On July 1, 2015, the U.S. Securities and Exchange Commission (SEC) proposed a rule directing national securities exchanges and associations to establish listing standards that require public companies to adopt and enforce a written executive compensation clawback policy. In particular, the rule would require current and former executive officers to pay back incentive-based compensation that they would not have received based on a material accounting restatement by the company. The proposed rule would implement Section 954 of the Dodd-Frank Act.

Which companies are affected?

Most listed companies, including foreign private issuers, emerging growth companies, smaller reporting companies, controlled companies, and issuers of only debt or preferred securities are subject to the proposed rule.

Who is an executive officer?

The definition of “executive officer” is based on the definition of “officer” under Section 16 of the Securities Exchange Act of 1934. It includes all of an issuer’s current executive officers as well as former executive officers who served at any time during the relevant performance period for which payment of the incentive compensation is based.

What is incentive-based compensation?

Incentive-based compensation is any cash or equity-based compensation that is granted, earned, or vested based wholly or partially upon the attainment of any “financial reporting measure.” As proposed, financial reporting measures are defined as measures based on the accounting principles used in preparing the issuer’s financial statements, any measures derived wholly or partially from financial information, and stock price and total shareholder return. 

What triggers a clawback?

A clawback is triggered when a listed company is required to restate its financial statements due to material noncompliance with a financial reporting requirement. A series of corrections of immaterial errors may be material for purposes of triggering the clawback policy. Recovery of incentive-based compensation is on a no-fault basis and is not predicated on an individual’s misconduct or responsibility in connection with the financial statement error.

What time period of compensation is subject to recovery?

Recovery policies would apply to incentive-based compensation “received” during the three fiscal years preceding the date on which the company is “required” to prepare an accounting restatement to correct a material error.  Compensation is considered “received” when a performance measure is attained, regardless of when the executive officer is actually paid. A restatement is “required” on the earlier of: (1) the date upon which the company’s board concludes or reasonably should conclude that a restatement is required or (2) the date upon which a court, regulator, or other governing body orders the company to prepare a restatement to correct a material error.

How much incentive-based compensation is subject to recovery?

“Excess compensation” is recoverable. “Excessive compensation” is the amount of incentive-based compensation paid in excess of the amount that would have been paid if the compensation had been calculated using the restated financial information, determined on a pre-tax basis. If incentive-based compensation is based on stock price or total shareholder return, companies may use a reasonable estimate of the effect of the restatement to determine the amount to be recovered. There is no exception for de minimis amounts.

Do companies have discretion not to recover excess compensation?

Recovery is mandatory with two limited exceptions: (1) when the direct expense of enforcing the recovery would exceed the recoverable amounts, or (2) when recovery would violate the law in a foreign issuer’s home country.

Which types of compensation are not subject to recovery?

Incentive-based compensation generally does not include (1) base salary, (2) compensation awarded based solely on the passage of time (e.g. a time-vesting restricted stock units or time-vesting stock options), (3) compensation awarded solely at the discretion of an issuer’s board of directors, or (4) compensation awarded based on the achievement of strategic or operational measures other than financial reporting measures.

What must be disclosed?

The clawback policy must be filed as an exhibit to the applicable annual reporting form, such as a proxy statement or Form 10-K. In the event of an accounting restatement that requires recovery pursuant to an issuer’s clawback policy, disclosures must be made about the recovery in the applicable annual reporting form disclosing executive compensation for the year in which the restatement occurred and also in any future year if the company is still trying to enforce the clawback.

What is the consequence of non-compliance?

A company would be subject to delisting from its national securities exchange or association if the company does not adopt a compliant clawback policy, disclose the policy in accordance with SEC rules or enforce the policy.    

When would companies have to comply?

The proposed rule is subject to a 60-day comment period that ends on September 14, 2015. If the rule is adopted, securities exchanges will have 90 days after publication of the final rule to propose listing standards. The proposed listing standards must be approved by the SEC and will become effective within 12 months after the publication of the final rule in the Federal Register. Companies would have an additional 60 days after the securities exchange listing rules become effective to adopt a clawback policy. A company will be required to claw back excess incentive-based compensation that is granted, earned or vested on or after the effective date of the final rule.   

What is the practical impact at this stage?

We anticipate that companies and practitioners will be seeking clarification on a number of aspects of the proposed rule during the comment period and responding to the more than 100 questions on which the SEC specifically requested comments.

Affected companies should inform their board of directors or the relevant committees of the proposed rule and consider any changes to their compensation committee charters that might be required. Companies with existing clawback policies should begin reviewing those policies in light of the proposed rule, consider what changes may be required, and determine whether to make any changes beyond what will be required by the final rule. Companies that do not have an existing clawback policy should begin considering policy, design, and administration issues as they develop a clawback policy.

We will track the progress of the proposed rule and will provide updates as they become available.