The changing face of bonus payments

Updated July 2009

Bonuses have been in the public eye for some time, with the market demanding longer term payment provisions, risk based performance measures and claw-back provisions if performance later proves to be overstated.

Responses to these demands are still taking shape. This update focuses on one aspect: claw-back, and considers how companies are adapting their bonus structures to cope.

What is claw-back?

Claw-back is simply the recovery of a bonus or share award where it later transpires that the bonus or award was calculated by reference to overestimated performance. That might be because:
1. the original performance measure was inadequate; or
2. unforeseen developments have come to light since payment of the award which show the performance to be illusory.

How can it be implemented?

Claw-back rules need to be objective for legal and practical reasons.

If claw-back is too widely drafted it will threaten the motivational power of the award, detracting from the whole point of implementing the bonus plan in the first place. From the legal perspective, widely drafted claw-back provisions may also be unenforceable under UK law.

Examples of effective claw-back would be based around;

• uncovering a breach of contract or code of conduct during the bonus period, where such breach did not come to light until after the award had been paid; and
• specified falls in company performance or asset levels occurring during the 12 month period following award.
  Realistically, claw-back can only be introduced through an amendment to plan rules. Employee consent will be needed unless express provisions in the plan rules allow otherwise, but in the current environment it may be possible to push the changes through and, in the absence of employee objection, rely on implied consent to the changes.

What about tax and risk?

Claw-back is tax inefficient. When the bonus is paid, income tax and national insurance will need to be deducted through PAYE and paid through to HMRC. If the net award is clawed back from an employee, it is unlikely that the income tax and national insurance can be recovered.

The biggest issue with claw-back is around recovery. Claw-back is only effective if employees can pay the money back and it’s that concern that is causing real problems in practice.

Possible practical solutions

The UBS model
UBS launched a new compensation model in late 2008, which amongst other things, set out its new variable compensation model based on a bonus/malus (good/bad) system.

The model does not use claw-back per se but replicates claw-back through the use of bonus and malus awards under a cash balance plan. Malus awards are made where there is a financial loss or large balance sheet adjustment within the recipient’s group or the recipient has, for instance, committed compliance misconduct or breached risk parameters.

The plan works on a rolling three year basis. At the end of any given year, to the extent the recipient has a positive balance in the cash balance plan, 33% of that balance is paid to them in cash. The remaining 66% is rolled over to the next year as described below*:

*Source UBS Compensation Report, November 17 2008. 

This smoothing of payments to executives manages the issue of illusory performance by holding back 2/3rds of the annual bonus award. The result is a smoothing of the payout to executives avoiding the enforceability, tax and cash recovery issues referred to above.

A loan based approach
Deferral of awards supported by short term loans may also resolve some of the tax and enforceability issues raised by claw-back.

With a loan based approach, a bonus would be banked at the end of a particular year but subject to clawback for a further period of time (perhaps 12 or 24 months) should performance prove to have been overestimated. Employees who wish to access their bonus during the deferral period could do so by drawing down under the terms of a loan, for which they would be required to pay interest on commercial terms.

At the end of the deferral period, the loan would be repaid and, taking into account whether any claw-back was required, the bonus paid.

This approach has received some criticism in the press where it has been used to accelerate the payment of deferred bonuses. There seems no reason to believe, however, that a loan based approach should not work on the above basis provided it is communicated to shareholders and employees correctly.

Conclusions

Claw-back is really a fall back mechanism and companies will be expected by shareholders to avoid paying overstated bonuses in future by adopting risk-adjusted performance measures. However, foreseeing all risk is always going to be difficult and, sensibly, protections need to be put into incentive plan rules to allow claw-back where unforeseen developments arise.

Claw-back provisions themselves may, however, be difficult to enforce and result in tax leakage. The better overall solution may be a smoothing of bonus awards based around the UBS or loan based approach.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at July 2009. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.