Copyright 2011, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Securities Regulation, November 2011
It will be interesting to see whether the use of "clawback" provisions – arrangements under which an employee forfeits previously awarded compensation – will become more common in Canada.
Canadian public companies listed in the U.S. are subject to statutory clawbacks for certain employees. As well, certain Canadian financial institutions regulated by the Office of the Superintendent of Financial Institutions (OSFI) have adopted clawbacks as an OSFI-recommended best practice. Other Canadian public companies are not required to adopt clawbacks, but may choose to do so by agreement with affected employees.
However, experience to date suggests Canadian issuers that are not required to do so, either by virtue of not being subject to U.S. securities laws or not being regulated by OSFI, have not adopted clawback policies in significant numbers. Our survey suggests that while 27 of the TSX/S&P 60 companies have clawback policies, only three of these issuers are neither subject to U.S. securities laws nor OSFI regulation and of those three, two are affiliated to one another.
Clawbacks can take various forms. The clawback of compensation can be triggered by misconduct or "bad behaviour" of some type, or simply negative financial results, can relate to vested or unvested awards and apply to different forms of compensation, such as annual bonus or longer term equity or non-equity compensation.
Historically, contractual clawbacks have been used, in the U.S. in particular, to address "bad behaviour", a common example of which has been situations where employees left to join competitors. One use of such a clawback in a Canadian context was illustrated in the case of Nortel v. Jarvis, where Nortel imposed in its option grants a term providing for a recovery of gains on option exercises from employees who went to work for competitors within a specified period of time after option exercise. Nortel brought a claim to recover option exercise gains from an employee who joined a competitor. In that case, a Canadian court held that a properly drafted contractual provision providing for a recovery of option gains was enforceable, notwithstanding arguments made by the employee that the provisions were in the nature of a penalty and thus not enforceable.
Provisions in the U.S. Sarbanes-Oxley Act of 2002 (SOX) developed in response to instances where executives received bonuses based on financial results which later turned out to be inflated or illusory provide that, in the event an issuer is required to prepare an accounting restatement due to material non-compliance of the issuer, as a result of misconduct, with any financial reporting requirement, the CEO and CFO shall reimburse the issuer for any bonus or other incentive-based compensation and any profits realized from a sale of securities of the issuer during the 12-month period following the issue of the misstated financial statements. This clawback is mandatory for S.E.C. issuers (including Canadian corporations which are foreign private issuers under U.S. securities laws).
This clawback is restricted to the CEO and the CFO. As well, to be triggered, it requires that there be "an accounting restatement due to material non-compliance", and the restatement also has to be "as a result of misconduct". Under the SOX provisions, the S.E.C. is the party entitled to bring an action to recover the amounts. U.S. litigation has established that the misconduct required to trigger the provision is not required to be that of the CEO or the CFO. The clawback relates to all types of compensation, but only that received in the specified time period of 12 months following the misstated financial statements.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) introduced a new, and additional, clawback provision for U.S. public companies. (It appears that, absent an exemption being made available, the new provision will also apply to Canadian companies which are foreign private issuers for S.E.C. purposes.) The Act provides that the S.E.C. direct U.S. national securities exchanges and national securities associations to prohibit the listing of an issuer which does not comply with the Act's clawback provisions. The provisions require that, in the event that the issuer is required to prepare an accounting restatement due to material non-compliance of the issuer with financial reporting requirements, the issuer will recover from any current or former executive officers of the issuer that received incentive-based compensation (including stock options) during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement. The issuer is required to disclose its policy in this regard.
The Dodd-Frank provisions, while they do not affect the continued application of the SOX clawback provisions, introduce a new mandatory clawback provision which is generally broader in scope and application than the SOX clawback provision. Like the SOX provision, the Dodd-Frank provision applies if there is an accounting restatement due to material non-compliance with financial reporting requirements. However, the clawback applies to all current and former executive officers of the issuer and extends to the three-year period prior to the date of the restatement. The Dodd-Frank provision also does not have a "misconduct" requirement – the mere accounting restatement due to material non-compliance with financial reporting requirements triggers the provision. However, the Dodd-Frank provision restricts recovery to the excess that the executive officers were paid based on the erroneous data in the restatement, not all incentive-based compensation, as is the case under SOX. The Dodd-Frank provision, unlike the SOX provision, relies on the issuer to enforce the clawback against its employees.
Financial Stability Board
The Financial Stability Board (FSB) is an international organization which co-ordinates the work of national financial authorities of various countries, such as the U.S., Canada and the United Kingdom. Canadian members are the Bank of Canada, OSFI and the Federal Ministry of Finance. The FSB issued FSB Principles for Sound Compensation Practices – Implementation Standards in response to the 2008 U.S. financial crisis. The FSB Principles provide that subdued or negative financial performance of a firm should generally lead to a considerable contraction of the firm's total variable compensation, including through "malus" or clawback arrangements. The principles go on to say that unvested portions of deferred compensation are to be clawed back in the event of negative contributions of the firm and/or the line of business.
Based on these principles, the member countries of the FSB (including Canada and the United Kingdom) have required, or recommended as a best practice, that financial institutions under their jurisdiction adopt some form of clawback provision.
Under the United Kingdom's Financial Services Authority Remuneration Code, unvested deferred variable remuneration is to be reduced (i.e., clawed back) in the event (i) there is reasonable evidence of employee misbehaviour or material error, (ii) the firm or the relevant business unit suffers a material downturn in its financial performance, or (iii) the firm or the relevant business unit suffers a material failure of risk management. The United Kingdom provisions accordingly do not necessarily require misbehaviour or misconduct to trigger a clawback – a "material downturn" in "financial performance" may trigger the provision.
Canadian Requirements and Practices
As noted above, there is no generally applicable requirement in Canada that public companies impose clawback provisions. However, Canadian issuers which are subject to S.E.C. listing requirements are subject to clawback provisions.
As well, certain Canadian financial institutions regulated by OSFI are strongly encouraged by OSFI to implement clawback provisions reflecting the FSB Principles as a best practice. As the OSFI-regulated entities are not subject to a specific legislative provision in this regard, there is no prescribed form of clawback as in the U.S. and thus there is some variation in the form and manner of implementation of clawback provisions by Canadian financial institutions. As well, as these are being implemented contractually, not through binding legislation such as SOX or the Dodd-Frank Act, they are subject to the same enforceability concerns as any contractual form of clawback.
The Canadian Coalition for Good Governance (CCGG), an organization representing institutional investors and asset managers, has issued a report regarding issuer disgorgement policies. It noted there was significant variability in such policies. Some were fraud-based policies where only the executives responsible for the restatement of financials are required to repay performance-based compensation, and some were performance based, which apply to all executives regardless of their involvement in misconduct. The report notes there is also variability on what is to be repaid.
The CCGG report indicates that in Canada, as of 2007, only three issuers had "disgorgement" policies. Not surprisingly, CCGG policies recommend that payments of performance-based compensation should be over the period of time that it takes for results to be known, to allow for a linking of compensation plans with risk-management plans and effective "clawbacks of compensation in cases of poor performance, fraud, illegal behaviour or restatements".
The CCGG report also notes that the use of clawback provisions in Canada, other than financial institutions regulated by OSFI and Canadian issuers subject to U.S. legislation, appears at this time to be quite limited. As noted above, it appears that only three of the TSX/S&P 60 companies have voluntarily adopted such policies.
Issuers that nonetheless wish to consider voluntarily adopting clawback policies have flexibility to design these to meet their own circumstances and objectives. As noted, as these became part of the employment contract, they must be effected through agreement with affected employees. The agreement can be effected in a variety of ways – a general provision in an employment agreement covering all compensation or specific terms in award grants that clawback those particular awards (or gains from them) in specified circumstances. Given the variety of clawback provisions, in developing clawback policies, issuers will need to consider which employees will be subject to such provisions, the triggering event for the clawback (e.g., financial statement restatement, business losses), the types of compensation to which the clawback will apply (e.g., annual bonuses, equity or other long-term compensation, and whether vested or unvested), the relationship of the employee to the triggering event (e.g., was there misconduct of the employee contributing to the financial restatement or not) and the relevant time period for the compensation to be clawed back.
In addition, as in Canada the clawback is not mandated by a legislative requirement which makes it binding, issuers wishing to adopt clawbacks will wish to design contractual clawback provisions with sufficient clarity, and without being in the nature of a penalty, so as to be enforceable, unless the exercise is intended to be a cosmetic one.
Under Form 51-102F6 pursuant to National Instrument 51-102 Continuous Disclosure Obligations, there is a requirement for Canadian reporting issuers to disclose any "policies and decisions about the adjustment or recovery of awards, earnings, payments or payables if the performance goal or similar condition on which they are based are restated or adjusted to reduce the award, earning, payment or payable". Accordingly, for Canadian reporting issuers which are subject to U.S. SOX or Dodd-Frank clawbacks, which are regulated by OSFI, or which adopt clawbacks voluntarily, there is a requirement to disclose any such arrangements in their proxy circulars.
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