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A compensation clawback provision allows an organization (typically a U.S. public company) to take back compensation from an executive or employee in the event of pre-defined trigger events. Over 95% of clawback provisions are triggered by an accounting restatement or other financial misconduct, though a small percentage are also triggered by noncompete violations A typical clawback provision states that, in the event of an accounting restatement or other fraud, the firm's board of directors may rescind any undeserved incentive compensation that was previously awarded based on incorrect financial information. Clawback provisions typically cover both cash and equity compensation. Clawback provisions are distinct from other forms of deferred compensation in that the bonuses are not initially withheld from the employee, but are rather taken back after the trigger event occurs.

Background

The prevalence of clawback provisions among Fortune 100 companies increased from lower than 3% prior to 2005 to 82% in 2010 . The growing popularity of clawback provisions is likely, at least in part, due to the Sarbanes-Oxley Act of 2002, which requires the U.S. Securities and Exchange Commission (SEC) Securities and Exchange Commission to pursue the repayment of incentive compensation from senior executives that are involved in a fraud. In practice, the Securities and Exchange commission has enforced its clawback powers in only a small number of cases.

The Dodd-Frank Act of 2010 mandates the SEC to require that U.S. public companies include a clawback provision in their executive compensation contracts that is triggered by any accounting restatement, regardless of fault (whereas the clawback provisions per the Sarbanes-Oxley Act only applied to intentional fraud). As of early 2012, this portion of the Dodd-Frank Act has yet to be implemented as the SEC has not yet issued guidance on the specific type of clawback provision that firms must employ.

Implications

The usual objective of a clawback provision is to deter managers from publishing incorrect accounting information. Academic research finds that voluntarily adopted clawback provisions appear to be effective at reducing both intentional and unintentional accounting errors. The same study also finds that investors have greater confidence in a firm's financial statements after clawback adoption, and that boards of directors place greater weight on accounting numbers in executive bonuses after a clawback is in place (i.e., pay for performance sensitivity increases). However, research shows managers who are subject to new clawback provisions offset their increased risk by demanding an increase in base salary that is not subject to being clawed back.