SEC Proposes Rules to Implement Dodd-Frank Act Executive Compensation Clawback

by Perkins Coie

The Securities and Exchange Commission (SEC) recently proposed another long-awaited set of rules to implement the clawback policy required under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).  The proposed rules would require the national securities exchanges to establish listing standards that require listed companies to adopt, implement and disclose a policy to recover excess incentive-based compensation received by current or former executive officers because of material noncompliance with financial reporting requirements that resulted in an accounting restatement.  The proposed rules would implement Section 10D of the Securities Exchange Act of 1934 (Exchange Act), which was added by Section 954 of the Dodd-Frank Act.  The public has until September 14, 2015 to comment on the proposed rules.

The proposed rules would require public companies to do the following:

  • Adopt a Clawback Policy Within 60 Days of Effectiveness of the New Exchange Rules.  Under the proposed rules, the stock exchanges must issue the new listing rules within 90 days after the SEC's final rules are published in the Federal Register, and the new listing rules must become effective within one year after publication of the SEC’s final rules.  Companies will have only 60 days to adopt a written recovery policy after the applicable exchange’s new listing rules become effective.
  • Enforce the Clawback Policy.  Each company would be required to recover the excess amount of incentive-based compensation actually paid to current and former executive officers during the three-year period preceding the year in which the company is required to restate its financial statements.  The amount the company is required to recover is the amount in excess of what would have been paid had the financial statements been correct at the time the compensation was received, irrespective of whether those executive officers (or any other person) engaged in any misconduct.
  • Disclose the Clawback Policy.  Each company would be required to file its recovery policy as an exhibit to its annual reports on Form 10-K filed on or after the effective date of the applicable stock exchange rules and provide disclosures about its policy in its annual proxy or information statement in the event the recovery policy is triggered.

This update highlights key provisions of the proposed rules and provides practical advice.

Adopting a Clawback Policy

Which Companies Must Adopt a Clawback Policy?

The proposed rules would apply to all companies with a class of securities listed on a national securities exchange, including smaller reporting companies, emerging growth companies, controlled companies, foreign private issuers and companies that have only debt or preferred securities listed.  The proposed rules would exclude security futures products, standardized options and the securities of certain registered investment companies.

Which Officers Must the Clawback Policy Cover?

The proposed rules would require the clawback policy to cover current and former “executive officers.”  An individual who served as an “executive officer” at any time during the relevant performance period for the incentive-based compensation would be subject to the recovery policy, even if not an executive officer at the time the award was granted.

  • Definition of Executive Officer.  Under the proposed rules, the definition of “executive officer” is modeled on the definition of “officer” under Section 16 of the Exchange Act (which covers a broader group than the definition of “named” executive officers for whom companies must disclose compensation under Item 402 of Regulation S-K).  In line with the Section 16 definition, the proposed rules include the principal accounting officer (or, if none, the controller), as well as the company’s president, principal financial officer, any vice president of the company in charge of a principal business unit, division or function, any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the company.  Executive officers of parent or subsidiary companies would also be considered “executive officers” to the extent they perform policy-making functions for the company.

Which Compensation Must Companies Clawback?

Under the proposed rules, companies must recover all “incentive-based compensation” defined as any compensation, including cash and equity, that is granted, earned or vested based wholly or in part upon the attainment of any “financial reporting measure.”

  • Incentive-Based Compensation.  Incentive-based compensation excludes certain types of compensation, such as discretionary bonuses; bonuses based solely on subjective criteria (e.g., demonstrated leadership), strategic measures (e.g., a merger or divestiture) and/or operational measures (e.g., completion of a project); salary (unless based on attainment of a financial reporting measure); and equity awards, including stock options and restricted stock units, that vest solely based on continued employment.
  • Financial Reporting Measures. Financial reporting measures are
    • Measures based on accounting principles used in preparing financial statements,
    • Measures derived wholly or in part from such financial information and
    • Stock price and total shareholder return.

What Time Period Must the Clawback Policy Cover?

Under the proposed rules, the recovery policy would apply to any excess incentive-based compensation received by a current or former executive officer during the three immediately completed fiscal years preceding the date on which an company is required to prepare an accounting restatement.

When Is Compensation Received?

Under the proposed rules, compensation is deemed to have been received in the fiscal period during which the financial reporting measure is attained, even if the actual payment or grant of the compensation occurs in a different period.  Awards subject to a financial performance measure that is followed by a service-based vesting requirement would similarly be deemed received when the performance measure was attained, even if the award remains subject to service-based vesting.

When Is a Company Required to Prepare an Accounting Restatement?

Under the proposed rules, the date on which a company is required to prepare an accounting restatement is the earlier of these two dates:

  • The date the issuer’s board of directors (or committee thereof) or an authorized officer concludes, or reasonably should have concluded, that the issuer's previously issued financial statements contain a material error.
  • The date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.

For example, if a company with a calendar fiscal year concludes in December 2018 that an accounting restatement is required and files the restatement in January 2019, incentive-based compensation received in 2015, 2016 and 2017 would be subject to the recovery policy.

Enforcing the Recovery Policy

Which Financial Restatements Would Trigger the Clawback Policy?

Restatements of financial statements to correct a material error in a previously issued financial statement would trigger application of the recovery policy.  There is no prescribed definition of what would constitute a material error—instead, companies would determine materiality based on facts and circumstances as well as judicial and administrative interpretations.  The SEC notes though that companies “should consider whether a series of immaterial error corrections, whether or not they resulted in filing amendments to previously filed financial statements, could be considered a material error when viewed in the aggregate.”  The proposed rules identify certain situations in which financial restatements may be required that would not trigger the recovery policy, such as a retrospective application of a change in accounting principles, retrospective reclassification due to a discontinued operation or retrospective adjustment for stock splits.

How Would Companies Determine Excess Incentive-Based Compensation?

The proposed rules define the recoverable amount of incentive-based compensation as “the amount of incentive-based compensation received by the executive officer or former executive officer that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement.”  Companies must calculate the recoverable amount on a pre-tax basis.

For equity awards, if an executive officer holds the shares, options or stock appreciation rights (SARs) at the time of recovery, the recoverable amount would be the excess number received.  If the executive officer has exercised options or SARs but still holds the underlying shares, the recoverable amount would be the excess number of shares underlying the options or SARs (less the exercise price paid).  If the executive officer has already sold the shares, the recoverable amount would be the sale proceeds received with respect to the excess shares.  For incentive-based compensation based on stock price or total shareholder return for which it may be difficult to calculate the impact of a restatement, companies may use a reasonable documented estimate of the effect of the accounting restatement on the stock price or total shareholder return to calculate the recoverable amount, which estimate would likely be prepared by a third-party provider.

How Would Companies Recover the Excess Incentive-Based Compensation?

The proposed rules do not prescribe a means for companies to recover excess incentive-based compensation—leaving it instead to each company to determine the most appropriate means.

By What Deadline Would Companies Need to Recover Excess Incentive-Based Compensation?

The proposed rules do not specify a time by which the company must recover the excess compensation. However, the SEC cautions that companies should recover excess incentive-based compensation “reasonably promptly,” as undue delay would constitute noncompliance with a company’s policy.

Would Companies Have Discretion on Whether to Seek Recovery?

Under the proposed rules, companies generally would not have discretion on whether to seek recovery.  Companies may forego recovery of erroneously paid, incentive-based compensation in these two limited circumstances:

  • If Recovery Would Be Impracticable.  The compensation committee determines that recovery would be impracticable because it would impose undue costs on the company or its shareholders, meaning that the direct costs of recovery would exceed the recoverable amounts.  To satisfy this exception, the company must first make a reasonable attempt to recover the compensation and provide documentation of that attempt to the exchange on which it is listed.
  • For Foreign Private Issuers, If Recovery Would Violate Home Country Law.  In the case of a foreign private issuer, recovery would violate home country law.  Under this exception, the company must obtain an opinion of home country counsel that recovery would result in a violation of home country law.

Companies May Not Indemnify Executive Officers for Recovered Compensation.  The proposed rules would prohibit companies from indemnifying, directly or indirectly, any current or former executive officer against the loss of erroneously paid incentive compensation. An executive officer may purchase an insurance policy to fund recovery obligations, but companies may not pay (or reimburse the premiums) for such policies.

Interaction With the Clawback Under Section 304 of the Sarbanes-Oxley Act of 2002 (SOX).  Section 304 of SOX requires a company’s chief executive officer and chief financial officer to reimburse the company for certain compensation received if the company is required to restate financial statements due to material noncompliance, as a result of misconduct, with any financial reporting requirement under the securities laws.  Under the proposed rules, any amounts recovered under Section 304 of SOX would be credited toward any amounts recoverable under the proposed rules.

Disclosing the Clawback Policy

Where Must the Clawback Policy Be Disclosed?

The proposed rules would require listed companies to file their recovery policy as an exhibit to their annual report on Form 10-K.

When Must Companies Make Clawback Policy Disclosures?

Disclosure would be triggered under the proposed rules, if at any time during the last completed fiscal year the following occurred:

  • The company completed a financial restatement requiring recovery of excess incentive-based compensation pursuant to the recovery policy, or
  • There was an outstanding balance of excess incentive-based compensation from the application of the policy to a prior restatement.

What Must Companies Disclose About the Clawback Policy?

The proposed rules would require the company to disclose with its Item 402 executive compensation disclosure in its annual report and/or proxy statement under a new S-K Item 402(w) the following information:

  • The date on which the company was required to prepare an accounting restatement, the aggregate dollar amount of excess incentive-based compensation and the aggregate dollar amount of excess incentive-based compensation that remains outstanding at the end of the last completed fiscal year;
  • The estimates used in determining excess incentive-based compensation if the financial reporting measure related to stock price or total shareholder return;
  • The names of individuals from whom the company decided not to pursue recovery as well as amounts forgone and the reason for not pursuing recovery; and
  • The names and amounts due from each person from whom excess incentive-based compensation has been outstanding for 180 days or longer.

Additionally, the proposed rules would amend the Summary Compensation Table disclosure requirements to require that recovered amounts reduce amounts previously reported in the applicable columns of the table and be identified by footnote.

Companies would be required to provide the new disclosure in interactive data format using extensible Business Reporting Language (XBRL).

What Consequences Would Companies Face for Noncompliance?

Under the proposed rules, companies will face delisting for any failure to do the following:

  • Adopt a recovery policy meeting the applicable listing standards;
  • Disclose the policy in accordance with SEC disclosure rules; and
  • Enforce the policy.

Practical Tips

What Steps Should Companies Take Now?

Although the timing for the new listing rules is uncertain, they could be effective within a year. Companies should consider taking the following actions:

  • Take a fresh look at their Section 16 officer group in light of the new significance of this designation and develop additional record keeping procedures to track when Section 16 reporting status terminates.
  • Review existing clawback policies to consider what kinds of changes will be needed to conform to the new listing standards.
  • Review the current incentive compensation programs to identify various elements potentially subject to clawback as well as potential design changes.
  • Review the compensation committee charter to identify changes required for the committee’s new responsibilities for overseeing enforcement of the clawback policy.

Additional Resources

A copy of the full text of the proposed rules is here.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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