Dividend Clawback

What Is a Dividend Clawback?

A dividend clawback is a contractual provision whereby investors in a project are required to repay their previously received dividends. This provision comes into effect if the project in question encounters a cash shortfall, such as by exceeding its budget.

Generally, dividend clawbacks are implemented by shareholders buying more stock in the company, using their past dividends to finance the purchase.

Understanding Dividend Clawbacks

The purpose of a dividend clawback provision is twofold. First, they assist in project financing by helping to ensure projects will survive through periods of financial distress. Because shareholders are committed to providing additional equity capital if needed, companies can avoid raising debt financing that might entail covenants and other restrictions. 

Second, dividend clawbacks provide an added incentive for projects to remain within their budgets. If shareholders know that they will be responsible for contributing new capital in the event of a cost overrun, they are likely to exert more oversight to ensure that overruns do not occur.

The general concept of a dividend clawback is also used in other sectors. For instance, clawbacks are commonly used in employee contracts or when negotiating raises and bonuses. A chief executive officer (CEO) may receive a raise in anticipation of completing an important project, but this raise may be conditional on a clawback provision whereby the funds are returned if the project is not completed to agreed-upon standards.

Similarly, contractors might be required to accept a clawback clause whereby a portion of their invoice is withheld if the service they provided fell short of their contractual obligations.

Real-World Example of a Dividend Clawback

Martin is one of three partners involved in an infrastructure partnership. As part of their partnership agreement, Martin and his partners are subject to a dividend clawback clause.

Altogether, the partnership raises $3 million equally from the three investors, which it plans to spend in equal installments over the next three years.

In year one, the partnership spends $1 million and is on track with its construction project, leaving it with $2 million in the bank. The following year, it achieves its construction milestones despite only spending $500,000. Accordingly, the partners decide to pay a $500,000 dividend. This reduces the partnership's remaining cash balance to $1 million.

However, in year three, the partnership discovers that it needs between $500,000 and $1.5 million more than initially expected. Because of their dividend clawback clause, the partners are required to pay back the $500,000 that they previously received as a dividend.

By combining the $1 million cash balance with the $500,000 "clawed back" from the partners, the partnership is able to complete its construction by the end of year three.