Clawback Provision: Definition & Example

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we'll discuss the clawback provision, which requires employees to return earnings under certain conditions. You may have heard about clawbacks since the financial crisis of 2008. They have become a popular form of making management and other employees more responsible for their actions.

Your Retirement Savings

Imagine that you and your wife invested your retirement savings in a company, and you just read in the Business section of the newspaper that the former CEO of that company is now being investigated for several shoddy things he did while CEO. Allegedly, he pressured internal accountants and auditors to be 'aggressive' in their financial reporting, so the company would meet Wall Street's earnings expectations. He also invested company money in a business started by his relatives without disclosing the conflict of interest. He created a sales force culture where it was common for an employee to continue to badger their potential client incessantly, even if the client asked them to stop. He also used company money for his family's vacation.

You'd be upset if you heard this, wouldn't you? You'd be even more upset when you think back to the millions and millions he earned while CEO. Depending on the company, however, shareholders may be able to clawback funds the CEO earned during that time. The word 'clawback' means just like it sounds--any earnings management received during a time of wrongdoing will be taken from them and returned to the company.

In this lesson, we'll discuss the concept in greater detail. We'll also give some real-world examples to help illustrate how the clawback provision works.

Clawback Provision

The formal definition of the clawback provision is that it's a clause in a contract, usually an employment contract, that stipulates money or other forms of compensation (such as shares) already paid must be paid back under certain conditions (i.e. account restatements, illegal activities, etc.). Clawbacks are often tied to bonus payments. For example, let's say you were hired by a company, and they told you if earnings per share increased by 10% over the next two years, you would receive a bonus of $25,000. Let's fast forward two years after the contract was signed. The company did grow earnings at 11%. The company would have to pay you your bonus. However, let's say an internal investigation led to a restatement of earnings per share over those two years, and it came out that earnings per share only rose by 8%. Whether you were behind the misstatement or not, you need to give back the bonus to the company.

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