Economic factors and financial challenges are causing companies and regulators to adopt the concept of Malus clauses to better align Executive incentive payouts with long term performance and ensure effective use of incentive spend.
Setting performance goals
Especially in executive compensation, the use of performance related incentives has grown and the setting of performance goals has moved from long term to short term outcomes. In the 1990s most corporations were moving from an executive pay model based on corporate stability to one focused on stock incentives, a fact that was recently blamed in the US Treasury report for the failure of the faulted mortgage giants Fannie Mae and Freddie Mac
Share performance goals undermine solid corporate governance and lead executives to ignore long term risks in their decisions.
The Malus concept
A Malus clause (also called ‘Bonus Malus’, ‘Staggered Payment’ or ‘Clawback’) in Executive contracts generally means the return of a performance related incentive because of poor performance. It usually causes a portion of an incentive to be held back for a period of time and requires multiple review steps to measure an employee’s true performance and release the incentive payment.
For example, an incentive payment can be distributed in chunks, with the first half reviewed directly after the review period and the second half reviewed one year later. This process increases the complexity and maintenance effort of the incentive scheme, but it ensures that employee compensation is linked to long term, sustained performance.
The US Treasury enacted a new legislation in October 2009
, which requires failed institutions that currently apply for government assistance to subject Executive bonuses to Malus clawbacks, but only if the payouts are based on misleading financial statements. A company would have to recover bonuses or incentive compensation paid to a senior executive based on performance measures that later proved inaccurate
As a result, corporations are changing their Executive reward schemes, eg, UBS bank has released details of its new executive remuneration scheme
which includes Malus conditions in relation to both short term cash bonuses and Long Term Incentive (LTI) share plans.
HR Consulting company Mercer’s Diane Doubleday predicts to see “more rigor in establishing peer groups, and increased use of clawback, anti-hedging and other policies to protect shareholders
Complexity in Compensation schemes
The concept of Malus for performance-related compensation has been around for a long time, for example as a clawback provision that requires new hires to return part of the bonus if they leave within in a certain period.
Nevertheless its complexity and administrative burden kept most companies from adopting it. Concepts like staggered review scenarios, ‘fair value’ of a long term incentive, calculation of ‘dividend yield’, and complicated vesting conditions make the administration of Malus conditions a nightmare.
Still the concept of Malus will fortunately grow due to increased pressure from legislators and shareholder groups. As a key instrument from the Corporate Governance toolbox that improves long term thinking, we can expect to see more Malus clauses in executive contracts.