UK: Bonus Clawback Proposals

Last Updated: 30 July 2014
Article by Nick Hurley and Bob Mecrate-Butcher

In March the Prudential Regulation Authority ("PRA") issued a consultation paper on its proposals to extend the Remuneration Code so that PRA-authorised firms will be required to include clawback provisions in employment contracts. The PRA is proposing that all vested variable remuneration awarded on or after 1 January 2015 will be subject to clawback and that employment contracts are amended to enable this. Under the proposals clawback would apply in line with the requirements on malus, i.e. if there is reasonable evidence of employee misbehaviour or material error, or if the firm or business unit suffers a material downturn in its financial performance or if the firm or business unit suffers a material failure of risk management. As for malus, the PRA also does not want clawback to be restricted to those directly culpable of malfeasance. Therefore, where an employee is indirectly responsible by virtue of their seniority or where they could have been reasonably expected to be aware of a material failure of risk management or misconduct but didn't take steps to deal with it clawback should apply. We take a brief look at some of the legal issues arising from these proposals.

Proposal to amend employment contracts

The PRA expects firms to amend employment contracts firstly so that, from 1 January 2015, clawback will be applied to all vested awards up to six years after vesting. Secondly, more controversially all firms will be required to take "reasonable steps" to amend contracts to allow clawback of awards made prior to 1 January 2015 but which vest after that date, again up to six years after vesting.

Amending employment contracts is not a simple matter and it may also be the case that scheme rules need to be amended. Amendments either require individual employee consent or there must be an express power permitting unilateral variation by the employer in which case generally, even where a contract does contain such a power, the courts have found this only permits minor rather than fundamental changes. In addition, these proposals will only affect the contracts of current and future employees and therefore, those who have already left whose contracts do not contain any clawback provisions will be financially better off.

Although it may not prove problematic to obtain agreement in respect of future awards it is less likely that employees will agree to these changes in respect of awards already made. Where employees don't consent firms will be left with the difficulties of having to force through a valid contractual variation by terminating and re-engaging on an amended contract. This approach in itself opens up significant employee relations issues, potential unfair dismissal claims and, dependent on numbers, the requirement for collective redundancy consultation. Employees could also allege that forcing this change amounts to a breach of trust and confidence entitling them to resign and claim constructive dismissal. Although the employer could seek to rely on compliance with the Remuneration Code as some other substantial reason for dismissal it would also need to ensure that any process it followed was fair and it remains to be seen what the approach of the tribunals would be.

Even where the employer is able to amend employee contracts the clawback provisions may not be implemented for several years potentially raising difficult issues for the employer in respect of evidence, for example, of culpability and also of enforcement particularly where employees have left.

In addition, where the employer is seeking to apply clawback provisions to awards made before 1 January 2015 relying on a right to vary unilaterally without express employee consent employees could also seek to argue estoppel by representation, i.e. that the employer is estopped from exercising clawback where it has previously notified them of awards without any reference to clawback and they have relied on these representations.

Grounds for clawback should be as wide as for malus?

The PRA also invited comments on the proposal that the grounds for clawback should be as wide as those for malus. In our view, it would seem more appropriate to limit clawback to employee culpability (i.e. employee misbehaviour or material error and possibly also culpable failures of risk management) as there is an important practical distinction between malus and clawback as malus is applied to unvested deferred remuneration (which is unspent) whereas clawback requires a repayment of what has already been received (and possibly spent). As a result, this firstly raises the moral issue of whether it is fair/equitable/right that employees should be at risk of clawback in as wide a range of circumstances as they should be at risk of malus. Secondly, it raises the practical issue of applying clawback when awards may have been spent through litigating against current and former employees, including likely challenges to the enforceability of clawback provision (for example, penalty clause arguments, in our view, such arguments should be straightforwardly defeatable through appropriate drafting), complex issues regarding the valuation of shares and share based awards as well as the costs of enforcement.

It is not clear how much discretion or flexibility a firm will have in choosing whether to enforce which could involve significant legal costs.

Conclusion

These proposals raise significant legal and practical difficulties which appear to have been underestimated by the PRA. The consultation closed on 13 May and we await the outcome with interest and will, of course, report back.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Nick Hurley
Bob Mecrate-Butcher
 
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