On January 27, 2023, the SEC’s new Executive Compensation Clawback Rules became effective. The rules require listed companies to: (1) develop and implement a policy to recover erroneously awarded incentive-based compensation received by current or former executive officers; and (2) satisfy related disclosure obligations. With new rules, come new risks. At a minimum, companies will have to closely examine the new rules and establish protocol to ensure adequate compliance and disclosure.

Brief Background

On October 26, 2022, the United States Securities and Exchange Commission (“SEC”) adopted Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). These rules were initially proposed in July 2015 and recently underwent two commentary periods before the final rules were adopted. According to SEC Chair Gary Gensler, the purpose of the new rules is to “strengthen the transparency and quality of corporate financial statements, investor confidence in those statements, and the accountability of corporate executives to investors.”

The clawback rule requires:  

[N]ational securities exchanges and associations that list securities to establish listing standards that require each issuer to develop and implement a policy providing for the recovery, in the event of a required account restatement, of incentive-based compensation received by current or former executive officers where that compensation is based on the erroneously reported financial information. The listing standards must also require the disclosure of the policy.

The clawback rule defines “incentive-based compensation” as “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure.” It further clarifies that “any incentive-based compensation recovered under the final rules is compensation that an executive officer would not have been entitled to receive had the financial statements been accurately presented.”

Although recovery is dependent on disclosure of an error in initial financial reporting, the rule applies on a “no fault” basis. The rule adopts the definition of “executive officers” as is provided in Exchange Act Rule 16a-1. The new rules provide for a three-year look back period applicable to three completed fiscal years. Therefore, executive officers, including former executive officers who are no longer serving at the time the clawback is required, are subject to the clawback requirements.

The clawback requirements are broad and therefore apply to both “Big R” and “little r” restatement filings. A “Big R” restatement occurs 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. A “little r” restatement corrects an error that would result in a material misstatement if the error was not corrected in the current period or was corrected in the current period and generally does not require Form 8-K filing. Therefore, there is a possibility that a “clawback analysis [may be required] when the error did not lead to erroneous compensation during the three-year period, or require a clawback of de minims amounts.”[1]

Timeline

The new rules require the national securities exchanges to propose listing standards implementing the new rules by February 26, 2023. Those listing standards must be effective no later than November 28, 2023.

A listed issuer will then only have 60 days to adopt a recovery policy after the applicable listing standards become effective.  If an exchange’s listing standards become effective at the latest possible date of November 28, 2023, then the listed issuer must have its new clawback policy in place no later than January 27, 2024.

Key Highlights / Looking Ahead

A few key highlights of the rules include:

1. Issuers are prohibited from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation;
2. An executive officer may be able to purchase a third-party insurance policy to fund potential recovery obligations. However, the indemnification provisions prohibit an issuer from paying or reimbursing the executive officer for premiums for these policies; and
3. Indemnification arrangements that permit executive officers to retain or recover compensation that they were not entitled to receive may violate Section 10D of the Exchange Act.

In light of the new rules, listed companies should carefully review the SEC requirements, confirm who is actually listed as an executive officer, and consider updating their compensation plans. In addition, of note for D&O insurers in particular, the new Rules may lead to increased shareholder derivative lawsuits seeking to force companies to pursue clawback.

[1] SEC Commissioner Hester M. Peirce’s dissent to the new rule can be found here.