Contractual Enforcement. Many hedge funds, private equity and financial institutions have adopted contractual clawback protections for employee fraud or misconduct and as a tool for enforcing noncompetes and other restrictive covenants. Clawback provisions may be in an executive’s employment agreement, restrictive covenant agreement, equity or bonus plan or agreement or as part of a general clawback policy document. There are questions of enforceability depending on whether consideration was received for the clawback and whether the clawback was acknowledged and agreed. In addition, some states such as New York require advance written authorization for certain types of repayment obligations.

Trying to void their restrictions, plaintiffs will challenge the choice of law and whether the dispute is arbitrable, and some disputes face further challenges if there is a lack of consistency between agreements, plan documents and clawback policies. Companies and executives also need to take into account the expense and investment in enforcing clawbacks through litigation or arbitration. There may be factual disputes over the conduct triggering the clawback, as well as questions of contractual interpretation, which might not bode well for predictable resolution.

US Federal and State Laws Protecting Employee Interests. As stated above, contractual enforcement may depend on whether the document provisions comply with or are consistent with applicable federal and state laws. With respect to a clawback triggered by breach of noncompetes and other restrictive covenants, the recent FTC final rule calls into question whether a clawback may even be triggered in the event of competition. The FTC final rule explicitly bans provisions providing for the forfeiture of compensation if an employee engages in competition. Though many states have case law supporting the forfeiture of bonuses upon violation of restrictive covenants, if the FTC final rule survives legal challenges, clawbacks based on competition may simply become void.

One of the critical questions is whether the clawback will be enforceable in the applicable jurisdiction. If the FTC final rule prevails, clawbacks may need to be narrowly drafted to explicitly exclude noncompete covenants and focus on other types of conduct, such as confidentiality breaches or financial misstatements. Even if the FTC Rule does not become effective due to several litigation challenges it faces, states are adopting more restrictions on non-competes and the public opinion climate for enforcing such clawbacks is rapidly changing. California is well known for banning noncompetes and enforcement of clawbacks based on breach of noncompetition restrictions creates significant risk.

Federal and state wage laws also impose certain conditions and requirements to ensure that workers are paid their earned wages. Many states, such as California, provide that bonuses for which all the services were performed are earned wages that cannot be forfeited, even if they have not yet been paid. Massachusetts, New Jersey and New York also have restrictive state wage protections in place that might make enforcement of a clawback difficult. In seeking repayment, companies will need to consider whether applicable state law provides statutory authority or case law supporting the demand for repayment.

Taxes. It is crucial for companies and executives to carefully review clawback provisions and consider the tax implications. The tax treatment of the repayment amount is a complex area of law that will depend on the timing of the repayment, the amount being repaid (gross or net of taxes), the form of repayment and the amount and type of taxes and withholdings that were previously withheld on the original bonus payment. The withholdings and deductions on the original bonus payment may include contributions to tax-qualified retirement plans or other benefits, as well as federal, state, local and/or foreign taxes. Separate rules will apply to each of these withholdings and deductions and the ability of the affected executive to recoup taxes being repaid as part of the clawback will depend on the tax year, other compensation paid to the executive, state or local tax law, and any developments relating to claim of right or other doctrine under federal tax law.

SEC Listed Companies. Where listed companies impose compensation rules, private companies oftentimes follow. US listed companies must comply with the December 1, 2023 deadline to formally adopt clawback policies of executive compensation with respect to financial restatements under Rule 10D-1 of the Securities Exchange Act of 1934, as amended. The final rules under Rule 10D-1 generally mandate clawbacks of erroneously awarded incentive compensation over a three-year look-back period where there has been a financial restatement impacting the calculation of the compensation awarded. This means that executives who have benefited from erroneously awarded compensation may face clawback rights and responsibilities, leading to potential unexpected outcomes.

Corporate Crimes. Finally, the US Department of Justice adopted a 2023 Pilot Program on compensation incentives and clawbacks to encourage good corporate behavior by individual employees by increasing their personal financial risk. On January 10, 2024, the Department of Justice announced a successful deferred prosecution agreement with German software conglomerate SAP SE on charges of bribery under the Foreign Corrupt Practices Act of $220 million.  One of the mitigating factors in reducing the penalty, and even perhaps avoiding prosecution, was the effort of the company to withhold $109,141 in bonuses from employees involved in the scheme. The company was favorably cited as having sought the return of the bonuses of employees suspected of wrongdoing or employees who were supervisors of the employees or business area engaged in misconduct (and knew of, or were willfully blind to, the misconduct), which approach is consistent with the DOJ 2023 Pilot Program on compensation incentives and clawbacks.  The agreement explicitly noted that the company invested in “substantial litigation to defend withholding from those employees”.  Even though the compensation recovery was a small relative dollar value in terms of the fine, a company under investigation may gain significant benefits in actively litigating the recovery of amounts in a business area subject to a DOJ investigation as part of a total settlement position.

Bonus clawbacks are an important tool for protecting corporate interests, but they come with legal risks and complexities. Hedge funds and executives should be aware of these risks and take necessary precautions when implementing and enforcing clawback provisions against employees. This is the time to consider the usefulness of bonus clawbacks from a policy standpoint and other strategies for employee retention and protection of proprietary information. Seeking legal advice and staying updated on relevant laws and regulations is crucial to navigate these challenges successfully.