Background

Clawback compensation has been a longstanding tool for both public and private companies to recoup excesses paid to employees after the occurrence of certain untoward events. For example, it is not uncommon to find clawback clauses in separation agreements of public and private companies that operate to take back severance if the former employee breaches nondisclosure, non-solicitation, or non-compete agreements. Various executive compensation plans can likewise incorporate clawback provisions entered contractually by private companies.

However, after several spectacular corporate meltdowns, federal law stepped in to regulate public companies by formalizing clawbacks of executive incentive compensation under specific circumstances. Private companies, taking a lesson from the federal statutes, may but are not required to design executive compensation to include clawback provisions in the event of financial misstatements and other inappropriate actions.

Sarbanes-Oxley

Clawbacks first found their way into federal law in 2002 under Section 304 of Sarbanes-Oxley. To discourage the manipulation of the finances of a public company that skew incentive compensation awards in favor of executives, Sarbanes-Oxley requires clawbacks of excess compensation to the CEO and CFO when the SEC determines that the financials of a public company (to which Section 12 of the Exchange Act applies) must be revised due to any misconduct resulting in material errors, omissions, and material misstatements in the financials. The CEO and CFO are to reimburse the issuer for the following:

• any bonus or other incentive-based or equity-based compensation received from the issuer during the 12-month period after the first public issuance or filing with the SEC (whichever first occurs) of the financial document embodying such financial reporting requirement; and
• any profits realized from the sale of securities of the issuer during that 12-month period.

Dodd-Frank

In 2010, Section 954 of the Dodd-Frank Act instituted stricter requirements on clawbacks by covering a broader group of public company executives for a longer period and requiring clawbacks whenever financials must be restated, regardless of fault. Under Dodd-Frank, the restatement of the financials due to the material noncompliance of the issuer under any financial reporting requirements of the securities laws requires the issuer to recover from any current or former executive officer incentive-based compensation (including stock options) awarded during the three years preceding the accounting restatement.

Boards are prevented from reimbursing or indemnifying executives for clawbacks that must be paid in the year in question and not offset against future compensation payments. Recovery is restricted only when (1) the direct cost of recovery would exceed the correction amount, and (2) the recovery would violate the home country’s law if additional conditions were met. 

A separate rule under Dodd-Frank pertains to financial institutions, including depository institutions, broker-dealers, credit unions, investment advisors, and mortgage associations. Such institutions may claw back incentive-based compensation from lower-level executives who do not exercise significant control over decision-making, even if those executives had no role in the accounting restatement. Such clawbacks are triggered when the senior executive or significant risk-taker engages in misconduct resulting in financial or reputational harm to the covered institution.

Senate Bill 1045

Following on the heels of the collapse of many midsized banks, including Silicon Valley Bank, First Republic Bank, Silvergate Capital, and Signature Bank of New York, a bill has now been proposed and was recently passed by Senate Banking Committee expanding the powers of the FDIC to recoup incentive pay of senior bankers who are paid within two years before the bank failure. The clawback of compensation can look back as much as five years, as necessary, to prevent unjust enrichment and ensure that the party bears losses consistent with its responsibility.

Compensation that may be clawed back under the proposal refers to:

• salary;
• bonuses;
• any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure or other performance metric;
• equity-based compensation;
• time or service-based awards;
• awards based on nonfinancial metrics; and
• any profits realized from buying or selling securities.

SEC Rule 10D-1

The SEC issued rules regarding clawback policies in October of 2022, implementing Section 954 of Dodd-Frank. The rules cover the following:

1. Policy Needed. SEC Rule 10D-1 sets forth the requirements that exchanges are directed to establish. Under the rule, a listed issuer is required to develop and implement a clawback policy that provides for the recovery of incentive-based compensation from current or former executive officers in the event the issuer is required to prepare an accounting restatement.
2. Recoverable Amount. The recoverable amount is the difference between the amount received by the executive and the amount that should have been received based on the restated financials. The policy must provide for recovery of any erroneously awarded compensation received during the three completed fiscal years immediately preceding the date the issuer is required to prepare the accounting restatement.
3. Penalty for Noncompliance.  An issuer will be subject to delisting if it does not adopt a compensation recovery policy that meets the requirements of the listing standards once they are in effect. Issuers may also be delisted if they fail to comply with their compensation recovery policy.
4. Executives Covered by Rule. The group of executives of the public issuer subject to the rule includes executive officers and any person who served as an executive officer at any time during the three fiscal year lookback preceding the date on which the issuer must prepare the restatement.
5. No Indemnification. The issuer may not indemnify the executive from clawbacks.
6. Disclosure Requirements. The amendments to Item 402 of Regulation S-K, Form 40-F, and Form 20-F (and for listed funds, Form N-CSR) require listed issuers to disclose how they have applied their recovery policies. If an issuer was required to prepare an accounting restatement that triggered a clawback under the issuer’s recovery policy, or there was any unpaid clawback compensation to be recovered as of the end of the last completed fiscal year, an issuer is required to make disclosures to the government.
7. Effective Dates. The rules took effect on January 27, 2023, but the issuers’ policy implementation is January 27, 2024.

Takeaways

1. Executive compensation is often structured so that it is awarded when financial targets are met.
2. The law on executive compensation clawbacks among public companies, which has been expanding over the last twenty years, is intended to curb the misstatement of financials among public companies so that inappropriately excessive executive compensation is not awarded. 
3. SEC Rule 10D-1 under Dodd-Frank imposes a requirement that public companies develop clawback policies by January 27, 2024.
4. While not required to adopt clawback provisions, private companies may do so to ensure that corporate fiduciary requirements are met, and executive compensation is appropriate.
5. Special clawback rules may take effect for banks, depending on the disposition of Senate Bill 1045.