Faculty of law blogs / UNIVERSITY OF OXFORD

Clawback Provisions in Executive Compensation Contracts


Johanna Stark
Senior Research Fellow at the Max Planck Institute for Tax Law and Public Finance in Munich


Time to read

3 Minutes

In the wake of financial crises or corporate scandals, at some point the issue of executive compensation invariably comes up. When companies are in distress and shareholders, stakeholders and society are negatively impacted, it is often perceived as problematic that executives should take home hefty pay packages, arguably unharmed from the negative consequences they have been involved in bringing about. 

The challenge of properly designing executive compensation has received particular attention when it comes to bankers’ pay packages and the behaviour they reward. Many of the regulatory responses that we have seen after the 2008 financial crisis were directed at banks and other financial institutions, particularly those that were deemed systemically relevant, or ‘too big to fail’. The macroeconomic function of banks and other financial institutions calls for a regulatory approach tailored to their specific roles and realities, as failures in their corporate governance affect not only shareholders, but debtholders and other creditors including states that would ultimately be compelled to provide public money for bail-in schemes and other types of emergency relief. 

The question whether and how to effectively regulate executive compensation is not limited to the financial sector, however, and neither were the legal initiatives that came out of the post-crisis political agenda. The main concern driving the initiatives that were not specifically aimed at financial institutions was that pay schemes rewarding short-term performance incentivise managers to take excessive long-term risks or engage in financial misreporting. 

Among the ideas that have gained some prominence in the course of this post-crisis debate about general corporate governance reforms is that, when things turn out to have gone wrong, executives should be exposed to the negative consequences, and know in advance that their employment contract stipulates such exposure. Clawback provisions in executive employment contracts are an expression of this idea; very generally speaking, a clawback is a contractual provision that allows recovery of variable compensation that has already been paid. Two types of clawback provisions can be distinguished: performance clawbacks on the one hand require a return of payments that were made based on a factual basis that later turns out to have been false (such as variable pay based on accounting figures that are later restated); compliance clawbacks on the other hand are typically triggered by some form of objectionable behaviour of an executive, such as ethical misconduct or other violations of a company’s Code of Conduct.

Clawback prevalence in listed companies has risen considerably over the last two decades, beginning in the US after the 2000 financial crisis and the collapse of Enron, and continuing in European companies over the last years. Despite widespread adoption, however, the US experience shows that current clawbacks are rarely ever activated and much less enforced. 

Based on this observation, my recent paper on ‘Clawback Provisions in Executive Compensation Contracts’ focuses on the added value that clawback provisions may or may not provide as a general corporate governance mechanism. Leaving the specific challenges of bank governance aside, the paper analyses clawbacks’ merits as well as the challenges that arise when trying to design them in a way that effectively incentivises executives to act in the long-term interests of a company and its shareholders. The paper thus starts out from the following two questions: Do clawbacks as a measure of corporate governance generally make sense? And if so, how should such provisions be designed in order to best serve their purpose?

Without a clear answer to both of these questions, the increasing prevalence of clawbacks may just be handy window-dressing that acquiesces investors and the general public, but either has no actual effects on how managerial decisions are made, or worse has distortionary effects due to circumventory manoeuvres by its addressees. 

The paper concludes that companies and their shareholders would do well to focus on properly calibrating performance clawbacks, if clawbacks must be introduced in order to conform to investors’ expectations at all. The added value perspective leaves room for scepticism regarding both performance and compliance clawbacks, for a variety of reasons. To put it briefly and sharply: performance clawbacks may not be necessary, and compliance clawbacks may—at least in some jurisdictions—not be enforceable.

In any case, clawback design must provide a solution to the problem of activation and enforcement incentives: given that strong and permanent deterrence effects cannot be expected to come from a provision that is practically never enforced, there should be little discretionary leeway for the board of directors in decisions about clawback activation in the event that the recoupment trigger has been set off, or the decision must be placed into the hands of a sufficiently resourced oversight body. There is little reason, however, to expect voluntary implementation of a provision that involves handing enforcement authority to an external body.

Added value may therefore be expected only from a ‘mechanical’ approach to clawbacks that requires a narrow understanding of performance based on measurable criteria. Certainly, mechanical performance clawbacks are no cure for all sorts of executive misbehaviour and compliance issues. The main reason for tailoring them in this narrow fashion, however, is that if clawbacks are to strengthen the link between pay and performance of corporate executives, they must be designed in a way that they have the right sort of teeth not only on paper, but also in practice.

Johanna Stark is a Senior Research Fellow at the Max Planck Institute for Tax Law and Public Finance in Munich.


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