All companies that have securities listed in the United States, including foreign and domestic companies, are required to adopt an executive compensation recoupment (a.k.a. “clawback”) policy by, in most cases, no later than December 1, 2023.

TAKEAWAYS

• The Securities and Exchange Commission (SEC) and national exchanges have adopted rules requiring issuers to adopt and implement clawback policies for the recovery of erroneously awarded executive compensation.
• The time is now for boards and compensation committees to adopt clawback policies, with the deadline of December 1, 2023, for all NYSE and Nasdaq-listed companies rapidly approaching.
• Issuers will be required to disclose their clawback policy in their annual report and any clawback actions taken pursuant to such policy.

In late 2022, the SEC adopted a new rule (Rule 10D-1) and rule amendments (collectively, the “Rules”) that, through listing standards promulgated by the national exchanges (primarily NYSE and Nasdaq), will require all issuers with securities listed in the United States to adopt an incentive-based compensation (IBC) recovery policy (hereinafter, a “clawback policy”). The Rules are sweeping and impact all domestic issuers, as well as foreign private issuers, including those whose only U.S.-listed securities are Level 2 and 3 ADRs. The NYSE and Nasdaq final listing rules implementing the Rules were approved by the SEC on June 9, 2023, and importantly, for NYSE and Nasdaq-listed companies, require the adoption of a compliant clawback policy by no later than December 1, 2023.

The Rules will also require the affected companies to provide certain disclosures in their Exchange Act reports, including a copy of the clawback policy it has adopted, as well as details regarding any actions to clawback executive compensation made pursuant to the clawback policy.

What Do the Rules and Clawback Policy Require?
The Rules require that a company’s clawback policy provide for the company’s clawback of erroneously awarded IBC of past or current executive officers awarded during the three full fiscal years preceding the date on which the issuer is required to prepare an accounting restatement. Clawback is required without a determination or assessment of fault or scienter (i.e., on a “no-fault” basis).

Who Are the “Executive Officers” Subject to Clawback?
The Rules subject “executive officers” to clawback, and in turn define “executive officer” virtually identically to the definition used in Rule 16a-1(f), the rule that is used to determine the company’s officers that must file Section 16 reports (Forms 3, 4 and 5). This means a company’s president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice president in charge of a principal business unit, division or function, any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the company are covered by the Rules and therefore their IBC is subject to potential clawback. “Executive Officers” certainly include the company’s executive officers identified and disclosed in the tabular disclosure in the “management” section of the company’s proxy statement (i.e., its NEOs).

While the executive officers for domestic companies may be easily identified with this definition, foreign private issuers or large multinational companies may have to undertake a more complex analysis to determine which executive officers’ IBC is subject to clawback.

What Compensation Is Defined as “Incentive-Based Compensation?”
IBC is defined as any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure. In turn, “financial reporting measures” is defined as financial measures that are determined and presented in accordance with accounting principles used in preparing the company’s financial statements (i.e., for domestic companies: GAAP) and any measures derived from such information, as well as stock price and total shareholder return (TSR). Under this definition, the following commonly awarded IBC are subject to clawback:

• Stock options and other equity awards whose grant or vesting is based wholly or in part on the attainment of financial reporting measures;
• Bonuses paid from a bonus pool, whose size is determined by achieving financial reporting measures;
• Other cash awards based on satisfaction of a performance goal; and
• RSUs, restricted stock, PSUs, SARs and proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based on achieving a financial reporting measure or performance goal.

Compensation that is not subject to clawback includes:

• Salaries;
• Bonuses paid based on satisfying a subjective standard (e.g., demonstrated leadership);
• Non-equity incentive plan awards earned by satisfying strategic objectives (e.g., consummating a merger or divestiture), or operational measures; and
• Other equity awards for which the grant and vesting is not contingent upon achieving any financial reporting measure performance goal.

What Restatements Trigger the Clawback of Incentive-Based Compensation?
Clawback of IBC is triggered when a company is required to prepare an accounting restatement that corrects an error in previously issued financial statements that is material to the previously issued financial statements, or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period. Therefore, both a “big R” or a “little r” restatement may trigger clawback for any affected IBC.

Both types of restatements inherently require a materiality analysis and judgment. The SEC explicitly states that companies may continue to rely on existing SEC guidance regarding the definitions of “accounting restatement” or “material noncompliance,” and that the Rules are not intended to affect that guidance. Importantly, the Rules state that one factor to include in the materiality analysis is whether the misstatement has the effect of increasing management’s compensation. A company considering whether it is required to undertake a restatement should seek the early and active engagement of its independent accountants and outside legal counsel for any materiality or restatement analysis.

How Is the Three-Year Lookback Calculated?
The three-year lookback period for at-risk IBC is calculated based on the “date on which the issuer is required to prepare an accounting restatement,” which in turn is the earlier to occur of:

• The date the company’s board of directors, a committee of the board of directors or its officers are authorized to undertake a restatement, or if such board action is not required, concludes, or reasonably should have concluded, that the company’s previously issued financial statements contain a material error; or
• The date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.

No Indemnification
The Rules specifically prohibit companies from indemnifying covered executives from clawback, or for reimbursing covered executives for insurance that they procure to cover potential clawback.

Limited Exceptions
The Rules provide three categories of exceptions to clawback. No clawback of IBC is required if:

• The expense paid to a third party to enforce the clawback would exceed the amount to be recovered, provided that the company has made and documented reasonable attempts to recover the IBC;
• The clawback would violate home country law, where that law was adopted prior to November 28, 2022, and provided that the company obtains the opinion of home country counsel acceptable to its U.S. exchange that the clawback would result in such violation; and
• The clawback would cause an otherwise tax-qualified retirement plan, under which benefits are broadly available to employees, to fail to meet the requirements of Section 401(a)(13) or Section 411(a) of the U.S. Internal Revenue Code and U.S. Treasury regulations promulgated thereunder.

Additional Disclosure
Companies will also be required to file their clawback policy as an exhibit to their annual report (Form 10-K or 20-F) and indicate via a checkmark whether the financial statements included in the filing reflect the correction of an error and requisite restatement. Companies must also disclose details of any clawback actions taken pursuant to their clawback policy.

Advice to U.S.-Listed Companies
Given that the Rules may significantly affect the compensation of executives, boards may require additional counseling regarding the requirement to adopt a compliant clawback policy, which applies even if the company does not currently award IBC that is subject to clawback under the Rules. The Rules are also unique in that they prescribe very specific definitions for their key concepts, but in some cases those definitions create ambiguity that will not be cured until the issues are litigated or further guidance from the SEC is provided. Depending on the jurisdiction of incorporation and the specific terms of a company’s organizational documents, the Rules and the adoption of a compliant clawback policy may create tension in the company’s charter and/or bylaws provisions that indemnify its executive officers, and possibly even with the indemnification provision of the state incorporation statute itself. The Rules also generate ambiguity related to how much IBC should be recovered in cases where the at-risk IBC is based on market-linked financial measures, such as TSR or share price. Despite these ambiguities, impacted companies should act now to ensure they have a compliant clawback policy adopted by the applicable deadline, which, for companies with securities listed on NYSE or Nasdaq, is December 1, 2023.

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