On October 26, 2022, the Securities and Exchange Commission (“SEC”) adopted a final rule that will require most publicly traded companies to adopt a clawback policy to recover incentive-based compensation from current or former executive officers in connection with certain accounting restatements.  In addition, companies will be required to disclose their clawback policy and certain actions taken pursuant to the policy.

Background

The new rule comes after years of development.

The Dodd-Frank Wall Street Reform and Consumer Protection Act added a new Section 10D to the Securities Exchange Act of 1934.  Section 10D requires the SEC to direct the national securities exchanges (NYSE and Nasdaq) to establish listing standards that require each issuer to develop and implement a clawback policy.

In July 2015, the SEC proposed rules to implement Section 10D.  After a number of comment periods, the rule has now been adopted largely as originally proposed. 

Requirements

The new rule directs the national securities exchanges to establish listing standards that require each listed company to develop and implement a clawback policy and make certain related disclosures.  Companies that do not adopt and comply with a clawback policy that meets the listing standards will be subject to delisting. 

At its core, the new rule requires companies to recover incentive-based compensation received by current or former executive officers where that compensation is based on erroneously reported financial information.  Recovery is required if the company is required to prepare an accounting restatement, including to correct an error that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period.  In connection with such a restatement, the company must recover from any current or former executive officers the amount of incentive-based compensation received in excess of the amount that otherwise would have been received had it been determined based on the restated financial measure.

Key Definitions and Concepts

Covered Issuers

The new rule broadly applies to listed companies, with very few exceptions.  Significantly, the SEC expressly rejected requests to exclude smaller reporting companies, emerging growth companies, controlled companies, and foreign private issuers from the new rule.  Thus, even small public companies must comply with the new requirements when they take effect. 

Recovery Triggers

Recovery under a clawback policy will be required in connection with an accounting restatement due to the material noncompliance of the company with any financial reporting requirement under the securities laws.  Clawbacks are triggered both by “Big R” restatements, which correct an error in previously issued financial statements that is material to the previously issued financial statements, but also “little r” restatements, which correct errors not material in themselves, but which would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period.

Covered Executives

The clawback policy applies to incentive-based compensation received by an executive officer after beginning service as an executive officer or at any time during the three-year recovery period (see below).  The term “executive officer” is interpreted consistently with the term “officer” in Rule 16a-1(f) under the Exchange Act, and includes the 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 (such as sales, administration, or finance), any other officer who performs a similar policy-making function for the company (such as an officer of a subsidiary). 

At a minimum, executive officers for purposes of the clawback policy include all executive officers listed in the company’s Form 10-K report or proxy statement. 

No Misconduct Required

A clawback is triggered by any covered accounting restatement, without regard for whether any misconduct occurred and is not limited to executives who might be viewed as “at fault” for the erroneous financial statements. This is broader than existing clawback provisions under the Sarbanes-Oxley Act, which only apply if a restatement is due to misconduct.

Incentive-Based Compensation

Under the new rule, incentive-based compensation is “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure.”  Financial reporting measure is broadly defined to include any measures “that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, and any measures that are derived wholly or in part from such measures.”  This includes both GAAP and non-GAAP measures, as well as stock price and total shareholder return.

Examples of financial reporting measures include: revenues, net income, operating income, profitability of one or more reportable segments, EBITDA, liquidity measures (such as working capital or operating cash flow), return measures (such as return on invested capital and return on assets), and earnings measures (such as earnings per share). 

Specific examples of “incentive-based compensation” include, but are not limited to:

• 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.
• 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.
• 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.

Examples of compensation that is not “incentive-based compensation” for this purpose include, but are not limited to:

• Salaries (but a salary increase earned in wholly or in part based on the attainment of a financial reporting measure performance goal is subject to recovery under a clawback policy).
• Discretionary bonuses paid solely at the discretion of the compensation committee or board that are not paid from a bonus pool that is determined by satisfying a financial reporting measure performance goal.
• Bonuses paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) and/or completion of a specified employment period (time-based retention bonuses).
• Non-equity incentive plan awards earned solely upon satisfying one or more strategic measures (e.g., consummating a merger or divestiture), or operational measures (e.g., opening a specified number of stores, completion of a project, increase in market share).
• Time-based equity awards (in other words, equity awards for which the grant is not contingent upon achieving any financial reporting measure and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more nonfinancial reporting measures).

Recovery Period

The clawback policy must apply to compensation received during the three completed fiscal years preceding the date on which the company is required to prepare an accounting restatement as described above.  For this purpose, a company is deemed to be required to prepare an accounting restatement on the earlier of (a) the date the company’s board or applicable board committee (or officers, if no board action is required) conclude, or reasonably should have concluded, that the company is required to make an accounting restatement or (b) the date a court, regulator, or other legally authorized body directs the company to prepare an accounting restatement. 

Amount of Clawback

The amount of incentive-based compensation that must be subject to the clawback policy is the amount of incentive-based compensation received that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatements, computed without regard to any taxes paid. 

For incentive-based compensation based on stock price or total shareholder return, if the amount of erroneously awarded compensation is not subject to mathematical recalculation from the information in an accounting restatement, the company must make a reasonable estimate of the effect of the accounting restatement on the stock price or total shareholder return upon which the incentive-based compensation was received and maintain documentation related to such determination.

Obligation to Seek Recovery

Companies are required to seek recovery of erroneously awarded compensation under the clawback policy unless the compensation committee determines that recovery would be impracticable for one of the following reasons:

• The direct expense paid by the company to a third party to assist in securing the recovery (e.g., legal fees) would exceed the amount recovered (following reasonable attempts to recover the compensation and subject to documentation requirements).
• Recovery would violate home country law, in effect prior to the publication of the final rule, as evidenced by an opinion of home country counsel.
• Recovery would cause a tax-qualified retirement plan to fail to meet qualification requirements.

Note that a potential violation of state law will not create an exception to recovery under a clawback policy.  The SEC takes the position that there are strong arguments that the rule and resulting listing standards will preempt any contrary state law.

Indemnification Prohibited

A company may not indemnify any covered executive officer against the loss of erroneously awarded compensation.  An executive officer may purchase third-party insurance to fund potential recovery obligations, but the company may not pay or reimburse the premiums for such an insurance policy.

Disclosure Obligations

In addition to the listing standards required by the new rule, the SEC has amended various rules to mandate certain disclosure obligations.  First, the company will be required to file its policy with its annual report on Form 10-K. The 10-K cover page will include two new check boxes: one to indicate whether the financial statements include the correction of an error to previous financial statements and another to indicate whether the correction requires analysis under the clawback policy.  Second, new Item 402(w) of Regulation S-K will require any company that was required to prepare an accounting restatement that triggered a clawback or had an outstanding balance on a recoverable amount from the application of its clawback policy to disclose:

• The date on which it was required to prepare an accounting restatement.
• The aggregate dollar amount of erroneously awarded compensation attributable to such accounting restatement, including an analysis of how the amount was calculated.
  • If the aggregate dollar amount of erroneously awarded compensation has not yet been determined, the company must disclose this fact, explain the reasons, and disclose the other required in the next filing that is required to include disclosure pursuant to Item 402 of Regulation S-K.
• If the financial reporting measure related to a stock price or total shareholder return metric, the estimates that were used in determining the erroneously awarded compensation attributable to such accounting restatement and an explanation of the methodology used for such estimates.
• The aggregate dollar amount of erroneously awarded compensation that remains outstanding at the end of the last completed fiscal year.

In addition, if the company has determined that recovery of amounts subject to the clawback policy is impracticable as described above, the company must disclose the amount of recovery forgone and include a brief description of the reason the company decided in each case not to pursue recovery.

Finally, if a company recovers amounts pursuant to its clawback policy, it must update its Summary Compensation Table to reduce the amount reported in the applicable column and the total column for the fiscal year in which the amount recovered was initially reported (with a footnote identifying the amount recovered). 

Timing of Effectiveness

The new rule will be effective 60 days after its publication in the Federal Register.  Exchanges will be required to file proposed listing standards no later than 90 days following publication of the final rule in the Federal Register, and the listing standards must be effective no later than one year following such publication.  Companies will be required to adopt a clawback policy no later than 60 days following the date on which the applicable listing standards become effective and must begin to comply with the disclosure requirements in proxy and information statements and the company’s annual report filed on or after the company adopts its clawback policy.

Next Steps

Although there will be some time before the new rule is fully implemented through corresponding listing requirements, companies should begin the process now of preparing to implement new clawback policies.  Any previously adopted clawback policy may not fully comply with the requirements set forth in the new rule, so companies should not assume that any existing clawback policy will be sufficient without modification.  In addition, companies should consider whether it would be desirable to adopt a clawback policy that goes beyond the minimum requirements established by the SEC and applicable exchange.