In this blog post, Ishan Sharma, a student who is currently pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses the claw-back clauses concerning the employment sector.
Introduction
A claw-back clause is nothing but a type of increment which is being levied in advance by the company to the employee for fulfilling certain targets of the company and getting the company benefiting from it. It is considered to be one of the most substantial reasons for motivating an employee at the time of their employment tenure so as to extract out their calibre for the efficient working of the company in which they are employed. However, there are several disadvantages that can result in an employee losing his job due to non-completion of targets which the employee had proposed to do. So much so, in the case of termination of employment, the employee has to repay the extra incentives or bonus which was given to them for such targeted work which they were unable to do.
In such type of clauses which are embedded in the employment agreements, the targeted work is given to an employee by the company to complete it in a certain period of time in lieu of which an extra increment is given to him as an advance which acts as a very powerful motivator as well as helps to keep up a healthy relationship between the employer and the employee.
Background
The concept of the claw-back clause was used to manage both risk and control future fraud. Claw-backs can be understood to be the contractual elements that stand between the drive for economic development and community development and the slippery slope of corporate welfare. They are highly controversial and are to be utilised as community-based guarantees for some expectation of performance.
Definition
A claw-back provision is a financial or other benefits which is given, but it is later taken back due to some unique circumstances. It can also be used to refer to any money or benefits that have been given out but need to be returned due to special circumstances or events, which are mentioned in a contract. In other words, it is provision under in law or contract that reverses a payment or distribution for specified reasons. Claw-backs are distinguished from repayments or refunds as they involve a penalty in addition to a repayment. But it can also include interest as a penalty on top of the agreed-upon claw-back percentage.
Objective of insertion of such clause
The objective of keeping or embedding such clauses in employment agreements is that the employers need to strike the right balance between protecting the company’s interests, adhering to regulatory requirements, attracting the best people and retaining their services and also to keep its employees stay focused in their obligation in a fair manner. But still there are certain objectives:
- Completion or Non-Completion of the targeted work by the employee.
- If the employee leaves during the period of probation or training before getting recruited by the company so as to repay all those expenses which the company has levied from his pocket to train him during probation period (Secure Recruitment).
- In a case of termination of employment on the basis of misconduct, poor individual or business performance, low calibre, etc.
- Failure of the condition precedent to the employer’s obligation to pay or a pre-vesting claw-back clause.
- Helps in binding up a healthy relationship between the employer and the employee for an efficient working in the course of an employment period.
- To return the monetary value of the incentives plus a penalty in case of any monetary loss to the company by the employee.
- To reimburse the company for any gains from exercising options by the employee.
- To reclaim a portion of any bonus if an investment worsens.
- To encourage loyalty.
- To incentivise in relation to future performance.
- To reward past performance.
Mechanism
Suppose an employer hires an employee, gives him incentives and forms an agreement with him embedding a claw-back clause which states that in case the employee fails to complete specified targets, then he is required to reimburse the incentive which was given to him in advance and then the employee is entitled to forfeit the claimed incentive.
Also, many start-ups now add an equity claw-back clause where stock options and other benefits already paid to the employee need to be paid back to the company in case of a drop in performance or missing milestones. However, some investors may insist on this clause as a prerequisite for funding.
Implications
The employees’ bonuses are, in a claw-back scheme, tied specifically to the performance (or lack thereof) of their work the individual(s) may have created as part of his or her job expecting a high profit. If the work/job executed does indeed do well over a long period of time, and permanently improves the nature of the firm, the bonuses paid to the individual are allowed to be retained by the individual. However, if the work fails, then the firm has the inherent right to revoke, reclaim, or otherwise repossess some or all of the bonus amount(s).
Also, it is seen that investors have greater confidence in a firm’s financial statements after claw-back adoption, and that boards of director’s place greater weight on accounting numbers in executive bonuses after a claw-back is in place (i.e., pay for performance sensitivity increases).
But claw back of paid or vested amount would normally be difficult to implement because once a right has accrued and been paid, it is difficult to claim it back under Indian law. In addition to the difficulty of recovering such benefits from employees, there will also be
difficulties from a tax regulation perspective since an employee will not be able to recover paid income tax from the government directly. Further, for employees earning less than INR 10,000 the provisions of the Payment of Wages Act would be applicable which permits
deductions in only certain limited circumstances.[1]
The clause should also include a pro rata repayment structure – the amount to be repaid in what form and manner and to what an extent, i.e.,
(i) The basis for which the bonus has been awarded,
(ii) The circumstances in which it must be repaid, and
(iii) The manner in which it must be repaid.
Otherwise, the repayment provision will be unenforceable for lack of certainty.
Representing Guidelines/Notifications
In Guidelines on Compensation of Whole Time Directors / Chief Executive Officers / Risk takers and Control function staff, etc. issued by the RBI Dated January 13, 2012 has stated in their notification under 2.1.4 Malus / Claw-back heading states in the event of negative contributions to the bank and/or the relevant line of business in any year, the deferred compensation should be subjected to malus/claw-back arrangements. 
A malus arrangement permits the bank to prevent vesting of all or part of the amount of a deferred remuneration. Malus arrangement does not reverse vesting after it has already occurred. A claw-back, on the other hand, is a contractual agreement between the employee and the bank in which the employee agrees to return previously paid or vested remuneration to the bank under certain circumstances. Banks may put in place appropriate modalities to incorporate malus / claw-back mechanism in respect of variable pay, taking into account relevant statutory and regulatory stipulations as applicable.[2]
Transparency on such clause
The validity of such a clause would only prevail when there was a written agreement with the employee providing that if he or she left the company within a certain period of time, he or she would have to repay the money to the company. Generally, employers do have a written agreement in place with the employee, and the agreement may have a provision that only provides for a clawback if the employee leaves the company voluntarily.
The written agreement may also have a provision regarding how the bonus will be paid back. Having the agreement in writing is helpful as proof that the employee received and agreed to pay the bonus back.
Remedies
Unless the bonus arrangements are carefully drafted and the circumstances in which an employer can claw-back a bonus are objective and reasonable, the employer may find itself facing an action for breach of contract (including breach of the implied term of trust and confidence) or unlawful deduction of wages. Complaints of discrimination may follow if certain employees feel targeted and they believe this is only because of a protected characteristic.
Whether a claw-back will be permitted will mainly be down to the interpretation of the claw-back provision, but in no circumstance should the provision be drafted so as to restrict an employee’s freedom of leaving the employer or be so onerous so that it will be deemed to be a penalty.
Conclusion
So, this claw-back clause is an ultimate tool where it acts as a role of a powerful motivator for the employees and an insuring agent for the company to maintain an equilibrium in the company to serve justice in the equal ant manner for both the parties.
References:
[1]https://www.mayerbrown.com/files/uploads/Documents%5CGuide%20to%20Restrictive%20Covenants/MB_rest_cov_asia.pdf
[2] https://rbi.org.in/scripts/NotificationUser.aspx?Id=6938&Mode=0
