On October 26, 2022, the U.S. Securities and Exchange Commission (SEC) approved final rules that will ultimately require public companies to adopt, enforce, and disclose policies to recover (or “clawback”) excess incentive-based compensation from current and former executive officers in the event of an accounting restatement, whether or not the executive officer was at fault for the restatement. The final clawback rules have been long in the making as they were mandated more than 12 years ago by Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act).

The final clawback rules include the following:

• new Rule 10D-1 under the Securities Exchange Act of 1934, as amended (Exchange Act), requiring stock exchanges to enact listing standards requiring each listed company to adopt and comply with a written clawback policy, or be subject to delisting;
• new Item 402(w) to Regulation S-K (Reg S-K) requiring certain disclosures in the company’s annual report on Form 10-K and proxy statement if there was a restatement that triggered a clawback during the last fiscal year, or if there was an outstanding balance of excess incentive-based compensation from a prior restatement;¹ and
• new Item 601(b)(97) to Reg S-K requiring the filing of the clawback policy as an exhibit to the Form 10-K, and two new checkboxes on the cover of the annual report indicating whether the filing contains the correction of an error to previously issued financial statements and whether any of those error corrections resulted in a restatement that triggered a clawback analysis.

The final rules are effective 60 days after the date they are published in the Federal Register (“publication date”). However, further action by stock exchanges will be required. Stock exchanges will have up to 90 days following the publication date to submit their proposed listing standards to the SEC for approval, and those listing standards must be effective no later than one year following the publication date. Once the applicable stock exchange listing standards become effective, listed companies will have 60 days to adopt their clawback policies, and comply with the disclosure requirements in the first SEC filing following adoption of the clawback policy.

Background

Section 954 of the Dodd-Frank Act added Section 10D to the Exchange Act, requiring the SEC to adopt rules directing the national securities exchanges, such as the New York Stock Exchange and The Nasdaq Stock Market, and national securities associations, to adopt listing standards that would require each listed company to adopt, enforce, and disclose a written clawback policy, or be subject to delisting.

In July 2015, the SEC issued proposed clawback rules that, if adopted, would have satisfied the mandate under Section 954 of the Dodd-Frank Act. However, no further action was taken on the proposed rules until late last year. In October 2021, the SEC reopened the public comment period on the proposed clawback rules, and then in June 2022, reopened it yet again. See our previous Client Alert on the 2015 proposed rules and our previous Client Alert on the October 2021 reopening for more information.

In addition to these final clawback rules, executive clawbacks are also addressed under Section 304 of the Sarbanes-Oxley Act of 2002 (SOX). Under Section 304, if a company is required to prepare an accounting restatement that results from misconduct, then the chief executive officer and chief financial officer are required to reimburse the company for certain compensation received by them and any profits realized by them from the sale of company securities, in both cases, during the 12-month period following the first public issuance or filing with the SEC of the misstated financials. As discussed below, the final clawback rules differ in many ways from the SOX requirement, including by applying to a broader group of executive officers, and irrespective of fault or misconduct on the part of the executive officers.

Final Clawback Rules

The following is a detailed discussion of the final clawback rules in question-and-answer format, as well as practical takeaways. As a reminder, companies that fail to comply with the new rules will be subject to delisting from their applicable stock exchange.

Adopting the Clawback Policy

Which companies are required to adopt a clawback policy?

Subject to limited exceptions, the rules apply broadly to all public companies, including emerging growth companies (EGCs), smaller reporting companies (SRCs), controlled companies, foreign private issuers, and issuers of listed debt whose stock is not listed. In the adopting release, the SEC noted that, unlike certain other provisions of the Dodd-Frank Act, U.S. Congress did not direct the SEC “to consider differential treatment for certain classes of issuers, such as SRCs and EGCs[,]” with respect to the clawback rules. Accordingly, these final rules stand in contrast to many of the other rulemaking mandates under the Dodd-Frank Act, such as pay ratio disclosures, say-on-pay and say-on-frequency proposals, and pay-versus-performance disclosures, for which EGCs are exempted.

Which executive officers must be covered under the clawback policy?

The rules apply to a company’s current and former “executive officers.” The definition of “executive officers” is modeled after, and consistent with, the definition of “officers” in Exchange Act Rule 16a-1(f), and would, at a minimum, include all executive officers identified under Item 401(b) of Reg S-K. Thus, executive officers will include a company’s president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice-president of the company in charge of a principal business unit, division, or function (such as sales, administration, or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the company. It will also include officers of the company’s parent(s) or subsidiaries if they perform such policy-making functions for the company.

The category of executive officers under the final clawback rules is much broader than under SOX Section 304, which only applies to the chief executive officer and chief financial officer.

Are there any limitations to “current and former executive officers” covered under the clawback policy?

Yes. The clawback policy will only be required to apply to incentive-based compensation received by a person 1) who was serving as an executive officer at any time during the performance period for such incentive-based compensation, and 2) during the three-year lookback period (discussed below under “Enforcing the Clawback Policy”), even if they are not an executive officer at the time the financial statements are restated or at the time the company is seeking recovery.

In a departure from the proposed rules, the final rules provide that any incentive-based compensation received by a person prior to becoming an executive officer (i.e., when the individual was an employee but not an executive officer) would not be subject to the clawback policy. Thus, recoupment of compensation received while the individual was serving in a non-executive role prior to becoming an executive officer will not be required.

What types of restatements will trigger clawbacks under the clawback policy?

All required restatements made to correct an error in previously issued financial statements are covered under final Rule 10D-1.

This means that a clawback may be triggered by any of the following:

• material errors in previous financial statements, known as “Big R” restatements; and/or
• errors that were not material to the previous financial statements but would result in a material misstatement if left uncorrected in the current report or the error correction was recognized in the current period, known as “little r” restatements.

The inclusion of “little r” restatements in the final rules differs from the original 2015 proposal (which covered only restatements for material errors in previous financial statements). However, in the reopening releases, the SEC stated that including only “Big R” restatements could lead companies to make questionable materiality judgments in order to avoid recoupment of incentive compensation. By including the more commonplace “little r” restatements in the final rules, the SEC broadened the scope of the rules considerably.

Conversely, the following are examples from the adopting release of changes to financial statements that would not trigger a clawback:

• Out-of-period adjustment (i.e., where the correction of an error is recorded in the current period financial statements, and the error is immaterial to the previously issued financial statements and correction of the error is also immaterial to current period financial statements)
• Retrospective application of a change in accounting principle
• Retrospective revision to reportable segment information due to a change in the company’s internal organizational structure
• Retrospective reclassification due to a discontinued operation
• Retrospective application of a change in reporting entity
• Retrospective adjustment to provisional amounts in connection with a prior business combination (IFRS filers only)
• Retrospective revision for stock splits, reverse stock splits, stock dividends, or other changes in capital structure

Does anyone have to be at fault in the restatement?

No. The final rules, like the original 2015 proposal, have no requirement for misconduct or that the executive officer be at fault in the restatement. This differs from the clawback policies currently in effect at many companies, which require misconduct before a clawback may be implemented. Most of these policies were based on SOX Section 304.

What type of compensation is subject to clawback?

Only incentive-based compensation is subject to clawback. Incentive-based compensation is defined as any compensation that is granted, earned, or vested based wholly or partially upon attainment of any “financial reporting measure.”

What are financial reporting measures for purposes of the final rules?

Financial reporting measures include 1) measures based on accounting principles used in preparing the company's financial statements, 2) any measures derived wholly or in part from such measures including financial measures not prepared in accordance with generally accepted accounting principles such as EBITDA or free cash flow (non-GAAP measures), as well as other measures, metrics, and ratios such as same store sales, 3) stock price, and 4) total shareholder return (TSR).

The adopting release included the following non-exhaustive list of financial reporting measures:

• Revenues
• Net income
• Operating income
• Profitability of one or more reportable segments
• Financial ratios such as accounts receivable turnover and inventory turnover rates
• Net assets or net asset value per share
• EBITDA
• Funds from operations and adjusted funds from operations
• Liquidity measures such as working capital or operating cash flow
• Return measures such as return on invested capital and return on assets
• Earnings measures such as earnings per share
• Sales per square foot or same store sales, where sales is subject to an accounting 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 statement
• Any financial reporting measures relative to a peer group, but only where the company’s financial reporting measure is subject to an accounting restatement (not any of the peers)
• Tax basis income
• Stock price
• TSR

Enforcing the Clawback Policy

What is the required lookback period for recovery of incentive-based compensation under the clawback policy?

The time period required to be covered in the clawback policy will be the three completed fiscal years immediately preceding the date on which the company is required to prepare an accounting restatement. Accordingly, incentive-based compensation received during this lookback period will be subject to the clawback policy.

When is incentive-based compensation received by an executive officer?

Incentive-based compensation is deemed to have been received in the fiscal period during which the financial reporting measure is attained, even if the payment or grant occurs after the end of that period or not all conditions to payment have been satisfied (e.g., additional service conditions or board of directors’ certification of performance criteria).

However, if the incentive-based compensation is an equity award that vests upon the attainment of a financial reporting measure, then the award would be deemed to have been received in the fiscal period when it vested.

When is a company required to prepare an accounting restatement, i.e., the “trigger date” for the clawback lookback period?

As under the original 2015 proposal, the final rules provide that the clawback is triggered when the board, a committee of the board, or officers (if board action is not required) concludes or reasonably should have concluded that the company is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirements under the securities laws (or when a court, regulator, or other legal body orders a restatement, if earlier).

How is the amount of the recovery calculated?

The amount of recovery is the amount (pre-tax) received by the executive officer in excess of the amount that would have been paid based on the restated financial statements. This differs from the clawback policies currently in effect at many companies, which provide for recovery of after-tax amounts.

Where the financial reporting measure is not directly tied to the restated financial statements (such as in the case of stock price or TSR), the company is entitled to base the amount to be recovered on a reasonable estimate of the effect of the restatement on the financial reporting measure. The company must document its analysis and provide that documentation to the applicable stock exchange.

How does the company determine the amount to be recovered in the case of a bonus pool?

If the size of the bonus pool is determined based on financial reporting measures (rather than the individual bonus amount tied to the measure), the company should recalculate the bonus pool based on the restated financial statements and then determine the executive’s pro rata portion of the reduced bonus pool in order to calculate the amount to be recovered.

How does the company determine the amount to be recovered when incentive-based compensation is in the form of equity?

In the case of equity incentive compensation, if the shares, options, or stock appreciation rights are still held at the time of the clawback, the amount to be recovered is the excess of the securities received over the number of securities that would have been received based on the restated financial statements (or the value of that excess number). If the options or stock appreciation rights have been exercised but the shares have not been sold, the amount to be recovered is the number of shares underlying the excess options or stock appreciation rights (or the value thereof).

How and when must the company recover the excessive incentive-based compensation once a clawback is triggered?

The final clawback rules do not prescribe the manner or deadline by which companies must recover excess incentive-based compensation, leaving these decisions to the discretion of the company. However, the SEC stated that companies should recover the excess compensation “reasonably promptly” and new Item 402(w) of Reg S-K requires companies to disclose any shortfalls in recovery at the end of the last fiscal year.

The adopting release notes that the rules do not prevent companies “from securing recovery through means that are appropriate based on the particular facts and circumstances of each executive officer that owes a recoverable amount.” As an example, depending on the facts and circumstances, a company might be acting “reasonably promptly” if it establishes “a deferred payment plan that allows the executive officer to repay owed erroneous compensation as soon as possible without unreasonable economic hardship to the executive officer[.]”

Notwithstanding the foregoing, the stock exchanges may adopt more prescriptive rules for the timing and method of recovery and, thus, it will be important to review the stock exchange proposals when published.

Can the board waive the requirement to recover incentive-based compensation?

There are three limited exceptions under which boards can waive the recoupment required under the new rules. These limited exceptions are all based on the impracticability of recovery, and specifically if pursuing the clawback, would:

• impose undue costs on the company or its shareholders (i.e., direct costs to pursue recovery would be in excess of the amount of the recovery), 
• violate the home country law of a non-U.S. company, provided the law was adopted prior to the publication date, or
• cause a tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code.

In the case of the first exception, the company must attempt recovery before it determines there are undue costs, and it must document its attempts to recover the compensation and provide that documentation to the applicable stock exchange. In the case of the second exception, the company is required to provide the stock exchange with a legal opinion from counsel in the company’s home country (acceptable to the applicable stock exchange) stating that recovery would violate the law and citing the provision it would violate. 

With respect to any of the three limited exceptions, the decision to forego recovery of incentive-based compensation can only be made by the compensation committee (or a majority of independent directors, if there is no compensation committee).

Can the company purchase insurance against the clawback for the executive officers or reimburse executive officers for the insurance?

No. Executive officers may purchase such insurance at their own expense, but if the company reimburses the officer or purchases the insurance for them, that is a prohibited indemnification.

How does the clawback under Section 304 of SOX relate to this new provision?

SOX Section 304 requires companies to recover incentive compensation from the chief executive officer and chief financial officer if there is a restatement of financial statements for material failure to comply as a result of misconduct.

Although this standard differs from Rule 10D-1, any incentive compensation amounts recovered under SOX Section 304 may be counted toward the recovery required under Rule 10D-1. 

Disclosing the Clawback Policy

What information must a company disclose and where does it appear?

Companies will be required to file their clawback policies as an exhibit to their Form 10-K (or Form 20-F or Form 40-F, as applicable). Companies will also be required to indicate by check box on the cover page of their annual report whether the financial statements in the filing reflect a correction of an error to previously issued financial statements and by separate check box whether those corrections are restatements that triggered a clawback analysis.

In addition, disclosure regarding the application of the clawback policy would be required in the company’s proxy statement (or annual report if they do not file a proxy statement or if they do not forward incorporate by reference from the proxy statement) if, during the prior fiscal year, there was either 1) an accounting restatement that required a clawback, or 2) an outstanding clawback balance.

The required disclosure would include the following:

• For each restatement:
  • the date on which the company was required to prepare the restatement;
  • the aggregate dollar amount of the excess compensation attributable to the restatement, including an analysis of how the amount was calculated or, if the amount has not yet been determined, an explanation of the reasons why it has not been determined, and disclosure of the amount and related disclosures in the next filing subject to Item 402 of Reg S-K;
  • the aggregate dollar amount of excess compensation outstanding at the end of the company's last completed fiscal year; and
  • estimates used to determine the excess compensation that was subject to any financial reporting measures relating to stock price or TSR and an explanation of the methodology used to estimate the effect on stock price or TSR.
• If recovery would be impracticable, then for each current and former named executive officer and for all other current and former executive officers as a group, the amount of recovery forgone and a brief description of the reason the company decided not to pursue recovery, which should include the element of the rule that caused the impracticability and additional context relating to that element, such as (when applicable) an explanation of the types of direct expense paid to a third party to assist in enforcement of the policy, identification of the home country law that the clawback policy would violate, or an explanation of how the clawback would cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code.
• For each current and former named executive officer, the amount due from each such person at the end of the company’s last completed fiscal year from whom clawback amounts had been outstanding for 180 days or more.

Any amounts that are recovered under the clawback policy from any named executive officer's compensation for the fiscal years reported in the summary compensation table will reduce the amount reported in the applicable column and in the “total” column in the table for the fiscal year in which the amount recovered initially was reported. The reduction also is required to be identified by footnote to the summary compensation table.

This disclosure may be included on a standalone basis in the proxy statement or, if the company is required to provide Compensation Discussion and Analysis under Item 402 of Reg S-K, then the company could include this disclosure as part of the Compensation Discussion and Analysis along with any disclosures relating to its recovery policies and decisions already required under Item 402(b)(2)(viii) of Reg S-K.

If the company complies with new Item 402(w) of Reg S-K, then it would not be required to disclose the clawbacks under Item 404(a) of Reg S-K, relating to disclosure of related person disclosures.

If the company determines that no clawback is required, are there any disclosure requirements?

Yes. The final rules provide that if at any time during the company’s last completed fiscal year, it prepared an accounting restatement and concluded that no clawbacks were required under its clawback policy, then the company must briefly explain why the application of its clawback policy resulted in this conclusion.

Will this information be required to be in Inline XBRL format?

Yes. The final rules require the disclosures to be tagged using Inline XBRL format.

Next Steps

When do companies have to comply with these new rules?

Companies are not required to comply with these new rules until after the applicable stock exchange implements its listing standards. As discussed above, the final rules are effective 60 days after the publication date; however, further action by the stock exchanges will be required as follows:

• The stock exchanges will have up to 90 days after the publication date to submit proposed listing standards to the SEC for approval.
• The proposed listing standards must be effective no later than one year after the publication date.

Once the applicable stock exchange listing standards are effective, listed companies will have 60 days to adopt their clawback policies, and must comply with the disclosure requirements in the first SEC filing following their timely adoption of the clawback policy.

Unlike the proposed rules, the final rules provide an additional transition period for the application of the clawback policy to incentive-based compensation granted prior to the effective date of the final rules. Clawback policies will only be required to apply to incentive-based compensation received by current or former executive officers on or after the effective date of the applicable listing standard. Note, however, that if the company had pre-existing compensation contracts or arrangements (i.e., prior to the effective date of the applicable listing standard), and incentive-based compensation under those contracts or arrangements was received after the effective date of the applicable listing standard, then this compensation would be subject to the clawback policy under the final rules. 

What next steps should companies take?

Companies should begin to prepare for implementation of the new rules as soon as possible. In particular, companies should:

• review the stock exchanges’ proposed rules, once submitted to the SEC, and comment on them, if appropriate;²
• review executive compensation policies and procedures and determine which are based wholly or partly on financial reporting measures and so potentially will be subject to clawback;
• consider any changes to executive compensation policies and procedures that may be advisable in light of the incentive-based compensation that will be at risk going forward;
• review any existing clawback policies and consider amendments that may be necessary to comply with the new listing standards that will be adopted by the stock exchanges;
• brief the board of directors on the new rules and the company’s proposed amendments to executive compensation design or adoption of clawback policies in response to the new rules;
• review executive officer designations and educate those whose compensation will be subject to the final clawback rules;
• update disclosure controls and procedures to ensure compliance with the new rules; and
• prepare to comply with the new annual report and proxy statement disclosures required by the final clawback rules.

[1] Generally, if the company files its annual meeting proxy statement within 120 calendar days after the end of its fiscal year, it would not include this information in its annual report on Form 10-K but would instead forward incorporate Item 402 of Reg S-K information by reference from the proxy statement. Foreign private issuers will be required to include this information under new Item 6.F. in their annual reports on Form 20-F, and certain Canadian issuers will be required to include this information under new Item 19 in their annual reports on Form 40-F.

[2] Wilson Sonsini will issue another client alert when the stock exchanges propose their clawback rules to the SEC for review.