What happens when a person promises to perform and then fails to deliver on their promises? Or what happens when it is found that a performance report was flawed? In some situations like that, clawback provisions, as stated in a signed contract, come into play.
Clawback is a provision under which money that’s already been paid out must be returned to the employer or the firm. This is a special contractual clause, used mostly in financial firms, for money paid for services to be returned under special circumstances or events as stated in the contract. Clawbacks involve a penalty, making them different from simple repayments or refunds.
The primary aim of such a provision is to prevent managers from using incorrect accounting information. According to research, after the provision of clawback is included, investors develop more confidence in a firm’s financial statements.
Before 2005, clawback provisions in Fortune 100 companies were lower than 3%, but rose dramatically, to 82%, by 2010.
The provision of clawback is aimed at striking a balance between economic and community development and corporate welfare. It is mostly used in securing tax incentives, abatements, refunds, and grants.
How Do Clawbacks Work?
Let us suppose there is a big business headed by a Chief Executive Officer (CEO). The annual reports of the company show that the CEO worked hard to keep the company profitable. So, the company wants to reward his efforts and a contract is signed, stating that if the sales of the company increase by at least 10% within the next two years, then the CEO will be paid a bonus of $200,000. In the corporate financial statement, it shows that the company registered a profit of 13% in the two years and as a result, the CEO is rewarded with the promised amount.
After an audit of the company, it is found that the profits were over-reported and the profit was actually 9.5% and not 13% as stated in the previous report. In a situation like that, under the clawback provision, the company can take back the bonus amount previously paid out to the CEO. Depending on the specific clawback clause, the CEO may also have to pay a penalty because the original financial reports submitted were flawed.
Uses of Clawback Provisions
Medicaid recovery: Medicaid is allowed to recover the money paid for the healthcare of a Medicaid recipient who has died and therefore obviously no longer needs the care. All states aim to recover Medicaid money spent in advance on long-term care such as nursing homes.
Mortgage lending: Most banks use clawback provisions to recover money from unprofitable home loans.
Life insurance: In case of cancellation of a policy, a provision of clawback might require the benefits and payments previously received to be repaid.
Executive pay agreements: If there is any breach of an agreement by an executive, and he or she goes on to work for a competitor or a rival company within a certain number of months as stated in the contract, then the executive might be required to reimburse the company that previously employed them, according to the provisions of clawback.
Pensions: Pensions can be clawed back if it is found that there has been some fraudulent activity and suppression or adulteration of information.
Dividends: Under certain circumstances, such as bankruptcy, dividends can be clawed back.
Government contracts: If the contractor has failed to meet specified quality standards or if the requirements of the contract are not fulfilled, then the provision of clawback may be exercised upon the contractors.
Clawback Provisions in the Financial Recovery Act (FRA)
Clawback provisions received more attention from authorities and regulators following the Global Financial Crisis of 2008. A ruling on clawback provisions was issued as a part of the Dodd-Frank Financial Reform Legislation by the Securities and Exchange Commission in July 2015. According to the ruling, companies need to institute clawback provisions against executive compensation that is due to intentional over-reporting. Executives can also be asked to return stock options exercised or bonuses received if the profits of the company do not match the specified levels.
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