Compensation incentives and clawbacks: analysing the DOJ’s Pilot Program

October 2023  |  FEATURE | BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

October 2023 Issue

Following recent updates to its guidance, the US Department of Justice (DOJ) launched a Pilot Program on Compensation Incentives and Clawbacks in March 2023. “Every corporate resolution involving the Criminal Division will now include a requirement that the resolving company develop compliance-promoting criteria within its compensation and bonus system,” explained Lisa Monaco, deputy attorney general, in remarks formally announcing the Pilot Program in early March. “Our goal is simple: to shift the burden of corporate wrongdoing away from shareholders, who frequently play no role in the misconduct, onto those directly responsible. We intend this program to encourage companies who do not already factor compliance into compensation to retool their programs and get ahead of the curve.

“Tomorrow, we will release this new policy, and Assistant Attorney General Polite will provide more details about the program,” she continued. “We believe the best way to combat corporate crime is to prevent it, or barring that, to surface it and address it head on. Now, these policies empower general counsels and compliance officers to make the case to company management, to make the case in the boardroom that investment in a robust compliance program, including a forward-leaning compensation system, is money well spent.”

Mitigating enforcement action

The scheme, which came into force on 15 March 2023 and will run for three years, has two main thrusts: compliance enhancements and deferred fine reduction. Under the auspices of the programme, a company may qualify for a fine reduction if it implements compliance-related criteria in its compensation and bonus system, and makes annual reports to the DOJ on the same during the term of the resolution.

These criteria may include, but are not limited to: (i) a prohibition on bonuses for employees who do not satisfy compliance performance requirements; (ii) disciplinary measures for employees who violate applicable law and others who both had supervisory authority over the employees or business area engaged in the misconduct, and knew of, or were wilfully blind to, the misconduct; and (iii) incentives for employees who demonstrate full commitment to compliance processes.

Furthermore, the resolving company must demonstrate that it has initiated, or will be initiating, a process to recoup compensation from employees who engaged in the alleged wrongdoing as well as from employees who had supervisory authority over the employees or business areas engaged in the alleged misconduct, and who knew of, or were wilfully blind to, the misconduct.

For those companies that have fully cooperated with the DOJ’s investigation and remediated the misconduct in a timely fashion, the Pilot Program contemplates fine reductions. Specifically, the Pilot Program states that when a company has begun efforts to recoup compensation ahead of seeking to resolve the matter with the Criminal Division, a company will be permitted to reduce the payment of any applicable fines by 100 percent of the compensation the company is trying to recoup. At the close of the resolution period, the company will keep all compensation recovered. To the extent a company is not able to recoup all of the compensation it sought to recover, the company will pay the difference between the amount withheld and the amount actually returned.

Of course, clawing back funds from executives and employees can be a complex, challenging process. As such, under the terms of the Pilot Program, those firms that attempt to pursue clawbacks in good faith but are ultimately unsuccessful, will still be eligible for fine reductions of up to 25 percent of the amount of compensation the company attempted to claw back. The Pilot Program notes that such reductions may be warranted where, for instance, a company incurred significant litigation costs, or can demonstrate that it is highly likely that it will successfully recoup the compensation shortly after the end of the resolution period.

Implementing compliance-related compensation incentives and clawbacks will only be mandatory under the Pilot Program for those companies that resolve a corporate criminal matter with the DOJ. However, as has been the case with prior DOJ compliance guidance issued in the enforcement context, many companies and their compliance departments will look to the Pilot Program as an indication of the DOJ’s expectations of best practice in corporate compliance.

This has been reinforced by the updated DOJ Evaluation of Corporate Compliance Programs guidance document, which now includes a section on ‘Compensation Structures and Consequence Management’. This section addresses compensation incentives and clawbacks.

Accordingly, such compensation structures and clawback provisions may become corporate compliance best practice even for companies not under DOJ investigation. In addition, establishing these mechanisms would put a company in a better position if it later found itself before the DOJ in connection with a corporate criminal matter. As a result, many companies will choose to implement these mechanisms proactively.

Indeed, the guidance makes it clear that the DOJ expects companies to already have these type of compensation criteria in place prior to any DOJ investigation. Consequently, any compliance programme that does not include these elements might not be considered ‘effective’. The revised compliance guidance issued by the DOJ requires prosecutors to look at “consistent application” of disciplinary actions and incentives “across all geographies, operating units, and levels of the organisation”. It also asks whether disciplinary actions and incentives have been fairly and consistently applied across the organisation and whether similar instances of misconduct were treated disparately, and if so, why.

SEC Rule 10D-1

The Securities and Exchange Commission (SEC) has also been active on compensation clawbacks in recent years. Section 954 of the US Dodd-Frank Act directs stock exchanges to establish listing standards requiring publicly listed companies to develop and implement a clawback policy in the event of a financial restatement, providing for the recovery of erroneously awarded incentive-based compensation received by current or former executive officers.

In October 2022, the SEC adopted final implementation of this Rule 10D-1. Companies must now enforce a clawback almost any time they restate their financials, regardless of whether the restatement was caused by fraud, mistake or any other error. Listed companies need to disclose their policy and any clawbacks that occur because of the policy. A company’s level of transparency and compliance with the new rule will influence the course of any future enforcement action triggered by restatements of corporate financials.

The SEC rule is not as broad as the DOJ’s Pilot Program, however, as it applies only to publicly traded companies and only in the event of a financial restatement, in which an executive officer received incentive compensation for a percentage of profits.

Clawback challenges

The DOJ’s Pilot Program raises a number of legal and compliance challenges for organisations seeking to claw back compensation already paid or to suspend packages that pay out in the future. Employers do have potential methods available to force current employees to return compensation. These may include threatening to terminate an employee’s position at the company, reducing their compensation, offsetting previously paid compensation against future bonuses, or effectuating forfeitures of incentive compensation or equity paid.

There is, however, no guarantee that the company will be able to successfully claw back any payments. There are also different wage and hour laws across US states that must be taken into consideration when setting out a clawback policy. For multinationals, the challenge of attempting to claw back compensation across different countries complicates the issue even further. Different jurisdictions have their own employment laws which may restrict or prohibit such attempts.

Furthermore, for employees, the risk of having compensation or bonuses clawed back by their company might not be much of a deterrent – especially in situations where individuals already face the risk of termination and possible criminal indictment. Moreover, compensation is just one part of a wider tapestry of factors which motivate individuals, and it may be reductive or even offensive to suggest that employees only act lawfully when they are paid to do so.

Compensation agreements also raise a number of other compliance considerations, including privacy concerns, substantive employment law, securities law and tax implications.

Furthermore, according to the Monaco Memo and the updated and revised DOJ Criminal Division’s Evaluation of Corporate Compliance Programs, compliance incentives for employees extend beyond the clawback of incentive compensation after it has been paid. To that end, companies should seek to more holistically integrate compliance into the HR function, including the use of ‘compliance benchmarks’.

Revising compensation schemes

Despite the challenges, there is little doubt that the renewed focus on identifying executives and supervisors involved in alleged misconduct marks a significant shift in the DOJ’s enforcement priorities. As such, it would be prudent for companies to re-evaluate and revise their compensation schemes.

The first step is to establish whether the company’s existing incentive compensation agreements and equity awards allow for compliance-related clawbacks. Companies should make sure that an employee is aware that their compensation may be impacted by policy violations, compliance-related concerns and so on, and reach an agreement with them regarding clawbacks.

Companies must also evaluate their ability to make and implement compensation decisions quickly. An audit of the organisation’s compensation committee for senior executives (and HR for other employees) should be carried out to assess their suitability. In the event that the conduct of an executive or an employee should affect his or her compensation, the compensation committee or other decision-making body should be prepared to follow established processes to effect the clawback. Adherence to company policy, local laws, tax regulations and shareholder disclosure requirements will need to be maintained.

For organisations to evaluate the contributions executives and other employees make to corporate compliance, metrics will have to be established. It is vital that the nature of these metrics and how they are evaluated are clear and communicated to all affected employees.

The compliance department will play a pivotal role in all of these determinations. As such, it should be integrated into the process of evaluating employees on key issues, including for the purposes of promotions, bonuses and other merit-based pay awards. The compliance team should also establish a repository for logging the details of any promotions or awards provided or denied to executives and employees, as well as for any compensation which has been recouped, deferred or cancelled, as well as any other compensation decisions which have been affected by compliance and ethics considerations.

In light of shifting tides, it is vital that companies proactively assess their current policies and lay the groundwork for any action they may need to take in the future following a breach of company policy or cases of individual malfeasance. A prerequisite is to include a policy that provides the tools to determine the ‘who, what, when and why’ of any serious misconduct, in order to ascertain the details of an incident.

Shifting the burden

For innocent shareholders who may be ‘punished’ for malfeasance, the Pilot Program represents an important step in the right direction, shifting the burden back to those individuals found to have engaged in wrongdoing. Both the SEC and the DOJ consider compensation to be a crucial factor in incentivising good behaviour. The introduction of the Pilot Program and Rule 10D-1 will be a good barometer of whether this assumption is true. The DOJ does not expect the Pilot Program to replace other compliance metrics. Instead, it is supposed to encourage companies to use compensation incentives as part of their overall compliance efforts.

Uncertainties remain around how successful the programme will be at furthering the DOJ’s stated goal of driving individual accountability among executives. The complexity of compensation packages and legal frameworks could make it difficult for companies to satisfy the requirement to recoup pay (or demonstrate meaningful attempts to do so) from employees engaged in wrongdoing. As a starting point, it would behove companies to seek advice from experienced executive compensation counsel to evaluate if their pay, bonus and incentive systems have mechanisms that deter malfeasance and provide for clawbacks when necessary. Time will tell how successful the process may be.

© Financier Worldwide

BY

Richard Summerfield