On October 26, 2022, the Securities and Exchange Commission (SEC) adopted rules directing the national securities exchanges to create listing standards requiring listed companies to develop and implement policies that obligate such listed companies to recover, or “claw back,” incentive-based compensation “received” by their current or former executive officers as a result of materially incorrect financial statements.

The SEC first proposed the rules in July 2015, as described in our alert, and subsequently reopened the comment period for the proposed rules in October 2021 and June 2022. The adopting release provides for a new Rule 10D-1 under the Securities Exchange Act of 1934 (the Exchange Act) that sets forth the listing standard requirements and amends other rules and forms to require disclosure of a company’s clawback policy and actions taken under such policy.

Key Provisions of Rules

• A clawback would be mandatory in the event a company is “required” to restate a financial statement to correct material noncompliance with a financial reporting requirement, irrespective of whether the corrected errors were material to previously issued financial statements (i.e., including so-called “little r” restatements in addition to “Big R” restatements).
• The company would be required to recover excess “incentive-based compensation” received by its current and former executive officers during the three completed fiscal years immediately prior to the date on which the company is required to prepare the restatement.
• Incentive-based compensation includes compensation based, in whole or in part, on a company’s financial measures (described below). The incentive-based compensation to be recovered by a company would be the amount that the executive officer received based on materially incorrect financial statements that exceeds the amount such executive officer would have received had the compensation been based on the restated financial statements.
• Recovery of the excess incentive-based compensation must be enforced on a no‑fault basis—a company may not consider the responsibility or misconduct of the executive officer, subject to very limited enforcement exceptions.
• All listed companies are required to implement a clawback policy reflecting these provisions, including smaller reporting companies, emerging growth companies, foreign private issuers and controlled companies.
• A company may be subject to de-listing if it does not adopt, disclose and enforce a compliant clawback policy.

Current and Former Executive Officers Covered by Rules

A clawback policy must apply to current and former “executive officers,” which the rules define as a company’s president, chief financial officer, principal accounting officer, any vice president in charge of a principal business unit or any other person in a company policymaking position. This group generally aligns with the definition of “officer” under Section 16 of the Exchange Act.

The rules apply to executive officers who provided services at any time during the three-year lookback period (described below) even if they are not executive officers at the time the restatement is required or when the company seeks to recover the excess incentive-based compensation. However, the rules do not require recovery from awards received prior to an individual becoming an executive officer, even if that person served as an executive during the recovery period (i.e., at or following the financial restatement). All incentive-based compensation received (described below) by such covered executive officers during the three-year lookback period would be subject to clawback.

Financial Restatements Triggering Clawback

A company must recover incentive-based compensation (described below) in the event the company is required to prepare a restatement to correct an error that is “material” to the previously issued financial statement (a “Big R” restatement) or an error that is not material to such statements but would result in material misstatements if left uncorrected in the current report or the error was corrected in the current period (a “little r” restatement).

Materiality is not defined; rather, companies must determine materiality based on the facts, circumstances and relevant legal and accounting guidance. The rules, however, do exclude certain corrections under generally accepted accounting standards, such as the retrospective application of a change in an accounting principle.

Compensation Subject to Clawback

Under the rules, the incentive-based compensation that is subject to clawback is compensation that is granted, earned or vested based on the attainment of any financial reporting measure, which includes:

• Measures based on accounting principles used in preparing financial statements, and measures derived at least in part from such financial information
• Stock price
• Total stockholder return (TSR)

Importantly, the rules exclude the following compensation from clawback, as they are not deemed to be based on financial reporting measures:

• Time-based awards such as stock options or restricted stock units (RSUs) that are granted or vest solely upon completion of a service period, notwithstanding that their value will fluctuate based on the company’s stock price
• Awards based on nonfinancial strategic or operating metrics such as the consummation of a merger or achievement of nonfinancial business goals
• Service-based retention bonuses
• Discretionary compensation
• Salary

These exclusions are significant and may impact decisions by compensation committees regarding whether to award performance-based equity compensation rather than time-based awards, notwithstanding investor preference of performance awards. They may also impact the selection of performance criteria where performance-based awards are granted, resulting in a greater emphasis on nonfinancial operating goals and metrics.

Under the rules, the amount of recoverable incentive-based compensation is the amount received by the executive officer based on the materially incorrect financial statements that exceeds the amount such executive would have received had the compensation been determined based on the financial restatement. In the case of an equity award, the rules indicate that the award itself (or the shares issued upon exercise/settlement thereof) would be subject to recoupment, unless and until the shares had been sold, in which case the cash proceeds (pre-tax) would be recoupable by the company. In the event that an award is net-settled, then presumably both the issued shares and a cash amount equal to the amount of tax withheld would be subject to clawback.

Note that the rules clarify that the addition of a layer of discretion atop incentive compensation that is otherwise payable/funded based on satisfaction of financial measures does not generally remove such incentive compensation from the scope of the clawback rules. For example, the rules expressly provide that if a bonus pool is funded based on satisfaction of financial performance criteria, but is subject to discretionary allocation following funding, any bonuses paid from such pool would be subject to the clawback.

Questions remain regarding the treatment of performance awards that are subject to alternate vesting conditions (e.g., an award vesting upon either achievement of two separate financial conditions or one financial condition and one nonfinancial condition). In the event such an award vests due to satisfaction of one financial condition that is later restated, but before such restatement the second condition is achieved, it is unclear whether the award is subject to recoupment. Also unclear is whether recoupment must occur due to a restatement where an alternate vesting condition remains possible.

In the adopting release, the SEC had noted that it would be acceptable for companies to use reasonable “estimates” to determine the impact of a financial restatement on stock price and TSR. Likewise, the rules indicate that use of an outside expert may be appropriate for this purpose.

The Three-Year Lookback Period

A clawback policy must require recovery of excess incentive-based compensation received during the three completed fiscal years prior to the year in which it is determined that the company is required to prepare an accounting restatement.

The date on which a company is required to prepare a restatement is the earlier of:

• The date that a company’s board of directors, a committee of board directors or authorized officers conclude, or reasonably should have concluded, that the company is required to prepare an accounting restatement due to its material noncompliance with financial reporting requirements under securities laws as described in Rule 10D-1
• The date that a court, regulatory or other authorized legal body directs the company to prepare an accounting restatement

Incentive-based compensation is deemed received at the time the financial measure is achieved, even if the payment or grant occurs on a later date or if there are additional payment requirements, such as time-based vesting or certification by the compensation committee, that have not yet been satisfied. For example, if the number of shares earned under a performance-based RSU is determined based on a company’s TSR over the three-year performance period ending in 2022 (and such award is determined to be based on materially incorrect financial statements), but the RSU then remains subject to a two-year time-based vesting requirement, the RSU is deemed received in 2022 at the end of the relevant performance period. If the board determines in 2023 that a restatement is required, the RSUs would be subject to clawback even though they remain subject to time-based vesting.

The compensation to be recovered would be calculated on a pre-tax basis. Note that if the company paid an amount that was nondeductible under 162(m) or 280G of the U.S. tax code, but that amount is later recouped, the company may not be able to recoup the value of its lost deduction in a prior year.

No-Fault Standard and Limited Discretion to Not Claw Back

The rules do not permit a company to consider the fault or responsibility of the executive officers. A company may exercise discretion to not enforce its clawback policy in only the following situations:

• The expense of enforcing the recovery would exceed the amount recovered and the company has made a reasonable attempt to recover.
• Enforcing the recovery would violate non-U.S. local law.
• Recovery would cause an otherwise tax-qualified retirement plan to fail to meet requirements under the Internal Revenue Code.

A company must make a reasonable attempt to recoup erroneously paid compensation (and document such attempt) prior to asserting that the expense of recovery exceeds the potential recoverable amount. Likewise, it is important to note that only direct costs paid to a third party (such as legal fees) may be taken into account. The decision to not recoup the compensation, which must be made by the company’s compensation committee or the majority of its independent directors, must be publicly disclosed and would be subject to review by the applicable exchange.

It is important to note that the exception for enforcement where the clawback would violate non-U.S. local law is restricted to laws adopted prior to the date of publication of Rule 10D-1 in the Federal Register. This could lead to conflicts of law that lead to adverse consequences for U.S.-listed companies, wherein they are forced to either violate non-U.S. local law or violate the U.S. securities laws. This exception applies only to non-U.S. local law; a company may not assert a conflict with state laws as a justification to not enforce its clawback policy.

The rules also prohibit companies from insuring or indemnifying current or former executive officers against losses resulting from clawbacks, although individuals would be able to purchase their own insurance to fund potential recovery obligations.

All Listed Companies Subject to Rules, with Very Limited Exceptions

Generally, all listed companies must comply with the clawback rules except certain registered investment companies and issuers of securities futures products or standardized options. Notably, there is no exception for emerging growth companies, smaller reporting companies, controlled companies or foreign private issuers.

Required Disclosure

The rules amend Item 601(b) of Regulation S-K to require a company to file its clawback policy as an exhibit to its annual report on Form 10-K. A company must also indicate via two new check boxes on the form’s cover page (1) whether the previously issued financial statements included in the filing have an error correction, and (2) whether any such correction(s) are restatements that triggered a clawback analysis during the fiscal year.

In addition, the rules require the following disclosures under new Item 402(w) of Regulation S-K in a company’s Form 10-K or proxy statement if a triggering restatement occurs and/or there remains an outstanding balance of compensation subject to clawback that relates to a prior year’s restatement:

• For each restatement, the date on which the restatement was required, the aggregate amount of recoverable incentive-based compensation, a description of estimates used to determine the amount of erroneously paid incentive-based compensation attributable to the company’s stock price or TSR metrics, and any outstanding balance of compensation to be repaid at the end of the last completed fiscal year
• If a company decides not to pursue recoupment for an individual based on cost impracticalities, the name of such individual if a current or former named executive officer (NEO), the amount forgone for each NEO and all other former executive officers as a group, and an explanation of the company’s reason to not pursue recovery
• The name of each current and former NEO from whom recoupment was owed at the end of the last completed fiscal year if the amount to be repaid remained outstanding for 180 days or more since the company determined the amount owed and the outstanding amount

A company would also have to disclose if it had to prepare an accounting restatement during or after its last completed fiscal year but concluded that recovery was not required under its clawback policy and explain the basis for its conclusion.

The information required by Item 402(w) would not be deemed to be incorporated by reference into any other filing under the Securities Act unless the company specifically makes the decision to do so.

In addition, to the extent that any amount previously reported in the summary compensation table of a company’s SEC filing, including Securities Act registration statements, is reduced due to the company’s clawback policy, a company must disclose the reduction in compensation in a footnote to the table.

XBRL Tagging

The rules require the tagging of specific data points in a company’s compensation recovery disclosure in the Inline XBRL format. The two new cover page check boxes must also be tagged in Inline XBRL.

Timing for Compliance

The rules are effective 60 days after the date of publication in the Federal Register. The exchanges will have 90 days from the date of publication of the rules in the Federal Register to issue their proposed listing rules. The exchanges’ listing rules must be effective no later than one year following the publication of the SEC’s rules. Companies would then be required to adopt a clawback policy no later than 60 days following the effective date of the applicable exchange’s rules.

A company must comply with the clawback policy for incentive-based compensation received on or after the effective date of the listing rules of its exchange. Likewise, a company must provide the disclosures required by the rules in its applicable SEC filings on or after the effective date of the listing rules of its exchange.

Considerations for Compensation Structuring

Although the likelihood of an individual executive being subject to a clawback is very low, the three-year lookback for a significant portion of their income is a potentially substantial impediment to recruiting and retention. Avoiding exposure to clawbacks (involving no fault on their part) may be an important decision factor for talented executives, especially for those without significant preexisting wealth or who are being recruited by newer, less-mature companies, particularly where companies are in novel industries with significant uncertainty in accounting treatment or practices.

Compensation committees should consider the impact of the rules on their performance-based compensation programs, and whether their retention and operational performance goals can be achieved without such programs. In consultation with their compensation advisors, it is possible that in reaction to these new rules, compensation committees may consider shifting compensation program design toward higher salaries, discretionary bonuses or time-based equity awards. Similarly, where performance-based compensation is used, compensation committees may consider whether their goals can be achieved without the use of financial-related or stock price/TSR metrics subject to the rules (such as key performance metrics tied to nonfinancial operational goals).

When weighing these considerations, compensation committees must also take into account their pay-for-performance philosophy and the goals that their performance-based compensation programs serve, as well as the investor preference for significant weighting of performance-based compensation in executive compensation programs and their likely reaction to changes in program design. Shifting away from performance-based compensation would also run afoul of the stated preferences for performance-based compensation of major institutional investors and proxy advisory firms, such as ISS and Glass Lewis, and could negatively impact a company’s say-on-pay vote.

Ultimately, the compensation committee will need to consider what is in the long-term interests of the company and its stockholders and other stakeholders, while building a high‑value, sustainable enterprise.

What’s Next?

In addition to the compensation design considerations discussed above, once the new rules go into effect, companies should work with counsel and consider taking the following actions in response:

• Adopt a clawback policy (or restate an existing clawback policy) and related procedures to comply with the rules and ensure communication to affected employees.
• Add clawback provisions to new incentive-based compensation arrangements, or amend existing arrangements, to subject the compensation to the clawback policy to be adopted to comply with the new rules.
• Review company bylaws, D&O insurance and executive officers’ indemnification agreements to remove indemnification with respect to compensation subject to the clawback rules (the rules prohibit a company from indemnifying executive officers).
• Review compensation committee charters to determine whether the charters address the new duties required by the rules, and/or consider whether a separate independent committee should be established for these purposes.

Additional Information

The SEC’s Fact Sheet describing the rules can be found here.