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What is a clawback provision in simple terms?
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What Is A Clawback Provision
A clawback provision is a contractual clause allowing a contracting party to reclaim payments made under specific circumstances.
In other words, if a payment was made by one contracting party to another, on the basis of the “clawback” provision, the party that has paid a certain amount can ask for the money to be returned.
For example, an employer may include a clawback provision language in an employment agreement allowing it to claw back bonuses, incentives, or other payments due to poor performance, misconduct, or due to other triggers.
Following the 2008 crisis, we have seen a surge in the use of clawback clauses, particularly in the financial industry.
Companies started using clawback policies in their executive compensation packages to recover incentive payments or performance-based payments when the executive had falsified data, used unethical practices for personal gains, or other types of misconduct.
Only 3% of Fortune 100 companies had clawbacks before 2005 but this percentage increased to 82% by 2010 following the 2008 financial crisis.
Why Use Clawback Provision
Clawback provisions are used in many types of contracts and in different situations.
The main reason why you will want to use a “clawback provision” is to protect yourself from having made payments to another party based on wrong or manipulated data.
For example, in the financial industry, clawback provisions are used to ensure that employees do not engage in unethical practices to falsify, manipulate, or alter company financial data for personal gain.
Also, a Securities and Exchange Commission ruling in 2015 required that companies provide for clawbacks in their executive compensation packers, stock option plans, and bonus payouts.
Whenever you are paying another person or entity and you want to have the protection to be able to claim back some of the payment in certain situations, you can leverage the clawback clause.
A party knowing that it may potentially be obligated to reimburse payments received will have less incentive to manipulate reports, financial data, or use other dishonest practices for personal gains.
In the financial industry, clawbacks allow companies to restore investor confidence and protect the company’s image due to poor executive performance, misconduct, or in situations of crisis.
Common Uses of Clawback Provisions
In what situation are clawback provisions used the most?
Here are some examples of when clawback provisions are used in a contract.
Employers will use a clawback in their executive compensation package in the event an executive leaves the company for a competitor within a certain period of time following his or her termination.
Lenders will use clawbacks in their mortgage contracts to ensure they can get some money back when dealing with unprofitable loans.
Insurance companies include clawback clauses in their policies should they make a payment to the beneficiary on the basis of false information or misrepresentation.
Pension funds are known to claw back payments made based on fraud or other unethical conduct.
A bankruptcy trustee is able to recover dividends that a company pays its shareholders in the context of bankruptcy.
The state will make use of clawback rights to claim money back from healthcare recipients who may have received payment while they were not covered or were deceased.
Governments will include some form of clawback ability when granting public contracts in the event their contracts are not fulfilled or due to other breaches.
In private equity, limited partners can get the right to reclaim part of the general partners’ carried interest should they receive extra compensation for the losses borne.
Statutory Clawback Obligations
Although you have many situations where clawback clauses are used in private relationships, you also have a number of laws and statutory frameworks imposing the obligation to provide for a clawback mechanic.
In 2002, the Sarbanes-Oxley Act first introduced the clawback obligation to allow companies to reclaim bonuses, rewards, and other incentives paid to employees or other beneficiaries.
Should there be an employee misconduct, accounting discrepancy, or record alteration, there should also be a penalty imposed.
In the event of wrong reporting, either intentional or not, the clawback rights would be exercised.
In 2015, a ruling on clawback provisions issued as part of the Dodd-Frank Financial Reform Legislation by the SEC required that companies were required to institute clawback provisions against executive compensation packages due to intentional over-reporting.
How To Draft A Clawback Clause
How do you draft a clawback clause to ensure that it is complete?
Although every situation should be considered individually to draft the most appropriate clawback protective rights, here are some guidelines to help you:
- To what type of payment or compensation are you linking the clawback
- Be clear about the event (or events) leading to the clawback right to be triggered
- For how long can the clawback provision be exercised
- Consider the applicable laws to your contract
- Will you add a penalty in addition to the clawback
So long as you are clear about what you are going to claw back, what events or circumstances allow you to trigger the clawback rights, how much can be clawed back, how far back can you recoup money, you will have the fundamentals.
It’s also important to consider the applicable laws to your contract.
For example, if you are including a clawback provision in an employment agreement, you need to make sure to comply with applicable labor laws.
Clawback Provision Example
Let’s look at an example of how to use the clawback provision in real-life.
Imagine that you have a company executive who is entitled to receive a performance bonus of $500,000 if the company’s net profits increase by 10% this year.
To the extent the company’s net profits legitimately increase by 10%, then the company will pay the executive the $500,000, no questions asked.
What happens if the executive had provided wrong reports or had used wrong data to demonstrate that the 10% net profit target was achieved.
In that case, should the company find out that the $500,000 was paid out due to the executive’s wrongdoing or that the company had not effectively met its 10% net profit target, then it will have the right to claim the reimbursement of the $500,000.
Clawback Clause Takeaways
So there you have it folks!
What does a clawback provision mean?
In essence, a “clawback provision” or “clawback clause” is a non-negotiable contractual provision allowing a party to claim back money already paid to another party.
Many companies use clawback policies in their employee contracts, particularly in claiming refunds for bonuses, incentive payments, and other types of variable compensation in certain specific events.
You’ll find clawbacks in different types of contracts such as employment agreements, public contracts, M&A transactions, or others.
Now that you know what a claw back provision refers to, why it’s important, and how it works, good luck with your research and investigation!
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