Economy Cleanup: Clawback to the Future

We are in the midst of a cleanup of toxic financial waste that will cost taxpayers hundreds of billions of dollars, at the very least. The primary manufacturers of these hazardous products pocketed multimillion-dollar paychecks for their efforts. So why aren't we making them pay for the mop-up?

This is, after all, what Congress decreed in 1980 for producers of actual toxic waste. Under the Superfund law enacted that year, polluters pay for the messes they make. Environmental lawyer E. Michael Thomas sees no reason lawmakers couldn't demand the same of financial polluters and force them to ante up some of the bank-bailout money. "This is a directly parallel policy judgment," he says. "It's beautiful in its simplicity, and it's also beautiful in its justice."

The word for it is clawback, and it's not forthcoming, at least not anytime soon. "I'm just a plain old country lawyer, and I haven't heard from anybody who counts," says Thomas, a veteran of the Environmental Protection Agency and a couple of big law firms who is now a solo practitioner in suburban Boston--and whose letters to Capitol Hill have so far gone unanswered. Also, clawing back money from individual employees, as Thomas proposes, is a far more fraught and complex endeavor than hitting up corporations, as Superfund does.

Still, while Thomas' bold idea is a long shot, talk of more modest clawbacks is in vogue on Wall Street. Clawback provisions have long been standard at venture-capital and private-equity firms, where partners are expected to regurgitate past earnings to make good on unmet promises to investors. And wherever outright fraud can be proved, those who benefited can be forced by the courts to disgorge their gains--as investors who withdrew money from Bernard Madoff's apparent Ponzi scheme before it collapsed might discover in the coming months.

Clawing back gains absent fraud--and where there are no preset clawback agreements--is another matter. The concept is foreign to most of Wall Street. Hedge funds generally have only what you might call "claw forwards": high-water-mark provisions that prevent managers from pocketing performance fees after a loss until they've made up that loss to their investors. Investment banks, meanwhile, have for decades paid out bonuses on the basis of one year's profits and worried about the consequences later.

This latter practice is now under intense scrutiny. Several big banking firms have announced that their top dogs will get no bonuses this year and that their future compensation will be structured to allow clawbacks of gains from bets that turn bad. It's not yet a sea change, though.

"It only applies to senior executives, by and large, and those aren't the people who lost all the money," says Alan Johnson, a compensation consultant specializing in financial services. Bringing clawbacks down into the ranks of traders and investment bankers would be almost impossibly complicated, he contends. That, and it might not accomplish much. "Changing the pay system would not have prevented the current crisis at all," says Johnson, because the people taking crazy risks didn't think they were taking crazy risks. Top executives at now defunct Lehman Brothers had most of their wealth tied up in company stock, for example, yet that didn't stop them from steering the company over the cliff--because they had no inkling that was what they were doing.