The Advisors' Blog

– Gregory Schick, Sheppard Mullin Richter & Hampton

A key element of better executive compensation practices is whether an employer has a clawback policy which enables the employer to recoup incentive compensation from an employee under certain circumstances. Typically, a clawback may apply if an employee has committed an egregious act or if there is a restatement of the financial results from which the incentive compensation payment was derived. To the delight of corporate governance reform advocates, many public companies have voluntarily adopted clawback policies.

The federal government has also increasingly mandated the clawback of incentive compensation. The Sarbanes-Oxley Act of 2002 and the American Recovery and Reinvestment Act of 2009 each compel a clawback of incentive compensation paid to certain enumerated employees if the employer has a financial accounting restatement. Even more recently, in October 2009, the Federal Reserve Board of Governors proposed guidance that would generally compel banks under its supervision to delay the actual payout of an incentive award to an employee until significantly beyond the end of the applicable performance period. This proposed guidance would require that any such payments should be decreased for actual losses or other aspects of performance that become clear only during the deferral period.

The California Supreme Court recently rendered a decision in the Schachter v. Citigroup case which dealt with incentive compensation. The ruling itself was not all that surprising – but the court’s opinion did indirectly highlight a potential pitfall for clawbacks. In Citigroup, the employer maintained a program whereby an employee could voluntarily elect to reduce his/her salary by a stated percentage and in exchange receive restricted shares (at a discount) that would vest over time. The restricted shares would be forfeited without consideration if the employee resigned employment prior to vesting. However, if the company terminated the employee’s employment without cause prior to vesting, then the employee would receive a cash payment equal to the amount of the foregone salary as consideration for the forfeited shares.

A former employee, who had resigned his employment, filed suit challenging the compensation arrangement. He argued that he should have received his foregone salary after his resignation on the theory that various California labor code statutes generally prohibiting the disgorgement or nonpayment of wages were violated. The California Supreme Court disagreed and ruled that, as is typically the case with unvested equity compensation arrangements, failure to satisfy the vesting conditions meant that the incentive compensation was not earned and that the employee was not deprived of any wages.

However, the court’s opinion took notice of the differing consequences for the incentive compensation depending on whether the employer or employee had initiated termination of employment. The court noted that payment of the incentive compensation if the employer was the initiating party to terminate employment was consistent with “contract law principles prohibiting efforts by one party to a contract to prevent completion by the other party.” The court further noted that an employee may be able to recover at least a pro-rata share of a potential bonus if the employee’s employment is terminated by the employer without a valid cause prior to completion of the terms of the bonus agreement. In addition to the applicable California labor code statutes, as support the court cited California state regulatory agency opinions and state appellate law decisions.

The point is that state laws, regulations and/or agency decisions could potentially impede the ability of an employer to recoup or delay/deprive an employee from receiving incentive compensation. For example, California Labor Code Section 221 specifically states “It shall be unlawful for any employer to collect or receive from an employee any part of wages theretofore paid by said employer to said employee.” If a clawback was implemented to comply with a specific federal law, then such clawback may be better able to withstand a challenge under state law by virtue of federal law pre-emption.

But what if the clawback was being voluntarily implemented by the employer purely as a matter of good corporate governance? In such case, the clawback could be vulnerable to being invalidated based on state laws that protect an employee’s rights to compensation particularly if the employee was not culpable and/or if the employee could argue that the incentive compensation was already “earned” (or paid) under applicable state law.