The Securities and Exchange Commission (SEC) approved final rules implementing Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The new rules (Rule 10D-1) direct national securities exchanges and associations to establish listing standards requiring registrants to implement “clawback” policies to recoup incentive-based compensation following a material restatement of financial disclosures. They also include expansion of annual reporting and proxy disclosures so shareholders can quickly access the clawback policies, understand if they have been invoked and review how they have impacted executive pay.
The final rules largely follow the proposed rules, with updates and clarifications to address some of the questions surrounding how these “no-fault” Dodd-Frank clawback policies should be implemented. The rules are not entirely directive, as companies can use reasonable estimates for stock-based compensation to determine how much is to be clawed back and will have discretion not to pursue recovery if the direct expense of doing so would exceed the amount to be recovered.
These brief FAQs should provide sufficient detail for companies to start considering how these policies must be implemented. We think that most companies can focus on year-end executive compensation matters during the remainder of 2022 and wait until early 2023 to start addressing clawbacks.
The final clawback rules apply to all listed companies, including emerging growth companies, smaller reporting companies, foreign private issuers and controlled companies. The final rules also adopt the limited exemptions included in the proposed rules for certain security futures products, registered investment companies that have not awarded incentive compensation and registered unit investment trusts.
This part can be confusing to decipher; there is a difference between the effective date of the final regulations and the effective date of the listing standards.
We anticipate that the listing exchanges and SEC will act promptly following publication of the final rules, so companies should start preparing for the likelihood that they will need a compliant clawback policy in place before the end of 2023.
The mandated clawback policy must apply to any incentive-based compensation that is received by current or former executive officers on or after the effective date of the applicable listing standard. As a result, grants made before the listing exchange rule’s effective date will be subject to the clawback policy if they are dependent on a financial measure attained after the effective date. For example:
As specified in the statute, the clawback requirement covers only accounting restatements due to the company’s material noncompliance with any financial reporting requirement under the securities laws. The final rules do not include a definition of “material noncompliance” because the SEC explained it is already defined in existing accounting standards and related guidance.
Importantly, the SEC’s final rule expanded on the proposed rules outlining the types of restatements that are subject to the clawback requirement. Under the final rule, the clawback requirement may apply as a result of an accounting restatement that corrects an error (1) that is material to previously issued financial statements (commonly referred to as “Big R” restatements that are required to be reported in an 8-K filing), or (2) that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period (commonly referred to as “little r” restatements).
Companies themselves will be required to determine when the materiality threshold has been met, in consultation with their accountants and attorneys. This will create some interesting dynamics. In determining whether a clawback should be invoked, company management and directors will need to balance the interests of executives and shareholders, considering the risk that plaintiff’s lawyers will be active in arguing that companies should aggressively seek to recoup incentive compensation erroneously paid.
The new rules require companies to adopt a compliant clawback policy and to disclose certain aspects of such policies and their application in annual reports and proxy statements. Compliance with the disclosure requirements is required in the first annual report, information statement or proxy required to be filed after the effective date of the new listing standards. Calendar-year companies should anticipate this will mean the 2023 annual report and the 2024 proxy. The disclosure regime is as follows:
The rules cover both current and former executive officers, with “officers” defined in regulations issued under Section 16 of the Securities Exchange Act. The definition would include the company’s:
Note that this is often a broader group than covered by a company’s existing clawback policies, which tend to focus on officers listed in the proxy.
Individuals in these roles are only considered an executive officer subject to recovery if they serve as an executive officer at any time during the recovery period (described below), and the recovery is only required for incentive compensation received while the individual served as an executive officer.
The statute provides that, regardless of when the restatement takes place, incentive compensation is only subject to recovery if it is received during the three-year period before the restatement is “required.” The three-year lookback period begins when the board, compensation committee or officer(s) authorized to take such action conclude or reasonably should have concluded (or a court or regulator determines) that a material error existed in prior financial statements.
The regulations define incentive compensation as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.” “Financial reporting measures” are defined as:
The amount required to be recouped is the amount of incentive-based compensation earned by an executive during the three-year lookback period that exceeds the amount the executive would have received based on the restated financial statements. This is the case even if amounts are paid after the end of the fiscal year when the financial reporting measures are attained, which is the rule as to how cash compensation is measured when calculating summary compensation table total compensation.
Deciding how this amount would be calculated was perhaps the most difficult issue for the SEC to resolve under the statute, with the commissioners ultimately deciding to leave the decision up to each individual company. In any event, the final rules make clear that erroneously awarded compensation must be calculated without respect to any tax liabilities that may have been incurred or paid by the executive.
For many incentive plans with financial hurdles, the calculation of the recoverable amount will be relatively straightforward by reference to the before and after information presented in the financial statements. The calculation will be exponentially more difficult for incentive-based compensation based on TSR or stock price, where the amount of erroneously awarded compensation cannot be mathematically calculated directly from the information in an accounting restatement. This is where the ability to determine a reasonable estimate of the impact of the restatement comes into play.
For performance share plans and relative-TSR plans, the determination of what stock value increases were attributable to misstated financials will be a vexing process, one that we anticipate will require expert advice to help companies and boards determine reasonable methods for performing the calculation.
Once those calculations are completed, a company will be required to disclose the amount of erroneously awarded compensation attributable to any accounting restatement, including an analysis of how erroneously awarded compensation was calculated, and provide documentation to the relevant exchange.
Enforcement can be avoided only in very limited circumstances. If a company’s committee of independent directors responsible for executive compensation decisions — or in the absence of such a committee, a majority of the independent directors serving on the board — determine that the cost of recovery would exceed the amount to be recovered, they would have the discretion not to pursue the clawback. Their reasoning must be discussed in the CD&A. A foreign private issuer would not be required to pursue recovery if it receives a legal opinion that doing so would violate local country law as in effect when these rules were finalized. The final rules also allow companies to forgo recovery for amounts deferred under tax-qualified retirement plans, although the SEC doesn’t expect this situation will arise very frequently; however, erroneously awarded incentive-based compensation contributed to plans limited only to executive officers, supplemental executive retirement plans, or other nonqualified plans and the resulting benefits, would still be subject to recovery.
Companies have discretion in how to accomplish recovery in a manner that “effectuates the purpose of the statute,” but the final rules do not provide details on how it must be done. Companies also must act “reasonably promptly,” with the SEC noting that directors and officers, in the exercise of their fiduciary duty to safeguard the assets of the company, should pursue the most appropriate balance of cost and speed in determining the appropriate means to seek recovery. The SEC notes that companies could explore recoveries that withhold from future pay, from incentive awards earned but not paid, or by cancelling unvested equity and non-equity awards.
No. The final rules specifically prohibit companies from entering into indemnity agreements with executives or purchasing insurance on behalf of executives to indemnify them against the financial effects of a clawback; however, the final rules do not directly prohibit executives from obtaining their own insurance against financial loss from clawbacks.
