Guidelines Issued by RBI for Induction of Claw Back Clauses

This article studies the guidelines of the Reserve Bank of India (RBI) to include the provision of claw back clauses for all private sector and foreign banks. This write-up lastly also discusses the challenges faced due to absence of expressed law or provision.
Estimated Reading Time: 11 minutes

Introduction
In November 2019, the Reserve Bank of India (RBI) issued guidelines for all private sector and foreign banks, on compensation of the Whole Time Directors (WTDs), Chief Executive Officers (CEOs), Material Risk Takers (MRTs) and Control Function Staff (CFS). The 2008 financial crisis made it possible to revisit contractual clauses of employees, especially those governing remunerations of executives in financial institutions. One of the clauses that gained prominence was the clause pertaining to ‘claw back’.

Meaning

Broadly speaking, claw back clause refers to an action for recoupment of a loss. It means the refund or return of incentive or compensation after they have been paid. The purpose of such a clause is to claim back unfair enrichment that has happened to an employee. Such a clause acts as a form of insurance and was originally applied in cases of misstatement of financial results or fraudulent acts by employees, but over time, the scope of this clause has gradually expanded.

Objectives

Aligned with global Financial Stability Board’s (FSB) principles for sound compensation practices, the guidelines are intended to enhance compensation governance, and discourage excessive risk taking. The new standards will place a greater focus on Board oversight of remuneration outcomes, risk-reward alignment, share-linked instruments, deferral of variable compensation, and malus and claw back provisions.[1]

Given recent identification of large non-performing assets and demand from shareholders and investors for stronger governance, compensation of senior executives is under increased scrutiny. Effective from performance periods commencing from April 1, 2020, all private sector banks, local area banks, small finance banks, payments banks, and wholly owned subsidiaries of foreign banks are required to comply with these guidelines. Failing to do so could result in severe penalties, including additional capital requirements.

Indian laws on claw back provision

In India, currently, there is no law that specifically governs or prohibits inclusion of claw back provisions. The Reserve Bank of India, in 2012 and 2019, issued guidelines that provided inclusion of claw back clauses in relation to variable and deferred remuneration of whole-time directors, CEO and other risk takers. However, these guidelines apply only to private-sector and foreign banks. 

In so far as company law is concerned, common law principles, as accepted in India, restrict directors from deriving profit (other than those provided by the company) during the course of the performance of their duties owed to a company, without the knowledge and consent of the company. In furtherance to the same, there are several provisions of the Companies Act, 2013 (“the Act”), which either imposes a duty on the directors to refund the amount unduly gained or empower the company to seek refund/ recovery of the amount given. 

Section 166(5) of the Act provides that a director of a company shall be liable to pay to the company the amount equal to the undue gain made either to himself or his relatives, partners, and associates. Refund of remuneration drawn in excess of the prescribed limit by the director to the company is provided under Section 197(9) of the Act, which can only be waived off by the company through special resolution passed within two years from the date the sum becomes refundable[2]

Additionally, Section 199 of the Act enables the company to recover the remuneration (including stock options) received by any past or present managing director or whole-time director or manager or CEO, in case of fraud or non-compliance, which required a restatement of the financial statements, and if the remuneration paid are found to be in excess of what is reflected in the restated financial statements. 

Section 130 and Section 131 of the Act deal with re-opening and revision of accounts of companies, which were notified on June 1, 2016, post the Satyam scandal. Under these provisions, financial statements can be restated if an order is passed by the Tribunal.

Power of Central Government to Investigate

Based on an application filed by the Central Government, Income-Tax authorities, Securities and Exchange Board of India, any other statutory regulatory body or authority or any person concerned on the grounds that:

(a) the earlier accounts were prepared in a fraudulent manner or 

(b) the affairs of the company were mismanaged during the relevant period, casting a doubt on the reliability of financial statements being fraudulent; or – 

Based on an application voluntarily filed by the companies, if it appears to the directors of a company that the financial statement of the company or the report of the Board do not comply with the provision of section 128 or 142 of the act. Section 212 of the Act empowers the Central Government to order an investigation to be carried out by the Serious Fraud Investigation Officer (“SFIO”) if it opines that it is necessary to investigate into the affairs of the company.

The Central Government may rely on such SFIO report and file an application under Section 130 before the Tribunal for re-opening the books of accounts and recasting the financial statements. It must, however, be kept in mind that even though such SFIO reports are deemed as reports filed by a police officer under Section 173 of Code of Criminal Procedure they are still considered as ‘opinions of such officer’ and do not constitute legal evidence. Therefore, a company may not be able to recover excess remuneration from its directors/ CEO under Section 199 of the Act, solely based on the SFIO report.

It appears that the company will be able to claw back any excess remuneration paid only if an order is passed by the Tribunal under Section 130 or Section 131, directing the company to restate the accounts and such restated accounts attain finality. Based on such restated accounts, the Company would need to demonstrate that the remuneration already paid to the directors/ CEO were in fact in excess of what was actually payable to them as per the restated accounts (i.e., in view of the readjusted net profits of the company for the relevant financial years). The Act and the rules made thereunder do not expressly spell out the mechanism under which a company can recover such excess remuneration. If the director/ CEO is no longer employed with the company and if he refuses to return the excess remuneration, the company may have to take recourse by filing a civil suit against director/ CEO for recovery of the excess amount.

The company may also simultaneously file a criminal complaint before the Magistrate under Section 452 of the Act against any officer or employee for wrongful withholding of property of the company. Though the current article does not deal with disgorgement, it is worthwhile to mention that Sections 212(14A) and 224(5) of the Act provide for disgorgement of assets, property or cash of such directors, key managerial personnel or other officer of the company, who are liable personally without any limitation of liability, if the SFIO report under Section 212(11) or Section 212(12) or the inspector’s report under Section 223 states that a fraud has taken place and such a person has taken undue advantage or benefit. However, such disgorgement can only be enforced by the Central Government by filing an application before the Tribunal for appropriate orders.[3]

In case of winding up

In the context of winding up, Section 339 of the Act provides that in case any director, manager, officer, or any persons knowingly carried out business with the intent to defraud creditors or for any fraudulent purpose, the Tribunal may order that such persons are personally responsible, without any limitation of liability, for all or any of the debts or liabilities as the Tribunal may direct. The said section also states that every person who knowingly carries on business in the manner aforesaid shall be liable for action under Section 447 of the Act[4].

Section 340 of the Act confers powers to the Tribunal to inquire into and further order repayment or contribution to the assets by any promoter, director, manager, company liquidator or officer of the company, who has misapplied, retained, become liable or accountable for money or property, or has been guilty of misfeasance or breach of trust. Section 341 of the Act extends the liability under Section 339 and 340 of the Act to partners and directors who held such positions at the time of the fraudulent transaction. Whilst Sections 337 to 241 applies only when a company is being wound up, Section 246 of the Act provides that the provisions of Sections 337 to 241 will apply mutatis mutandis in relation to an application made to the Tribunal for oppression and mismanagement under Section 241 or Section 245 of the Act.

Further, in case an amount on which tax has already been deduced by the employer is refunded under the claw back clause, the employer should be entitled to recover the entire gross amount from the employee. It should be the responsibility of the concerned employee to seek tax refund from the income tax department.[5]

Purpose of the guidelines

With these guidelines, RBI joins central banks and regulators of most developed markets in adopting standards that place a greater focus on Board oversight over remuneration outcomes. Although implemented almost a decade after some of the Anglo-Saxon markets, this is certainly a move in the right direction and will go a long way in strengthening risk-reward alignment.[6]

The new guidelines are aligned with global best practices to strengthen compensation governance. For example, companies are required to establish a formal Nominations and Remuneration Committee (NRC) of the Board, adopt a formal compensation policy, use qualitative and quantitative parameters to define MRTs, prescribe the mix between fixed and variable pay, and between annual bonus and share-linked instruments, implement bonus deferrals, adopt claw back and malus provisions, deleverage compensation for control staff, and adopt defined protocols regarding compensation disclosures. Additionally, companies are not allowed to offer guaranteed bonuses nor severance payments, and executives are prohibited from hedging their compensation structures to offset for the intended risk-reward alignment.

Implementation challenges

While there are several positives, there are also some areas that warrant additional clarity. In particular, there are four areas where banks are experiencing implementation challenges.

First is the identification of MRTs. The 2019 guidelines go a long way in making the MRT identification process objective across banks; however, they also make it tougher to capture organization-specific nuances. A key challenge relates to the standardized approach of identifying roles that may expose the bank to credit risk vs. operational risk vs. market risk. Also, the requirement that MRTs should comprise of 0.3% of highest paid staff may not truly reflect the roles that are likely to expose the bank to material risk.

Second is related to triggers for malus and claw backs. The guidelines allow for reducing or cancelling incentive payments. In some extreme cases, executives may even have to return incentives received back to the banks. However, there are also some areas which are left unaddressed, such as quantifying the triggers of non-performing assets, or defining the limits of subdued / negative performance that may warrant malus and claw backs to be exercised. It is also important to define the roles of NRC and Board Risk Committee in monitoring triggers leading to malus or claw back, including the time horizon for ex-post adjustments.

Third is related to share-linked instruments, with the requirement that between half to two-third of overall variable pay should be share-linked. The guidelines mainly refer to share-linked instruments as employee stock option plans (ESOPs), which ignores the whole range of other instruments that are widely used by global banks in other jurisdictions such as restricted share plans, performance share plans etc. The guidelines go on to specify a requirement that share-linked instruments should be fair valued on the date of grant by the bank using Black-Scholes model.

The prescription of Black-Scholes model may be stifling, as it can be used for pricing ESOPs, but not for determining fair value of restricted shares or performance shares – which globally are among the most prevalent share-linked instruments. Besides, whilst ESOPs are mainly linked to share-price performance, other instruments can provide stronger pay-for-performance linkage with multiple performance indicators, including share price, profits, non-performing assets, customer advocacy etc.

Finally, while banks focus on implementing these guidelines, it is also important to watch out for any unintended consequences. For example, in some European markets, adoption of similar caps and limits on variable pay has led to quite significant increases in fixed salary. Such institutional deleveraging of pay may ensure better risk-reward alignment but may dilute the pay-for-performance linkage. Similarly, as an unintended consequence of RBI guidelines, it is likely that banks that currently do not have share-linked instruments may see significant increases in total compensation. To meet the required proportions of deferrals and share-linked requirements, it is possible that banks end up increasing the overall variable pay – as companies generally prefer not to cut fixed salaries.

Enforcement of claw back clauses in absence of any express governing law

Given the absence of any express governing law, enforcement of claw back clauses can be a hindrance if there is no time period for claiming such claw back or the time period defined is unreasonable. There is also uncertainty as to whether claw back can only be claimed from the variable component of salary or whether it can be expanded to include amounts of the fixed or guaranteed components of salary. Moreover, many companies provide a large portion of variable compensation in company stock or stock options, which have uncertain valuation. It is, therefore, essential that claw back clauses are defined in crystal clear terms, along with spelling out the circumstances under which such claw back can be enforced.[7]

The new RBI guidelines should be applauded as they are definitely a strong move towards instilling confidence within investors, customers and employees regarding compensation governance and risk-reward-performance alignment. NRCs and boards will need to maintain their strategic and oversight perspectives, and careful attention will be needed in designing appropriate compensation arrangements that comply with RBI guidelines, align with interests of shareholders and broader stakeholders, and at the same time be able to attract, retain, and motivate high-caliber management talent within the competitive banking industry.

Conclusion

India has witnessed a series of corporate scandals over the last decade with an alarming regularity. Investigations into those scandals by law enforcement agencies have revealed a trend of falsification of accounts to show artificial profits, which appeared to benefit Managing Director/ CEOs and other executive directors. They have drawn disproportionate amount of money by way of profit-linked bonuses, stock options and other benefits, which they would not be entitled to, had the accounts reflected the true and fair view of the state of affairs of the company. It is advisable that all senior level appointments that are entitled to draw profit-linked commission, bonuses, etc., should have specific claw back clause in the employment contract, which will also act as deterrence to such malpractices. We should expect to see significant evolution of law on this subject in the coming years as number of such cases is currently pending adjudication.


[1] RBI NOTIFICATION 27/103

[2] SEBI CLAWBACK GUIDLINES

[3] ICSI NEWSLETTER

[4] TAXGURU JOURNALS NO.28

[5] RBI NOTIFICATION 2019,78

[6] GUIDELINES FOR PSUs

[7] TAXGURU JOURNAL

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