Red in Tooth and Clawback

The denizens of corporate America could sorely use tougher consequences for poor performance. Thankfully, more meaningful repercussions for operational failure may be on their way. Say goodbye to "golden parachutes" and their promise of a soft landing. Inept executives could soon enter the decidedly Darwinian world of "clawbacks."

For shareholders, parachutes have their perils
Too many companies currently maintain a perverse incentive system in which top brass not only can cash in while they're at the helm, but also profit mightily if they screw up -- or even if they're let go.

The business world has no shortage of golden parachute horror stories. (Well, they're horrifying for shareholders, at least.) Before Bank of America (NYSE: BAC  ) swallowed beleaguered Merrill Lynch, former Merrill CEO Stan O'Neal walked away with a $161.5 million farewell package. Home Depot's former CEO Bob Nardelli left his company in need of repair, but still walked away with $210 million.

Golden parachutes can even obstruct a struggling company's ability to procure a new leader. Back in 2005, former Blockbuster head John Antioco pretty much had shareholders over a barrel, reluctant to oust him for fear of paying a $54 million severance package upon his departure. With friends like that, who needs enemies?

As Berkshire Hathaway's Warren Buffett once put it: "Getting fired can produce a particularly bountiful payday for a CEO. He can 'earn' more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Today, in the executive suite, the all-too-prevalent rule is nothing succeeds like failure."

Time to toughen up?
Thankfully, this compensation quandary has a common-sense solution with a deliciously aggressive name: the "clawback." If executives really screw up, their former companies can "claw back" the executives' undeserved gains.

The current financial regulatory reform bill contains a requirement for clawback provisions in executive contracts, among other corporate governance initiatives. But refreshingly, many firms haven't waited for Uncle Sam -- they've adopted such practices voluntarily. According to compensation research firm Equilar, 73% of Fortune 100 firms have now added clawback provisions to their executive pay policies, a huge increase from a mere 16% in 2006.

Interestingly, some major Wall Street firms are even making those provisions more vicious -- at least in theory. J.P. Morgan Chase (NYSE: JPM  ) , Bank of America, Goldman Sachs (NYSE: GS  ) , Citigroup (NYSE: C  ) , and Morgan Stanley (NYSE: MS  ) have all instituted some form of clawback provisions, which used to be commonly limited to fraud or to the highest-ranking executives.

Newer, occasionally harsher elements include J.P. Morgan's decision to allow clawbacks to relate to any employee who receives stock compensation. The company will also take action against employees who take too much risk, or fail to sound an alert when they discover others' excessive risk.

Elsewhere, Bank of America is changing its existing clawback provision to include high-ranking executives. Morgan Stanley's including soured trades as a clawback trigger. And Goldman Sachs is using restricted stock to pay out bonuses, since that makes future clawbacks easier to execute.

Truth and consequences
However, some critics doubt that corporations will actually be able to use these tough-sounding provisions. Clawbacks are difficult to enforce, especially if the recipient has already spent -- and paid taxes on -- the money. For shareholders' sakes, let's hope companies can find ways to give these contingencies a bit more bite.

When corporations start heading south, their managers' inability (or lack of will) to retrieve undeserved gains from overpaid CEOs only adds insult to shareholders' injury. Although companies could better serve investors by reining in excessive pay in the first place, clawbacks at least ensure that executives' irresponsible or unwise actions come with consequences in the long run.

The judicious use of clawback provisions could add a much-needed dose of "tooth and claw" to our increasingly complacement corporate world. In a truly free market, achievement would trump entitlement, and CEOs who couldn't lead their companies effectively would earn only a swift kick out the door.

If top executives know that grave, painful consequences await them should the fruit of their labors prove rotten, perhaps they won't make so many terrible mistakes in the first place.

Check back at every Wednesday and Friday for Alyce Lomax's columns on corporate governance.

Alyce Lomax does not own shares of any of the companies mentioned. Berkshire Hathaway and The Home Depot are Motley Fool Inside Value picks. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Berkshire Hathaway. The Fool has a disclosure policy.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2010, at 9:38 AM, DDHv wrote:

    Wouldn't it be sensible to have a delayed bonus? It takes years for some executive choices to play out. Make the bonus be for the results in the longer term past, and over a time span of at least three years.

  • Report this Comment On April 29, 2010, at 8:19 PM, lemoneater wrote:

    Yes, I was incredulous at how Nardelli got a generous golden handshake when he left Home Depot in shambles. Also I couldn't believe how quickly he got another influential position right away. I will never knowingly invest in a company with a vampire style management.

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