP. This was due to the employer’s failure to include clawback provisions in the LTIP.
Thomas Cook further highlights the difficulty in invoking a clawback provision. Directors of the travel firm were reportedly paid £35m in the 12 years prior to 23 September 2019, and are at present facing scrutiny from the Business, Energy and Industrial Strategy Committee over their management of the business. It is thought, however, that any recovery of profits will be hampered due to the clawback provision contained in the director’s service agreements being limited to a period of two years.
As seen with Bell Pottinger, clawback provisions can act as useful insurance policies for businesses, helping them to recover profits when things go wrong, whereas the Patisserie Valerie case shows the problems that can arise where no clawback provisions are included in variable pay agreements. Thomas Cook highlights the difficulties employers face when clawback provisions are inadequately drafted.
To ensure proper protection, in addition to clawback provisions, employers should ensure variable pay agreements include clear and robust performance conditions, allow for use of discretion where appropriate and include suitable deferral and malus provisions.