On October 26, 2022, the Securities and Exchange Commission (the SEC) approved final rules (the Clawback Rules) requiring publicly traded companies to develop, implement and disclose policies providing for recovery, or “clawback,” of incentive-based compensation that is erroneously awarded to past or present executive officers based on issuers’ misstatements of financial performance requiring accounting restatements. The Clawback Rules are promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) and order national securities exchanges to adopt new listing standards mandating listed companies adopt the policies and make required disclosures, including annual disclosure of company clawback policies on Form 10-K and recovery activity in proxy and information statements on Schedule 14A and 14C.
The SEC noted its approach in finalizing the Clawback Rules sought to mirror what it considered the “straightforward” goal of the Dodd-Frank Act – namely, that executive officers of exchange-listed issuers “should not be entitled to retain incentive-based compensation that was erroneously awarded on the basis of materially misreported financial information that requires an accounting restatement” – by limiting issuers’ discretion in executing clawback policies.
1 The SEC also noted purposeful parallels between the “broad” definitions in Section 10D of the Securities Exchange Act of 1934, as amended (the Exchange Act) and the Clawback Rules, as exemplified by the definitions of terms such as “incentive-based compensation” and “executive officers.”
2 Finally, the SEC noted its intent to craft the Clawback Rules as setting forth a potential deterrent effect for affected registrants, stating the requirements may provide executive officers with “an increased incentive to take steps to reduce the likelihood of inadvertent reporting” by curtailing the financial benefits to those who choose to pursue impermissible accounting methods.
3 Registrants who fail to comply with the Clawback Rules are also subject to delisting.
Applicability of Clawback Rules
As finalized, the Clawback Rules apply to most listed issuers, including emerging growth companies, smaller reporting companies and foreign private issuers, with exemptions only for the listing of certain security futures products, standardized options, securities issued by unit investment trusts and securities issued by certain registered investment companies that have not paid incentive-based compensation to any current or former executive officer of the fund in any of the last three fiscal years (or, for funds which have been listed for fewer than three fiscal years, since the initial listing). Both internally and externally managed business development companies (BDCs) are subject to the rule; however, there is no applicable exemption if they have not paid incentive-based compensation in the last three years. This effectively requires most listed BDCs that are externally managed to adopt clawback policies and make the requisite disclosures under the Clawback Rules; however, due to their structure, it is unlikely such BDCs will have paid any incentive-based compensation subject to clawback in the event of an accounting restatement.
Effective Date for Clawback Rules
The Clawback Rules will become effective Friday, January 27, 2023, and the national securities exchanges’ listing standards must be effective no later than November 28, 2023. Issuers must then adopt compliant clawback policies within 60 days of the listing standards becoming effective.
New Requirements Regarding Clawback Policies
The Clawback Rules provide – via ordered listing standards – that listed issuers who pay incentive-based compensation to their executive officers must develop and implement written policies providing for the recovery of such compensation when it is erroneously awarded to an issuer’s executive officers due to material errors in the issuer’s financial statements necessitating an accounting restatement. The amount recovered under the issuer’s policies must be equal to the excess of what would have been paid to the executive officer under the accounting restatement. A discussion of each element of this mandate is set forth below.
Incentive-Based Compensation
As noted, to match Section 10D of the Exchange Act, the SEC purposefully defined “incentive-based compensation” subject to recovery under clawback policies in a broad manner.
4 Specifically, “incentive-based compensation” is defined as “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure.”
5 The SEC defines “financial reporting measures” as those measures “that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, and any measures derived wholly or in part from such measures.”
6
To offer clarity, the SEC provided a non-exclusive list of examples of financial reporting measures as including the following accounting-based measures and measures derived from:
- Revenues;
- Net income;
- Operating income;
- Profitability of one or more reportable segments;
- Financial ratios (e.g., accounts receivable turnover and inventory turnover rates);
- Net assets or net asset value per share;
- Earnings before interest, taxes, depreciation and amortization;
- Funds from operations and adjusted funds from operations;
- Liquidity measures (e.g., working capital or operating cash flow);
- Return measures (e.g., return on invested capital or return on assets);
- Earnings measures (e.g., earnings per share)
- Sales per square foot or same store sales, where sales are subject to an account restatement;
- Revenue per user, or average revenue per user, where revenue is subject to an accounting restatement;
- Cost per employee, where cost is subject to an accounting restatement; or
- Tax basis income.
Additionally, the SEC has clarified that performance-based measures such as the issuer’s stock price or total shareholder return are also considered “financial reporting measures” for purposes of the Clawback Rules, as they are measures which are “affected by accounting-related information and . . . subject to [the SEC’s] disclosure requirements.”
7
Common examples of qualifying incentive-based compensation under the Clawback Rules include:
- Non-equity incentive plan awards that are earned based wholly or in part on satisfying a financial reporting measure performance goal;
- Bonuses paid from a “bonus pool,” the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal;
- Other cash awards based on satisfaction of a financial reporting measure performance goal;
- Restricted stock, restricted stock units, performance share units, stock options, and stock appreciation rights that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal; and
- Proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based wholly or in part on satisfying a financial reporting measure performance goal.
While base salaries are generally not considered “incentive-based compensation” for purposes of the Clawback Rules, to the extent an executive officer receives a salary increase wholly or in part based on their attaining of a financial reporting measure performance goal, the SEC considers such an increase as subject to recovery as a “non-equity incentive plan award.”
8 Notably, equity awards that are not contingent upon achieving any financial reporting measure performance goal (e.g., restricted stock unit or stock option awards in which vesting is contingent solely upon completion of a specified employment period and/or attaining one or more non-financial reporting measures) are
not considered “incentive-based compensation” for purposes of the Clawback Rules.
Executive Officers
In a significant deviation from the term “named executive officers” that commonly accompanies compensation disclosures,
9 the Clawback Rules define “executive officers” in the same way as the term is used in Section 16 disclosures, thus “expressly include[ing] officers with an important role in financial reporting.”
10 Specifically, under the Clawback Rules, “executive officers” include the issuer’s:
- President;
- Principal financial officer;
- Principal accounting officer (or, if none, the controller);
- Vice president(s) in charge of a principal business unit, division, or function (e.g. sales, administration, or finance);
- Officer(s) who perform a policy-making function; and/or
- Employees who perform similar policy-making functions.
Additionally, executive officers of the issuer’s parent(s) or subsidiaries are considered “executive officers” of the issuer under the Clawback Rules if they perform similar policy-making functions for the issuer.
11 At a minimum, the “executive officers” of a registrant must include those who are included in the analogous definition contained in 17 CFR 229.401(b).
Notably, Section 10D(b)(2) of the Exchange Act requires recovery not only from current executive officers of the issuer, but also former executive officers – with no distinction for those executive officers that depart the issuer’s employ, retire, or transition to an employee role with the issuer.
12 However, the Clawback Rules specify that the issuer need only recover the amount of applicable compensation that the individual in question received
after beginning service as an executive officer, and only if that individual served as an executive officer at any time during the recovery period.
Misstatements Necessitating an Accounting Restatement
As adopted, the Clawback Rules mandate issuers establish recovery policies which are triggered in the event the issuer is “required to prepare an accounting restatement that corrects an error in previously issued financial statements.”
13 As detailed in the adopting release, such an error “must be material to the previously issued financial statements” (so-called big R restatements) or “would result in a material misstatement” if it “were corrected in the current period or left uncorrected in the current period” (so-called little r restatements).
14 Critically, “out-of-period adjustments” are not considered “accounting restatements,” and accordingly do not trigger compensation recovery analyses under the Clawback Rules; further, the SEC noted certain retrospective alterations to an issuer’s financial statements, such as changes in accounting principles, “do not represent error corrections” under current accounting standards.
15
Lookback Period and Applicable Dates
Section 10D(b)(2) of the Exchange Act mandates issuers’ clawback policies provide for recovery of incentive-based compensation which is erroneously awarded “during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement.”
16 The Clawback Rules define “the date on which an issuer is required to prepare an accounting restatement” as the earlier of the date when: (1) the issuer’s board of directors (or a committee thereof, or, if board action is not required, the issuer’s officer(s)) concludes, or reasonably should have concluded, that the issuer is required to prepare an accounting restatement due to its material noncompliance with any financial reporting requirement under the securities laws, as described in the Clawback Rules; or (2) a court, regulator or other legally authorized body directs the issuer to prepare an accounting restatement.
17
When determining the amount of compensation for an issuer to recover, the Clawback Rules specify that incentive-based compensation is considered “received” in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is achieved, even if the payment or grant of such award occurs
after the end of that period.
18 The date of “receipt” of the compensation in question depends upon the specific terms of the award. For example, if an equity award vests upon satisfaction of a financial reporting measure performance condition as well as continued service through a later date, the award is deemed to be “received” in the fiscal period in which the performance condition is satisfied rather than the later continued service date.
Amount to be Recovered
The Clawback Rules specify an issuer’s recovery policy must seek to recover “the amount of incentive-based compensation received by the executive officer . . . that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement, computed without regard to taxes paid.”
19 In other words, the clawback should result in the total return of the difference between the amount
actually paid to the executive officer and the amount the executive officer should have received, had the executive officer been paid in accordance with the financial metrics contained in the accounting restatement. Rule 10D-1 does not permit boards to settle for less than the “full recovery amount” unless they satisfy the conditions demonstrating recovery is impracticable.
20
Where the incentive-based compensation in question is based upon a performance metric like stock price or total shareholder return, and the issuer cannot determine the amount to be recovered solely by mathematical recalculation directly from the information in an accounting restatement, the Clawback Rules direct the issuer to recover an amount which is “based on a reasonable estimate of the effect of the accounting restatement on the applicable measure.”
21 The issuer must retain documentation to support the ultimate calculation of the amount to be recovered and provide such documentation to the securities exchange upon which it trades.
22
The Clawback Rules also prohibit issuers from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation, as well as reimbursing executive officers for premiums associated with their purchase of a third-party insurance policy to fund potential recovery obligations.
Means of Recovery
While the Clawback Rules generally provide very little discretion for issuers regarding
whether to obtain recovery for erroneously awarded incentive-based compensation and the
amount to be recovered, the discretion it does provide arises in the context of the
means of recovery.
23 While recovery must occur “reasonably promptly” to avoid allowing executive officers to capture the time value of money with respect to funds they did not earn, the Clawback Rules do not set forth any further prescriptions regarding means of recovery; rather, issuers must only “act in a manner that effectuates the purpose of the statute: to prevent current or former executive officers from retaining compensation that they received and to which they were not entitled under the issuer’s restated financial results.”
24 For example, an issuer might decide between recovery in installment payments versus a lump sum payment, or recovery in the form of repayment of shares of stock versus cash repayment.
Impracticability of Recovery
Generally, affected issuers may only decline to recover erroneously awarded incentive-based compensation where doing so would be “impracticable,” and only after making a documented “reasonable attempt” to do so.
25 An issuer may deem recovery “impracticable” if, for example, the direct cost of recovery would exceed the amount which would be recovered, or recovery would violate home country law; however, in any case where recovery is impracticable, the issuer must fulfill additional evidentiary conditions to demonstrate such impracticability.
26
Beyond the general mandate, the SEC provided an exception under the “impracticality” umbrella for issuers seeking to recover compensation which was erroneously awarded through a tax-qualified retirement plan.
27 Where recovery would cause the issuer to violate the anti-alienation provisions of ERISA, the issuer is excepted from recovery of the affected amount, and need only provide documentation explaining how recovery would cause the tax-qualified retirement plan to cease to be so.
28
New Disclosure Requirements Regarding Clawback Policies
To ensure all issuers are subject to the same disclosure requirements regarding their clawback policies, regardless of the exchange upon which they trade, the Clawback Rules also implement certain disclosure requirements related to issuers’ recovery policies. These include:
- Amendments to Item 601(b) of Regulation S-K to mandate issuers file recovery policies as exhibits to annual reports on Form 10-K;
- Amendments to Form 10-K to add check box disclosures on the cover regarding inclusion of accounting restatements, and whether such restatement necessitated a “recovery analysis”;
- The addition of new Item 402(w) of Regulation S-K to require issuers to disclose certain information about application of, and action under, their recovery policies;
- Amendments to Item 402 of Regulation S-K providing instructions regarding the Summary Compensation Table which mandates issuers disclose the effect of any recovered amount if, at any time during or after its last completed fiscal year, the issuer was required to prepare an accounting restatement that necessitated recovery of erroneously awarded compensation pursuant to the issuer’s recovery policy under Rule 10D-1.29
XBRL Requirements
Under the Clawback Rules, registrants must use inline eXtensible Business Reporting Language (XBRL) to tag their recovery disclosures, including the new check boxes on the cover of Form 10-K and the new disclosures mandated under new Item 402(w) of Regulation S-K.
Potential Next Steps
Issuers preparing for the Clawback Rules to come into effect may find a review of existing individual agreements and overall compensation policies fruitful as they develop or enhance their clawback policies. They may also want to consider the relative merit of retaining a separate policy relating to “for cause” clawbacks and non-executive officer clawbacks as compared to aggregating all policies into a single document. Issuers may also want to consider how their current policies comply with the Clawback Rules with respect to insurance coverage and indemnification.
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1 Listing Standards for Recovery of Erroneously Awarded Compensation, Release Nos. 33-11126; 34-96159 (Oct. 26, 2022) (Adopting Release). Under the Clawback Rules, an issuer must recover erroneously awarded compensation in compliance with its recovery policy “except to the extent that pursuit of recovery would be impracticable”; otherwise, recovery is required “regardless of ‘fault’ or responsibility for the error or resulting restatement.” Id. at 85.
2 Id. at 6-7.
3 Id. at 7.
4 Id. at 9.
5 The SEC specified that the term “in part” is included in the definition of “incentive-based compensation” to clarify that such compensation “need not be based solely upon attainment of a financial reporting measure”; for example, qualifying compensation would include awards “in which 60% of the target amount is earned if a certain revenue level is achieved, and 40% of the target amount is earned if a certain number of new stores are opened.” Id. at 57 n.181.
6 Id. at 58. The adopting release accompanying the Clawback Rules noted such measure may include measures which are not prepared in accordance with generally accepted accounting principles in the United States. Id.
7 Id. at 61.
8 Id. at 64 n.194.
9 “Named executive officers” has the meaning set forth in Item 402 of Regulation S-K, 17 CFR 229.402.
10 Adopting Release at 50.
11 Rule 10D-1(d), 17 CFR 240.10D-1(d).
12 Adopting Release at 52 n.157.
13 Id. at 32.
14 Id.
15 Id. at 37-38.
16 15 U.S.C. § 78j-4 (2018).
17 Rule 10D-1(b)(1)(ii)(B), 17 CFR 240.10D-1(b)(1)(ii)(B).
18 Notably, the compensation is only subject to the issuer’s recovery policy to the extent it is received while the issuer has a class of securities listed on an exchange or association.
19 Adopting Release at 75.
20 Id. at 98.
21 Id.
22 Id. at 77; Rule 10D-1(b)(1)(iii)(B), 17 CFR 240.10D-1(b)(1)(iiI)(B).
23 Generally, issuers may only decline to seek recovery where doing so would be impracticable; e.g., the direct cost of recovery would exceed the amount of recovery, or the recovery would violate home country law, with the fulfillment of additional conditions.
24 Id. at 99.
25 Id. at 89. The Issuer must provide the documentation evidencing its “reasonable attempts” to the securities exchange upon which it trades. Id.
26 Id. at 87-88, n.270.
27 Id. at 85, n.268 (noting recovery of compensation under a tax-qualified retirement plan could violate the anti-alienation provisions of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”)).
28 Id. at 111.
29 Id. at 108.
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