Claw-Back Clauses in the Employment Sector

Introduction:

The claw-back clause in the employment sectors provides financial and other benefits to the employee but later returned or taken back on occurring of certain unique circumstances as mentioned in the contract of employment. These provisions are perceived as contractual components that demarcates the economic and community progress and the dangerous slant of corporate upbeat and can be used both to manage peril and to control late frauds. They are profoundly questionable and are to be used as community-based assurance for some performance expectations.

A claw-back clause is kind of an increment levied beforehand by the company or the employer to the employee for benefiting the company by accomplishing certain targets set by the company. This is considered as a substantial reason to motivate the employees during their tenure so that their greater working potential can be extracted out for the efficient functioning of the company under which they are employed at that time. The clauses containing targeted works to be completed within the specified period of time are embedded in the employment contract in lieu of this an increment or benefit is given to the employee acting as a motivation to increase the efficiency and also maintain the friendly working environment between the company and its employees.

However, this could sometimes be detrimental to the employee in case of not achieving the proposed target resulting in termination of the employment. In such circumstances, the provisions under the contract or law itself reverse the benefits on the specified ground and so the employee is asked to repay the increments or benefits of that unaccomplished targeted work. Penalties including interests on the agreed claw-back percentage are added along with it in some cases to distinguish it from mere refunds or repayments. The claw-back clause was applied originally acted as an insurance for misstatements in the financial results and employee’s fraudulent acts which later gradually gained prominence and expanded during the financial crisis of 2008, giving rise to the possibility of revisiting employee’s contractual clauses particularly in financial institutions that governs remunerations of the executives and with the prime purpose of recoupment of unjust enrichment.

Objectives of the Clause

The object behind embedding the claw-back clauses in the agreement of employment is to maintain the perfect balance between increasing the efficiency by protecting the interests of the company and to retain the employee’s service and obligation towards the company in a just way while simultaneously adhering to the rules and regulations. It keeps tabs and check on the accomplishment or non-accomplishment of the targeted work given by the company and in cases of the employee abruptly leaving or halting during the training or probationary period even before the proper recruitment process, the employee has to reimburse the expenses that the company levied to train the employee in order to secure its recruitment strategies and process. This can be applied while terminating the employment due to gross misconduct, failure to perform the precedent conditions of obligation to the employer, or low performance and caliber of the employee or a claw-back clause that is pre-vested.

The clause provides for reclaiming portions of a bonus if the investments deteriorate or any gains by exerting options by employees or a proportionate number of incentives gained with an addition of penalty to balance the monetary losses incurred to the company through the actions of the employee. On the bright side, to stimulate dedication and loyalty, for rewarding past achievements together to incentivize with regard to future achievements and in general, promotes a healthy and efficient working environment. Various start-ups ad investors now insist on provisions of equity claw-back as a prerequisite in the contract where benefits and stock potions paid should be returned if a drop or miss in performance occurs. 

Legal Provisions

There are no specific laws or even legal provisions for regulating or prohibiting the claw-back clauses in the employment sector at present in India. In 2012[1] and 2019[2], The Reserve Bank of India issued directions and guidelines that apply only to foreign banks and private sectors providing the inclusion of claw-back clauses regarding deferred and variant remunerations of Chief Executive Officers (CEO), full-time directors, and other managerial or risk-takers. With regard to the company law, the accepted common law principles in India curtails deriving profits by directors other than that the company provides while performing the course of their duties and responsibilities towards the company which was not consented to or within the knowledge of the company. There are similar provisions in the Companies Act 2013 that empowers a company to recover the amount unduly gained and imposes refund duty on directors for that unjust enrichment.

Provision under the Companies Act 2013

• Section 166(5) of the Act: The director of a company is made liable to the company to pay the amount of money equivalent to that of the undue gain procured for him or his partners, relatives, or associates.
• Section 197(9) of the Act: It provides for the remuneration refund taken exceeding the prescribed extent by the director to the company but the company can waive this off by passing a special resolution within 2 years from the date when the sum gets refundable. It can only be waived off by the company through a special resolution passed within two years from the date that the sum is refundable[3].
• Section 199 of the Act: It enables the remunerations including stock options to be recovered by the company which was received by the managing director, whole-time director, manager, CEO in the past or present relating to non-compliance or fraud. The financial statements were required to be restarted and this restatement would reflect the excess remunerations paid in the financial statement.
• Section 130 and Section 131 of the Act: the revision and re-opening of the company’s accounts notified after the Satyam scandal[4] on June 1, 2016, are dealt with under this section. There were no particular provisions in The Companies Act, 1956 for restatement of accounts. But the Department of Company Affairs issued department circulars regarding the re-opening of accounts later on their adoption in the general meeting by the members. Restatements of the financial statement are passed by an order of the Tribunal based on applications. The financial statements can be restarted if an order is passed by the Tribunal on basis of the applications filed by Income- Tax authorities, Central Government, SEBI, or other statutory body or person that concerns on grounds of fraudulently prepared accounts and mismanaged company affairs at that relevant period of time which causes fraudulent and reliability doubts on the financial statement. Voluntary applications can also be applied by companies if the directors of the company feel that reports of the board of the company and their financial statements are not in compliance with the provisions given under Section 129 and Section 134 of the Act[5] and these revised and re-cast accounts would be final.
• Section 199 of the Act: the excess remuneration may not be recovered by the company under this provision since the reports[6] of the Serious Fraud Investigation Officer (SFIO) appointed by an order of the Central Government is considered only as an opinion and not given the value of a legal evidence[7]. So, the company can claw-back the excess benefits only by relying upon the order of the Tribunal as mentioned in the above provisions of restating to achieve finality. The company has to establish that the already paid remuneration is in fact in excess of the actual payable amount attributable to that restated account. Though there are no express provisions to spell out this claw-back mechanism in this Act, the company can take the recourse of filing a civil suit to recover the excess amount or simultaneously initiate criminal proceedings against the director, CEO, or any other officer or employee if they are no longer engaged in the employment or refuses to redress the unjust enrichment.  

The Reserve Bank of India issues guidelines in case of deterioration in performance of lender to incorporate claw-back provisions stating that appropriate mechanism should be adopted by banks and other financial institutions regarding variable pay. This was followed as a reaction after the global financial crisis to create responsiveness and accountability of decisions by senior management to prevent their misconduct and undue risk-taking.[8] Few banks like ICICI Bank and Yes Bank use claw-back clauses even though no standardized rules are present for this in the industry. The RBI stated the deferred compensation ought to be made subject to claw-back provisions in case of negative and subdued financial performance by banks including other relevant lines of business and should establish representative provisions to enable invoking the claw-back clauses which may apply to the whole variable pay. The RBI specified particularly that the clauses of claw-back emerge in case of deviations of more than 15 percent in bad loan classification requiring disclosure in public.

The Indian Contract Act can be applied on violation challenges regarding the limitation for claims of refund by the organization contenting unreasonable time period since this is a special contractual clause triggered on happening of specific events or circumstances involving penalties rather than a simple refund or repayment as stated in the employment contract.

Implementation of the Claw-Back

The company has inherent rights of reclaiming, revoking, or repossessing a part or in whole the incentives if the employee fails to execute the specific task and so the claw-back scheme ties these benefits directly to the employee’s performance. The implementation of claw-back clauses in companies increase the performance sensitivity pay as the board of directors give more importance to accounting numbers in benefits of the executives and this often attract investor’s confidence on financial statement.

However, it is difficult to implement and claim the already paid or vested incentives as a right is accrued on the employee. In addition to this, from the perspective of tax regulation, the employee won’t be capable of directly recovering the income tax already paid from the government. Further, the Payment of Wages Act can be applied for employees whose remunerations are less than INR 10,000, permitting deductions on certain circumstances.[9] For repayment provisions to be enforceable, a pro-rata (in proportion) repayment structure should be included in the claw-back clause stating:

1. Certain and lucid terms
2. The form in which the amount is repayable
3. The manner and extent of the repayable amount
4. The specific circumstance triggering the repayment
5. The basis for awarding the benefits
6. A written agreement providing these provisions

Generally, the company maintains a written agreement with the employees with provisions providing for claw-back only in cases of voluntary termination of the employment by the employee. The company or the employer may face charges of unlawful wage deduction, discrimination, and breach of contract including implied breach of trust and confidence if the claw-back clauses are non-objective or unreasonably drafted and implemented.

Conclusion

A claw-back clause acts as an insuring agent and a key to maintain equilibrium in the company to do justice both to the employee and the company. The claw-back provisions should essentially be transparent and crystal clear stating the specific enforceable circumstances as it should not be drafted, interpreted, and applied in any way restricting the choice or freedom of an employee to terminate the employment or be so onerous as to attract the penalty provisions. Due to the absence of any express laws to govern, the enforcement of a claw-back clause could be a hindrance especially if the time period for claiming back such claw-back is not present or the defined time period is unreasonable. Companies gradually started providing a huge part of variable compensation where the valuation was not certain in stock options or company stock. Hence the question as to whether the variable component of the remuneration can only be claimed in claw-back or be expanded to add the guaranteed components or fixed components of remuneration remained uncertain.

Over the last decade, India witnessed alarming corporate scams revealing artificial profits in false accounts benefiting especially the CEOs, managing and executive directors of companies by way of stock options, disproportionate money through profit-linked incentives, and other unjust enrichment contrary to the company’s fair state of affairs. All superior level recruitment entitled to bonuses and profit-linked incentives were advised to have claw-back clauses embedded in the contract of employment to effectively curb malpractices. Currently, the economic crises driven by the pandemic along with the long-pending cases for adjudication in this subject matter calls for significant development of law and specific regulatory norms to accomplish the unexploited potential of claw-back clauses in the employment sector to combat corporate misfeasance.

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References:

[1] Compensation of Whole Time Directors/Chief Executive Officers/ Risk takers and Control function staff, issued by the Reserve Bank of India, dated January 13, 2012.

[2] Compensation of Whole Time Directors/Chief Executive Officers/ Risk takers and Control function staff, issued by the Reserve Bank of India, dated November 04, 2019

[3] Section 197(10), Companies Act, 2013 read with Rule 7 of Companies (Appointment and Remuneration of Managerial Personnel) Rules, 2014.

[4] Venture global engineering v Satyam computer services Ltd & Anr, 11 Aug 2010

[5] Rules 76A and 77 of the National Company Law Tribunal Rules, 2016 respectively prescribe the procedure for filing application under Section 130 and 131 of the Act.

[6] Section 212(15), Companies Act, 2013.

[7] Satya Narain Musadi v. State of Bihar (1980 3 SCC 152); K. Veeraswami v. Union of India (1993 3 SCC 655); MC Mehta v. Union of India (2007 1 SCC 110)

[8] Ronesh Puri, Managing Director at Executive Access

[9] https://www.mayerbrown.com/files/uploads/Documents

Other Sources:

• ‘Claw Back Clauses in Employment Contracts: A New Tool to Fight Corporate Misfeasance’(Coventus Law), June 4 2020.
• Vasani B, Hasan M and Himadri E, ‘Claw Back Clauses in Employment Contracts: A New Tool to Fight Corporate Misfeasance’ (India Corporate Law June 4, 2020) 
• Rebecca Furtado, ‘Analyzing Claw-Back Clauses In The Employment Sector’, November 10, 2016
• ‘Clawback – Understanding How Clawback Provisions Work’ (Corporate Finance Institute) March 25, 2020
• RBI Clamps Down On Variable Pay Of Top Management At Private Bank, BQ Desk, November 04 2019
• https://www.bloombergquint.com/business/rbi-clamps-down-on-variable-pay-of-top-management-at-private-banks
• http://iclrap.in/importance-of-clawback-clauses-to-fight-corporate-misfeasance/
• https://www.conventuslaw.com/report/india-claw-back-clauses-in-employment-contracts