Executives who put their financial-performance based pay in a nonqualified deferred compensation plan could use a forfeiture from that account as a quick and easy way to meet their clawback obligations under Dodd-Frank if their company restates its financials. But there are tax rules to consider, a Troutman Pepper analysis shows.
The Securities and Exchange Commission in 2022 issued rules requiring Nasdaq and the New York Stock Exchange to require their listed companies to enact policies making clawbacks of financial-performance pay mandatory whenever the company restates its financials.
It doesn’t matter if it's an immaterial or a material restatement, and it doesn’t matter if there’s misconduct involved; even restatements based on simple errors trigger a mandatory clawback, with the amount tied to the amount of the restatement.
For executives facing a repayment obligation, coming up with the money can be a burden. But for those who put their annual cash bonus into a nonqualified deferred compensation plan, there could be a less painful way to meet the requirement, say Troutman Pepper attorneys who’ve thought through a solution.
If executives have their entire annual cash bonus put into the NQDC plan, for example, and they receive a matching contribution on the deferrals, it should be possible to pull, or forfeit, the amount of the clawback from this source – half from the deferred amount and half from the matching contribution – without violating IRS rules.
“A strong argument can be made that … a forfeiture of those amounts complies with Section 409A,” say the attorneys, referring to the IRS rules that govern NQDC plans. “That is because the employee was never entitled to that compensation; it was paid based on erroneous financial results [which generated the restatement and thus the clawback]. Removing the contribution (and related matching contributions and earnings) from the NQDC plan account through a forfeiture simply puts the employee and the NQDC plan in the position they would have been in had the compensation been correctly determined in the first instance.”
That’s a neat solution for a clawback, the attorneys suggest. But for executives who’ve elected not to defer their bonus but nevertheless have enough money in an NQDC plan to cover the clawback amount, it’s more complicated. They could have the amount forfeited from the account in the same way, but they face a riskier road that they’ll run afoul of the IRS.
The Section 409A rules include an anti-abuse provision that penalizes account holders for forgoing a future payment to the account in exchange for a new payment in the current year. To the extent the IRS views a forfeiture as a loan – you’re forfeiting a future payment to satisfy a current obligation, and expected to pay it back — you might trigger what the IRS calls a substitution under 409A.
“If the [performance-based] compensation received by the employee is treated like a loan from the company that the employee is required to repay, then use of the … NQDC plan benefits to satisfy the repayment obligation could be considered an accelerated payment under the substitution rule,” the attorneys say.
Given the uncertainty over how the IRS will treat at least one of these uses of NQDC plans to meet clawback obligations, there’s a role for in-house counsel to add a layer of protection against IRS action.
“There may … be strategies to improve enforceability of the Dodd-Frank clawback policy against NQDC plan benefits, short of amending the NQDC plan,” the attorneys say.
For example, the clawback policy might include a range of recovery methods that include forfeiture from NQDC plans and a requirement that executives acknowledge and agree to the policy. Or language could be added to annual deferral election forms to clarify that any portion of the deferred compensation later determined to be erroneously awarded compensation under the company’s Dodd-Frank clawback policy will be forfeited.
“The point of these strategies is to make enforcement of the Dodd-Frank clawback policy, if triggered, more efficient and less costly to the company,” the attorneys say.
If you don’t have a process for managing clawbacks in a relatively straightforward way, they say, you risk pushback from shareholders if there’s a restatement and the company has to come up with something on the fly.
“Shareholders may react negatively to [clawback] disclosures if the company could have acted to create more easily enforceable recovery rights but failed to do so,” they say.
