Claw back clauses in Employment Contracts - A new tool to fight corporate misfeasance

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 ‘clawback’. Broadly speaking, clawback 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.

INDIAN PERSPECTIVE:

In India, currently, there is no law that specifically governs or prohibits inclusion of clawback provisions. The Reserve Bank of India, in 2012[1] and 2019[2], issued guidelines that provided inclusion of clawback clauses in relation to variable and deferred remuneration of whole-time directors, chief executive officers (“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 impose 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[3].

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[4]. Under these provisions, financial statements can be restated if an order is passed by the Tribunal:

  • 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 provisions of Section 129 or Section 134 of the Act[5].

The accounts so revised or re-cast will be final.

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[6]. 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[7], they are still considered as ‘opinions of such officer’ and do  not constitute legal evidence[8]. 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 clawback 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.

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. 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 apply 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 clawback 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.

Given the absence of any express governing law, enforcement of clawback clauses can be a hindrance if there is no time period for claiming such clawback or the time period defined is unreasonable. There is also uncertainty as to whether clawback can only be claimed from the variable component of salary or whether it can be expanded to include amounts of the fixed or the 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 clawback clauses are defined in crystal clear terms, along with spelling out the circumstances under which such clawback can be enforced.

CONCLUDING THOUGHTS:

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 clawback clause in the employment contract, which will also act as a 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 are currently pending adjudication.


[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] The Companies Act, 1956 did not contain any provision relating to restatement of accounts. However, Department of Company Affairs had issued various department circulars dealing with re-opening of accounts after their adoption by members in the general meeting.

[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, Companies Act, 2013.

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

[8] 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).

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Photo of Bharat Vasani Bharat Vasani

Partner in the  General Corporate and TMT Practice at the Mumbai office of Cyril Amarchand Managaldas. Bharat has over 30 years of experience at senior management level. His areas of specialization includes company law, corporate and commercial laws, securities law, capital market, mergers…

Partner in the  General Corporate and TMT Practice at the Mumbai office of Cyril Amarchand Managaldas. Bharat has over 30 years of experience at senior management level. His areas of specialization includes company law, corporate and commercial laws, securities law, capital market, mergers and acquisitions, joint ventures, media & entertainment law, competition law, employment law and property matters. He heads firm’s media and entertainment law practice.  He is highly regarded in Government circles and in various industry organizations for his proactive approach on public policy issues. Bharat was a member of the Expert Committee appointed by the Government of India to revise the Companies Act, 2013.

Prior to joining the Firm, Bharat was the Group General Counsel of the Tata Group.  He has been at the helm of and steered several large key M&A transactions pursued by the Tata Group in the last 17 years.

Bharat’s contribution to the legal fraternity has been recognized by the Harvard Law School’s Award for Professional Excellence in 2016. Bharat has won several other national and international awards for his various achievements. He had a brilliant academic record in law and first rank holder in all India company secretary examination. He can be reached at bharat.vasani@cyrilshroff.com

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Principal Associate in the General Corporate Practice at the Mumbai office of Cyril Amarchand Mangaldas, Hasan’s practice includes advising on corporate restructuring, joint ventures, private equity transactions, business acquisition, along with advisory on various corporate commercial laws. He has advised on various transactions…

Principal Associate in the General Corporate Practice at the Mumbai office of Cyril Amarchand Mangaldas, Hasan’s practice includes advising on corporate restructuring, joint ventures, private equity transactions, business acquisition, along with advisory on various corporate commercial laws. He has advised on various transactions acting for leading Indian and multinational corporations across various industry lines. He can be reached at molla.hasan@cyrilshroff.com

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Associate in the General Corporate Practice at the Mumbai office of Cyril Amarchand Mangaldas. Esha has experience in general corporate and advisory work, primarily focused on corporate governance, mergers and acquisitions and corporate restructuring. She can be reached at esha.himadri@cyrilshroff.com