What Is A Clawback Provision?

Written by J. Hirby and Fact Checked by The Law Dictionary Staff  

Due to the variances in financial instruments over the long-term, more clawback provisions have been added to employment contracts. After 2008, this provision become a way to control employee benefits and prevent fraud. What is a clawback provision?

"Clawback Provision Restricts Future Bonuses"

The clawback provision is usually added to financial employment contracts to control the payment of bonuses. Many bonuses continue to be paid on complex financial instruments for years after they are created. If the performance should worsen, the clawback provision forces the original sales agent to give back a portion of this money.

Just like insurance claims regarding "Acts of God," financial institutions have realized that they needed to safeguard their compensation package for non-performing financial instruments. Most of these are mortgages or mortgage-backed securities. With the growth of the derivatives markets, the clawback provision is also useful to manage risk.

The organization with the employee with the clawback provision, is able to reclaim a portion of any bonus if an investment should worsen. This can also include interest as a penalty on top of the agreed-upon clawback percentage.

"Why are more Clawbacks Being Added?"

While a financial instrument - interest rate swap or credit default swap - may be profitable initially, once the economy falters, it can decline quickly. The derivatives market is high risk and high reward. Thus, as derivatives lose their value, the losses for the bank can worsen. As a hedge against this risk, banks have added clawback provisions.

Another key reason is the government bailouts of banks. As banks ran out of money, their top executives continued to receive impressive bonuses while their financial instruments had become "toxic" or non-performing.

The concept of the clawback was both to manage risk and control future fraud. If a sales agent knew beforehand that his financial instruments would lose money and he would need to give back a portion of the profits, he would have an incentive to be more accurate in calculating its value. Clients would be more impressed if clawback arrangements were part of their broker's contracts since this would involve shared future risk.

Banks can revoke or reclaim a portion of the bonus paid to staff. Any accounting restatement may trigger a clawback provision. Some bankers had deliberately "miscalculated" future earnings and would restate them after they started receiving their bonuses. The clawback provision prevents intentional and unintentional accounting errors.

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