I Want My Money Back!Ins and Outs of Compensation Clawbacks inPublic and Private Business

CLE Seminar for In-House CounselJune 8, 2016Chicago, Illinois

Pamela BakerPartnerDentonsChicago+1 312 876 8989pamela.baker@dentons.com

Daniel LangePartnerDentonsChicago+1 312 876 2374daniel.lange@dentons.com

• Clawbacks are generally considered the right of a company to recoupamounts paid to employees in certain situations

• Prior to Sarbanes-Oxley, these were more limited and typically related to equityawards• For example, the profit on exercised options or vested stock would be recovered (usually on a gross

basis and regardless of changes in stock value) if the recipient violated a restrictive covenant orengaged in activities detrimental to the company

• More of a push for clawbacks began in the early 2000s (Enron/Tyco)• Numerous restatements of financial statements generated demands for companies to take action

• Shareholders demanded that companies attempt to recover compensation that allegedly was not earned basedon the revised numbers

• Shareholders also demanded the adoption of policies to make such recovery easier

• Sarbanes-Oxley empowered the SEC to recover certain compensation paid to CEOs and CFOs if there was theneed for an accounting restatement due to the company's material non-compliance with financial reportingrequirements

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Why clawbacks are a hot topic (when there are stillno final regs)

• Dodd-Frank became law in 2010

• Requires public companies, in the event of a need to perform an accountingrestatement, to recover from executive officers incentive-based compensationpaid in the preceding three years to the extent the original payment was basedon erroneous data

• Clawbacks are becoming an accepted form of governance at publiccompanies

• Clawbacks are not yet as common for private companies, but theirprevalence is expected to increase

• Just like with public companies, when there is a diverse group of owners,clawbacks can help ensure that shareholder value is protected by discouragingundue risk or nefarious behavior

• They can give direct and indirect owners more confidence that the company isbeing managed appropriately

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Why clawbacks are a hot topic (when there are stillno final regs)

• Sarbanes-Oxley Section 304(a) - Requires companies to recoup

• Public companies

• Accounting restatement due to "material noncompliance" as a result ofmisconduct with any financial reporting requirement

• Enforceable only by SEC

• CEO and CFO "shall reimburse" the company for• Any bonus or other incentive-based or equity-based compensation received during the12-month

period following the filing of the erroneous financial document, and

• Any profits realized from the sale of company securities during that 12-month period

• (Roughly 3-5% of Russell 1000 Companies have restatements each year)

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Why should you have a claw back arrangement?

• Dodd-Frank Section 954 added New Section 10D to the SecuritiesExchange Act of 1934 - Listing standard

• Public companies must have and disclose a policy

• Must apply to current and former executive officers

• In the event the company is required to prepare an accounting restatement dueto "material noncompliance" with any financial reporting requirement

• The company WILL recover "incentive based compensation" (including options)

• During the 3-year period preceding the date on which the issuer is "required" toprepare an accounting restatement, based on the erroneous data, in excess ofwhat would have been paid to the executive officer under the accountingrestatement

• Note: no misconduct required

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Why should you have a claw back arrangement?

• Deter or thwart misconduct generally

• Underscore seriousness of restrictive covenants

• Improve internal accountability

• Induce managers to avoid risks that might lead to restatements and/orother bases for clawbacks

• Garner positive reaction from shareholders (but not much unless thepolicy is stricter than required by Dodd-Frank)

• Note, as an exception, that in 2013 McKesson's shareholders approved a shareholder proposal requiring removal of"intentional" and "material" from a policy that permitted a clawback if an employee engaged in "intentional misconductpertaining to a financial reporting requirement" that causes a restatement, or if an employee's conduct generated a"material negative revision of a financial operating measure" or if the employee "engaged in fraud, theft,misappropriation, embezzlement or dishonesty to the material detriment of the company's financial results." SeeMcKesson Corporation Form Def14A filed 6/21/13, p. 80; Form 8-K filed 8/02/13

• Vesting conditions that key off financial metrics would not be clawbacksat all, but could have a similar effect

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Why should you have a claw back arrangement?(Other reasons)

• Dodd-Frank clawbacks apply to incentive compensation (including stockoptions) based on a financial metric when there is a restatement

• Proposed regulations define "based on a financial metric"*

• "any compensation that is granted, earned or vested based wholly or in partupon the attainment of any financial reporting measure"

• "Financial reporting measures" are those determined and presented underaccounting principles on the company's financials, plus any measures derivedfrom those, plus stock price, plus total shareholder return (TSR)

* See SEC proposed regulations on Listing Standards for Recovery of Erroneously Awarded Compensation, Fed. Reg Vol 80 No. 134, pp 41154-41157 (July 14, 2015).

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What type of compensation is subject to Dodd-Frankclawback requirements?

• Revenues

• Net income

• Operating income

• Profitability of one or more reportable segments

• Financial ratios (e.g., various turnover rates)

• EBITDA

• Funds from operations

• Liquidity measures

• Return measures (e.g., ROIC)

• Earnings measures (e.g., EPS)

• Where subject to an accounting restatement: same store sales, revenueper user, cost per employee

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Examples of "financial reporting measures," eitherfor the company or relative to peers:

• Options or other types of equity (e.g., restricted stock, RSUs, PSUs,SARs) granted or vested wholly or partly based on attainment of such ameasure

• Bonuses paid from a bonus pool (e.g., under a 162(m) umbrella plan) thesize of which is based wholly or partly based on attainment of such ameasure

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Examples of compensation based on financialreporting measures

• Time-based vesting

• Opening a specified number of stores

• Obtaining regulatory approval of "x"

• Consummating a merger or divestiture

• Completing a restructuring plan or refinancing

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Examples of non-financial reporting measures:

• Salary

• Discretionary bonuses (not paid from a pool that is based on a financialreporting measure)

• Bonuses based on meeting a subjective standard (e.g., "leadership")

• Bonuses based on years of service

• Non-equity awards earned solely based on satisfying strategic measures(e.g., increase in market share)

• Equity awards not granted or vested based on meeting a financialreporting objective (e.g., annual grant with a value equal to a multiple ofsalary that vests over time or based on a strategic measure)

• Business unit financial measures - e.g., not a separately-reportable segment

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Should you change the structure of incentivecompensation to limit the impact of Dodd-Frank clawbackrequirements?

Examples of compensation NOT based on financial reporting measures:

• Many companies do not have a standalone "clawback" policy

• Clawback provisions are included in individual agreements and plans

• Employment agreement

• Severance plan

• Incentive (omnibus) plan

• Award agreements

• LTI plan

• Annual incentive plan

• Some companies have stand-along policies in include references to suchpolicies in other agreements

• May allow more flexibility

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Form of Clawback Policy

• From an omnibus incentive plan:

• Awards and Accounts are subject to the Company's policy on recoveries and such otherterms and conditions as the Committee may impose in the event the Committeedetermines a participant's own misconduct contributed materially to his or her receipt ofunearned amounts of cash, stock, or other property. The Company may (subject toapplicable law and 409A) deduct from and set off against any amount the Company mayowe to the employee from time to time, including amounts payable in connection with anyAward, owed as wages, fringe benefits, or other compensation owed to the employee,such amounts as may be owed by the employee to the Company, although the employeeshall remain liable for any part of the employee's payment obligation not satisfied through

such deduction and setoff.

• More limited, from an employment agreement:

• Executive acknowledges and agrees that he is subject to Section 304 of [SOX] and thatpursuant thereto he may under certain circumstances be obligated to pay back to theCompany certain amounts previously received by him. In addition, the Executiveacknowledges that he shall be subject to any clawback policy adopted or implementedby the Company in respect of the [Dodd-Frank Act] and such regulations as arepromulgated thereunder from time to time.

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Should your clawback policy be broader than thestatutory requirements (SOX, Dodd-Frank)?

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Who should be covered in your clawbackarrangement?

• Public Companies

• Dodd-Frank text applies to current and former "executive officers"*

• Proposed regulations clarifies this to include all current and former "Section 16Officers" (CEO, CFO, CAO, VPs of Principal Business Units, etc.)*

• At certain financial institutions, "significant risk takers" must also be subject to aclawback (possibly for up to seven years)**

• Nothing in the statute or the regulations requires that clawbacks apply to alarger group of employees, but they likewise do not limit the list of employeeswho may covered. Should they extend to all employees?• It is unlikely that lower-level employees are culpable for misstatements or erroneous/nefarious

behavior

• "Innocent" executives are subject to clawback policies. Should "innocent" lower-level employees betreated better than "innocent" executives?

* See SEC proposed regulations on Listing Standards for Recovery of Erroneously Awarded Compensation, Fed. Reg. Vol. 80 No. 134,

pp. 41190-41196 (July 14, 2015).

**See proposed regulations under Section 956 of the Dodd-Frank Act as approved by the National Credit Union Administration on April

21, 2016

• Private Companies

• No legal obligation to adopt a clawback policy exists

• Coverage at each company may be different depending on the circumstances

• Clawback policies are less necessary where the sole or primary owner isheavily involved in the day-to-day operation and management of the company

• Where some or all owners are less involved, clawback policies can help ensureproper management and financial conduct

• Private Equity portfolio companies may be uniquely suited for clawback policies• Fund may be subject to clawback if management fees exceed ultimate performance

• There is, by definition, a diverse group of indirect owners who are not closely involved with management

• Depending on the timing of a discovery of improper reporting, could affect sales price and directly affectshareholder return

• Should lenders impose clawback requirements in addition to other financialcovenants and events of default?

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Who should be covered in your clawbackarrangement?

• Possible triggers

• Financial restatement (with employee involvement or whether or not employeewas involved)

• Employee's direct involvement in reason requiring financial restatement (belowthe executive officer level) - cooking the books

• Misrepresentation of performance results to improve own incentive payments

• Innocent misrepresentation of financial performance results

• Excessive risk-taking?

• Fraud or other criminal activity? Embezzlement? Bribery?

• Harm to company's reputation?

• Violation of restrictive covenants post-termination?

• Violation of confidentiality standards

• Should misconduct be required (if not statutorily required)?• Any misconduct? Financial misconduct only?

• Misconduct of the employee?

• Misconduct of the employee's direct report(s)?

• Materiality threshold

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What are appropriate triggers (not required by D-F)?

• For public companies trying to comply with Dodd-Frank, the amount ofthe clawback is the excess of the amount that was actually paid overwhat should have been paid

• For some elements of pay, D-F is easy to apply--look at the payment formulaand apply it based on the restated accounting numbers

• Some cases are easier than others

• Tax issues can be problematic for executives--"innocent" executives are mostsympathetic

• Should public companies go beyond Dodd-Frank?

• Some issues to consider:• Should clawback be discretionary with the board/comp committee making final determination?

• Should clawback (other than D-F clawback) be net after tax?

• Should clawbacks apply only to vested amounts or also to non-vested amounts?

• Look back period? How long?

• Option gains? Only unexercised options?

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What and how much should be clawed back?

• Under SOX, only the SEC may enforce--no private right of action exists

• Dodd-Frank requires the company to recover, which implies theavailability of shareholder derivative action

• Mere "policy" without contractual provisions likely harder to enforce thanspecific provisions in an employment or severance agreement, or at leastreference to a policy, or "policies in effect from time to time"

• Consideration for imposing? Retroactively?

• Effect of release on ability to claw back?

• Carve out from indemnification provisions in by-laws or otherwise

• Severance plan provision for reimbursement of legal fees (for seeking toavoid a clawback)?

• Recovery from pledged shares? Hedged shares?

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Are clawbacks enforceable?

• Clawback for violation of non-compete?

• Viad Corporation v. Houghton, 2010 WL 748089 (N.D. Ill. 2010). (Clawback of incentivecompensation for competition is in the nature of a forfeiture - at least where planparticipation was voluntary and the employee did not have a non-cause termination - andnot an impermissible unreasonable restraint on the employee)

• Tatom v. Ameritech Corp., 305 F.3d 737 (7th Cir. 2002)(dictum regarding favorably theability to require forfeiture of unexercised options)

• Mechanics of clawing back/ enforcement techniques

• Defer payment of option gain?

• Require a "hold" on incentive pay or other compensation for a 3-FY period?

• Contractual right to recoup must be there

• Need a decision-maker to initiate clawback

• Need to designate who will calculate

• Cost/benefit analysis?

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Are clawbacks enforceable?

• State wage and hour laws?• IL - equity is generally not "wages"

• CA - equity and cash bonuses are both "wages"

• Effect of home country laws on foreign national (esp. non-resident alien)?

• HealthSouth 2002 Shareholder Derivative Litigation, (Richard Scrushy, AL law),Memorandum Opinion June 18, 2009

• "London Whale" Ina Drew clawbacks, (technically voluntary)

• Blanton v. Commissioner, (Flagg Grain Co. contract for recovery if IRS foundcomp "not reasonable") 1963. Similar: VanCleave v. U.S. 1983

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Are clawbacks enforceable?

• If a clawback occurs in the same year that the original compensation waspaid, the repayment amounts is treated for tax payment and reportingpurposes as if it was never paid.* This is the easiest scenario--butunfortunately, it's also rare

• Where clawback occurs in a later year, the employee cannot just amendthe tax return for the year of payment*

• For direct repayments (e.g., where the employee writes a check), the employercannot offset the repayment on the employee's current-year W-2. Instead, theemployee must deduct the repayment under other provisions of the tax code,but only if the requirements of those provisions are satisfied• 2% floor applies

• Deduction may be ignored for AMT purposes

• Section 1341 may allow a more complete tax deduction, but it requires a fact-based analysis

• While it may be less painful for the employee, the tax treatment for enforcing aclawback by offset of current compensation is unclear and could involve higherrisk for the employer for under reporting and under withholding

*Revenue Ruling 79-311

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Tax effects of clawbacks - generally

• Section 1341 deduction may be available if:

• (1) taxpayer includes income in one year because the taxpayer appears tohave an unrestricted right to such income, and (2) after the close of the priortaxable year, it is established that the taxpayer did not have the unrestrictedright to the income• Factual questions can make it difficult to comply with Section 1341

• Does the clawback policy itself pre-exist the original payment?

• For "bad-boy" clawbacks--was the right "actual" or "apparent" at the time of payment. If actual, then 1341 is notavailable. Example, severance paid in year one is subject to clawback for a violation of a non-compete in yeartwo

• Subject to a $3,000 minimum

• Section 409A

• Governs deferred compensation. Compensation is "deferred" until after it is nolonger subject to a substantial risk of forfeiture• Does a clawback create a substantial risk forfeiture (SRF)? Probably not in most cases

• A SRF can exist if clawback occurs due to termination for "cause" and "cause " is broadly defined.See Austin v. Commissioner 141 T.C. No 18 (12/16/13)

• Offset of currently-owed compensation can create a Section 409A violation• Much safer to draft as a forfeiture and address it accordingly

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Tax effects of clawback - special situations

• Section 83

• Governs receipt of equity in exchange for services

• Requires taxation when equity vests (i.e., no substantial risk of forfeiture)

• Does clawback create a substantial risk of forfeiture?

• Just like Section 409A, probably not

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Tax effect of clawbacks - special situations

• For equity awards, objective clawbacks are considered contingent andare ignored at the time of grant (See FASB Topic 718). Discretionaryclawbacks may delay grant date measurement or create variableaccounting if they preclude a mutual understanding of the key terms andconditions of the award

• If objective clawbacks are invoked, accounting recognition would only beneeded at the time to reflect the recoupment of the cash and/or shares.FASB Accounting Standards Codification 718-10-30-23 through 30-24and 718-20-35-2

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Accounting for clawbacks

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Thank You!We are very interested in your feedback -please take a moment to leave a note about this class and thepresenters on your evaluation form.

Pamela Baker

Partner

Dentons

T +1 312 876 8989

pamela.baker@dentons.com

Daniel Lange

Partner

Dentons

T +1 312 876 2374

daniel.lange@dentons.com