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Executive share schemes and founder shares: The trend of increased malus and clawback

9 October 2018
– 5 Minute Read

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There is an increasing trend for companies to recoup benefits paid to executives as part of executive share schemes. This is often based on circumstances where there have been errors in financial accounts or, more controversially and untested, where there has been executive misconduct. These situations are made possible by ‘malus’ and/ or ‘clawback’ provisions in executive share schemes.

The tax implications of these situations are also interesting and often have a significant impact on executives’ back pockets. Founder shares can also have interesting tax implications, again hitting an executive’s back pocket in a less than desirable way.

Executive share schemes

To have the best chance of enforcing ‘malus’ and/ or ‘clawback’ provisions in an executive share scheme (i.e. pre-or post-vesting forfeiture of a variable pay benefit), it is critical to ensure that the company has a contractual right to do so (i.e. these provisions should be clearly set out in the scheme rules, award letter and remuneration policy, and participants should have to confirm that they accept the terms of the awards).

Malus and clawback provisions generally only apply to a small group of employees/ executives and should only be invoked in instances where a significant ‘trigger event’ has taken place as it is a drastic measure which could potentially result in litigation.

If a share scheme or remuneration policy gives a board or remuneration committee a discretion to decide whether malus and/ or clawback provisions should be enforced (which is very common in South Africa and foreign jurisdictions), always ensure that the discretion is applied having regard to principles of substantive and procedural fairness.

The use of clawbacks (i.e. the recoupment of variable pay benefits post-vesting) are not intended to be punitive in nature. Rather, they are intended to be remedial: to restore the company to the position it would have been in had the executive(s) not been ‘overpaid’. This is in line with international trends and foreign regulations.

In terms of the Basic Conditions of Employment Act, an employer may only require an employee to repay an amount that was ‘overpaid’ as a result of an error in calculation. This is arguably easier to establish where the financial accounts have been misstated or performance conditions have been overstated. It may be more difficult to prove in cases of misconduct. None of these issues have been tested by South African courts.

However, it may be possible to claw back an amount of ‘overpaid’ variable pay in the case of ‘historical’ misconduct (i.e. misconduct that took place pre-award/ pre-vesting, but was only discovered post-vesting), but only if the company can show that the remuneration would have been calculated differently if the misconduct was known at the relevant time, and therefore there was an error in calculation.

Take Section 8C of the Income Tax Act into consideration. Share scheme participants may potentially fall within this section, subjecting them to up to 45% tax on the market value of their shares (less any consideration paid to acquire the shares). The tax will generally be triggered as soon as the shares become unrestricted and freely tradable (which may be before they sell the shares) and if those shares (or the value of the shares) are ‘clawed-back’ by the company, the participant will still liable for that tax (although he or she may be able to claim a deduction for the amount refunded).

It is important to bear in mind that this area of law is complicated and still untested in South Africa. Clients would be well advised to consult with tax, corporate and employment law experts when drafting, amending or implementing these provisions.

Pitfalls relating to founder shares: venture capital, private equity or new companies

Entrepreneurs who start new companies, and are issued shares as the founders of those companies, may find themselves subject to heavy taxes if their shares are restricted in any way (which they usually are).

Founders of venture capital entities, private equity companies, and the like, must be aware of the tax implications (Section 8C of the Income Tax Act) of any restricted shares.

This caution is applicable even if the founder shares are transferred to another employee in the company. The person taking transfer or buying those shares should be aware of possible heavy taxes that may apply.

This is likely an unintended consequence of Section 8C, as it discourages investment and entrepreneurship which is central to South Africa’s growth agenda. Although the legislation is not likely to change in the near future, lobbying from business will go a long way to encouraging possible law reform.

Conclusion

The bottom line is that executives should understand, upfront, all of the legal and tax implications affecting the shares that they hold, whether through share schemes or as founder shares. Without this, they may end up walking away from their employers company with less in their back pockets than they ever expected.