On October 26, 2022, the Securities and Exchange Commission (“SEC”) adopted rules1 implementing Section 10D-1 of the Securities Exchange Act of 1934, a provision added by the Dodd-Frank Act of 2010, which will require listed companies to establish “clawback” policies providing for a company's recovery, in the event of a required accounting restatement, of incentive-based compensation received by current or former executive officers where the compensation is based on the erroneously reported financial information. The rules also will require detailed SEC disclosures related to the policies. The summary below highlights key terms of the new rules.
Companies subject to the new rules
Subject to limited exceptions, the new rules apply to all listed companies, including emerging growth companies (EGCs), smaller reporting companies (SRCs), and foreign private issuers (FPIs).
Effective date of new rules
The new rules direct national securities exchanges and associations that list securities (“exchanges”) to establish listing standards that comply with the new requirements. A listed company will be subject to delisting if it does not adopt and comply with the substantive policy and disclosure requirements. The new rules will become effective 60 days following publication of the release in the Federal Register. Once published in the Federal Register, exchanges must file their proposed listing standards within 90 days, and the listing standards must be effective within one year following the publication of the rules in the Federal Register. A listed company would then be required to adopt a clawback policy no later than 60 days after the listing standards become effective and would also need to comply with the disclosure requirements in its proxy and information statements, as well as its annual report, after it adopts a policy. As a practical matter, it is anticipated that companies will be subject to the new listing standards in late 2023 or early 2024.
Incentive-based compensation subject to recovery
As noted above, the new listing standards will require companies to maintain a written policy providing for the recovery of erroneously awarded incentive-based compensation received by current or former executive officers in the event of a required accounting restatement. “Incentive-based compensation” is to be determined in a principles-based manner and is defined as any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure. “Financial reporting measures” are measures that are determined and presented in accordance with applicable accounting principles used in preparing the company’s financial statements, any measures derived wholly or in part from such financial information (such as non-GAAP financial measures), as well as stock price and total shareholder return (TSR). These measures are not required to be included in an SEC filing and may be presented outside the financial statements, such as in MD&A or the stock performance graph. Examples include but are not limited to: revenues, net income, operating income, segment profitability, financial ratios, net assets/net asset value per share, EBITDA, funds from operations, liquidity measures, return measures, earnings measures, same store sales and measures relative to a peer group.
Examples of incentive-based compensation include but are not limited to: equity awards (including options, restricted stock, restricted stock units, performance share units and stock appreciation rights) and non-equity incentive plan awards, bonuses and/or cash awards that are earned, at least in part, based on meeting performance measured goals. Incentive-based compensation does not include such items as salaries, certain discretionary or subjective bonuses (such as bonuses based on leadership or strategic or operational measures, e.g., consummation of a merger, new store openings, project completions, etc.) and equity awards based solely on continued service and/or attaining nonfinancial reporting measures.
Executive officers subject to clawback
The new rules apply to any current or former "executive officer". “Executive officer” includes a company’s president; principal financial officer, principal accounting officer (or 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 policy-making function; or any other person who performs similar policy-making functions at the company, which could include executive officers at a parent or subsidiary. The rules will only require recovery of incentive-based compensation received by a person (1) after beginning service as an executive officer and (2) if that person served as an executive officer at any time during the recovery period.
Accounting restatements covered and lookback period
In a change from the original 2015 rule proposal, the final rules broaden coverage to provide that the recovery provisions apply to both (1) restatements that correct errors that are material to previously issued financial statements (“Big R” restatements, as originally proposed) and (2) restatements that correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period (“little r” restatements). Changes to financial statements that should not trigger recovery include, for instance, changes to financial statements due to a retrospective application of a change in accounting principles, retroactive revisions for stock splits and other changes in capital structure, retrospective application of a change in reporting entity due to a reorganization and similar changes.
The new rules require that the policy apply to compensation received during the three-year period preceding the date the company is required to prepare the accounting restatement. The date the company is required to prepare an accounting restatement is the earlier to occur of (1) the date the company's board, board committee or authorized officer(s) concludes, or reasonably should have concluded, that the company's previously issued financial statements contain a material error (which should align with any Item 4.02(a) Form 8-K reporting requirement) or (2) the date a court, regulator or other similar body directs the company to restate the financial statements. The three-year lookback generally will cover the three completed fiscal years immediately preceding the date the company is required to prepare the restatement.
Recoverable amount
The recoverable amount is 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, as calculated on a pre-tax basis. Importantly, executive officer fault or misconduct is not required. By way of example, the SEC stated that, (1) for cash awards, the recoverable amount is the difference between the amount of the cash award that was received and the amount that should have been received applying the restated financial measure and (2) for equity awards, if the shares are still held at the time of recovery, the recoverable amount is the number of securities received in excess of what should have been received applying the restated financial measure. If application of the new rules would result in duplicative recovery (such as under the clawback provisions of Section 304 of the Sarbanes-Oxley Act of 20022 or other recovery obligations), the company can credit any amount already reimbursed by the executive officer.
Narrow exceptions to clawback
The new rules require a company to recover erroneously awarded compensation except where it is impracticable to do so in three limited scenarios: (1) direct expenses paid to third parties to assist in enforcing the policy would exceed the amount to be recovered and the company has made a reasonable attempt to recover; (2) recovery would violate home country laws that existed at the time of adoption of the rule and the company provides an opinion of counsel to that effect to the exchange; or (3) recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code. Furthermore, the new rules give boards of directors limited discretion to determine the appropriate means and timing of recovery.
New SEC disclosure requirements
In addition to the substantive policy requirements, companies must also comply with new SEC disclosure requirements. Specifically, a company must (1) disclose its clawback policy in accordance with the SEC rules; (2) file the policy as an exhibit to its annual report; (3) provide detailed proxy statement disclosure regarding application of the policy, including, for instance, the date of any triggering restatement, the aggregate dollar amount of the erroneously awarded compensation and how the amount was calculated, the aggregate amount outstanding at fiscal year-end and any reliance on the recovery exceptions (as well as disclosure of such recovered amounts in the Summary Compensation Table); and (4) indicate by check boxes on the annual report whether the company's financial statements included in the filing reflect a correction of an error to previously issued financial statements and whether any such corrections are restatements that required analysis of whether recovery was required and disclose any actions the company has taken under the policy. Companies must use Inline XBRL to tag their compensation recovery disclosure.
Indemnification and insurance
The new rules also prohibit companies from indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation or from paying or reimbursing an executive officer for insurance premiums under an insurance policy designed to fund potential recovery obligations.
Practical Considerations and Next Steps
Although companies will not be required to change or implement policies until the exchange listing standards are finalized, given the complexities of the new rules and related disclosure requirements, companies should begin assessing the effect of the new rules on not only their clawback policies but also their compensation practices in general. For instance, companies may consider whether their compensation programs should be modified, such as an increased focus on time-based metrics or performance metrics that would not trigger application of the new rules, discretionary bonuses or increased salaries – although investors and proxy advisory firms can be expected to disfavor compensation that is not considered performance-based. In addition, since the policies will be filed with the SEC (and related disclosures regarding application will be required), companies can expect investors to take a more critical look at the content and application of policies than in the past. Finally, companies should evaluate whether the new rules will impact other governance or risk management policies.
1 See Listing Standards for Recovery of Erroneously Awarded Compensation, available at Final Rule: Listing Standards for Recovery of Erroneously Awarded Compensation (sec.gov) (October 26, 2022) (the “Release”).
2 Section 304 of the Sarbanes-Oxley Act requires the chief executive officer and chief financial officer to return to the company incentive-based and equity-based compensation where the company must restate its financial statements due to material noncompliance with applicable financial reporting rules as a result of misconduct.
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