On October 26, 2022, the U.S. Securities and Exchange Commission (“SEC”) adopted the long-awaited incentive compensation recovery (“clawback”) and disclosure rule and related rule amendments required by Section 954 (of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”). Under the Dodd-Frank mandate, the SEC was required to adopt rules directing national securities exchanges and national securities associations to adopt listing standards which would require both (i) disclosure of a company’s policy with respect to recovery of erroneously awarded incentive-based compensation and (ii) recovery of any excess incentive compensation received by current or former executive officers during the three-year period prior to the date the issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws. The SEC first proposed clawback rules in July 2015 and reopened the proposal for comment in October 2021 and then again in June 2022.
As adopted, new Rule 10D-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), directs national securities exchanges and associations to establish listing standards which will, among other things: (i) apply to all listed companies, with very limited exceptions; (ii) apply to all of the issuer’s executive officers, as defined in the rule, and without regard to fault; (iii) apply when the listed company is required to present an accounting restatement due to material noncompliance of the company with any financial reporting requirement under the federal securities laws; (iv) define incentive-based compensation to include any compensation (cash or equity) granted, earned, or vested based in whole or in part on the attainment of financial reporting measures, including, among others, stock price, and total shareholder return; (v) narrowly limit a board’s discretion over whether to pursue recovery of excess incentive compensation; and (vi) prohibit a company from indemnifying its executive officers or paying insurance premiums for policies that would cover obligations arising under the rule. Mandated recovery policies will apply broadly in terms of the scope of incentive compensation subject to potential recovery and individuals covered.
Moreover, in a significant broadening of the originally proposed reach of the recovery provisions, Rule 10D-1’s provisions requiring incentive compensation recovery will encompass both revisions (or “little r” restatements) and reissuances (or “big-R” restatements) of previously issued financial statements. In implementing this provision of Dodd-Frank, the SEC posited that the broad application of the final rule comports with Congressional intent, as well as the SEC’s view that robust recovery policies will help to ensure that executive officers at exchange-listed issuers do not retain to the detriment of shareholders the benefits of erroneously awarded incentive-based compensation. A company that does not adopt and comply with a compensation recovery policy that meets the requirements of the applicable exchange listing standards will be subject to delisting.
Which issuers will be required to comply with the new listing requirements?
The new compensation recovery standards to be established by exchanges that list securities, including NYSE and Nasdaq, will apply to all issuers with listed securities, excluding only clearing agencies of certain security futures products and standardized options, securities issued by unit investment trusts, and certain registered investment companies that have not provided incentive-based compensation to any current or former executive officer in the last three fiscal years.
All other listed issuers, including, for example, emerging growth companies, smaller reporting companies, foreign private issuers, controlled companies, and issuers of listed debt or preferred securities, will be required to adopt, comply with, and disclose a written compensation recovery policy as required by the listing exchange.
A company that fails to adopt and comply with its compensation recovery policy will be subject to delisting.
What individuals are covered?
Current or former executive officers of the company will be subject to clawback of incentive-based compensation received during a three-year look-back period (“recovery period”) (i) if that compensation was received after that individual began service as an executive officer and (ii) if that individual served as an executive officer at any time during the recovery period.
Executive officer is defined under Rule 10D-1 to include the company’s president; principal financial officer; principal accounting officer; any vice-president in charge of a principal business unit, division, or function; and any other person who performs significant policy-making functions for the company. Companies will be required to recover all erroneously-awarded incentive-based compensation received by an executive officer, regardless of whether the officer who received the compensation was responsible for accounting errors that lead to a restatement or involved in the preparation of the inaccurate financial statements.
Incentive-based compensation derived from an award authorized before the individual becomes an executive officer but received after beginning his or her service as an executive officer will be subject to clawback if that individual served as an executive officer at any time during the recovery period. However, recovery of incentive-based compensation received while an individual was serving in a non-executive capacity prior to becoming an executive officer will not be required.
The final rule is thus broader in scope than Section 304 of the Sarbanes Oxley Act of 2002 (“Sarbanes Oxley”). Sarbanes-Oxley applies only to a company’s chief executive officer and chief financial officer and is limited to incentive-based or equity-based compensation and any profits realized from the sale of securities of the issuer received during the 12-month period after the company filed financial statements that were later restated because of the company’s misconduct.
What restatements will trigger a clawback?
The final rule requires recovery of erroneously awarded incentive compensation when the company is required to prepare either:
- an accounting restatement that corrects errors in previously issued financial statements that are material to the previously issued financial statements (commonly referred to as a “Big R” restatement), requiring the company to file an Item 4.02 Form 8-K and to amend its previous filings to restate the previously issued financial statements, or
- an accounting restatement to correct errors that are not material to previously issued financial statements, but would result in a material misstatement if:
- the errors were left uncorrected in the current report or
- the error correction was recognized in the current period (commonly referred to as a “little r” restatement).
Recovery will not be required, however, for an “out-of-period adjustment” in which correction of an error is recorded in the current period financial statements when that error is immaterial to the previously issued financial statements and the correction of the error is also immaterial to the current period.
Recoupment also would not be triggered by changes to prior period financial statements that do not represent error corrections, including, for example, retrospective application of a change in accounting principles, retrospective revisions to reportable segment information due to a change in the company’s structure, retrospective reclassifications due to discontinued operations and retrospective revisions for stock splits, reverse stock splits, stock dividends, or other changes in a company’s capital structure.
How is incentive-based compensation defined?
The final rules define “incentive-based compensation” as any compensation that is granted, earned or vested based wholly or in part on the attainment of any financial reporting measure and includes both cash- and equity-based incentive awards. By adopting a principles-based definition, the SEC noted that it intends to capture within the definition new forms of compensation that are developed and new measures of performance upon which executive officer compensation may be based. The adopting release for the final rules provides the following non-exclusive examples of compensation that are and are not “incentive-based compensation” for purposes of these rules.
Compensation that is “incentive-based compensation”:
- 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
- Other cash awards based on satisfaction of a financial reporting measure performance goal
- Restricted stock, restricted stock units, performance share units, stock options, and stock appreciation rights (“SARs”) 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
Compensation that is not “incentive-based compensation”:
- Salaries (except to the extent a salary increase is linked in whole or part to the attainment of a financial reporting measure performance goal)
- 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
- 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
- Equity awards for which the grant is not contingent upon achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more nonfinancial reporting measures (i.e., awards which vest solely on time-based or service-based conditions)
“Financial reporting measures” are defined to be measures that are determined and presented in accordance with the accounting principles used in preparing the company’s financial statements and any measures derived wholly or in part from such measures, as well as stock price and total shareholder return (“TSR”). This expansive definition captures non-GAAP financial measures and other measures, metrics, and ratios that are not non-GAAP measures, such as same store sales.
Financial reporting measures need not be included in a company’s SEC filings, and may be presented outside the financial statements, such as in Management’s Discussion and Analysis of Financial Conditions and Results of Operations or the company’s stock performance graph.
The SEC provided in the adopting release a non-exclusive set of examples of financial reporting measures including, among others:
- Operating income
- Earnings before interest, taxes, depreciation, and amortization
- Liquidity measures (e.g., working capital, operating cash flow)
- Return measures (e.g., return on invested capital, return on assets)
- Earnings measures (e.g., earnings per share)
The SEC highlighted that including stock price and TSR in the definition of financial reporting measures that may be subject to recoupment is consistent with their understanding of congressional intent. Although not accounting-based, the SEC noted that measures such as stock price and TSR are affected by accounting-related information and subject to disclosure requirements.
Additionally, the SEC noted that not including such measures could encourage companies to alter their executive compensation arrangements to avoid application of the mandatory recovery policy. Acknowledging the challenges and potential costs, subjectivity, and uncertainties associated with calculating amounts of recoverable erroneously awarded compensation with respect to incentive awards linked to stock price and TSR, the final rules allow companies to use reasonable estimates to assess the effect of the restatement on these performance measures to determine the amount to be recovered.
When is incentive-based compensation considered “received” and what is the required time period for recovery?
Incentive-based compensation will be subject to the company’s recovery policy if it is received while the company has a class of listed securities. Similar to reporting requirements under Item 402 of Regulation S-K for Summary Compensation Table purposes, incentive-based compensation will be deemed “received” for the purpose of the final rules in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if the payment or grant occurs in a subsequent fiscal period. Incentive-based compensation will be deemed to be received by the executive officer upon attainment of the applicable financial reporting measure, even if payment is subject to additional conditions, such as calculating the amount earned or obtaining the board of directors’ approval of payment.
The time period covered for the recovery policy will be the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement.
When does the recovery period begin?
Under the final rules, the date on which the recovery period begins, i.e., the date on which a company is required to prepare an accounting restatement, is the earliest of:
- the date the company’s board of directors, a committee of the board of directors, or the officer or officers of the company authorized to take such action, concludes, or reasonably should have concluded, that the company is required to prepare an accounting statement due to material noncompliance with any financial reporting requirement under the securities laws; or
- the date a court, regulator, or other legally authorized body directs the company to prepare an accounting restatement. In the latter case, the date of the initial court order or agency action would be the trigger date for the recovery period, but that the determination and application of the recovery policy would occur only after the order is final and non-appealable.
The rules also clarify that the company’s obligation to recover erroneously awarded compensation is not dependent on if or when restated financial statements are actually filed with the SEC.
How is the amount of “erroneously awarded compensation” subject to recovery calculated?
As adopted, the final rules define the recoverable amount 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 statement.” The recoverable amount is required to be calculated on a pre-tax basis.
Following an accounting restatement, the company will first need to recalculate each applicable financial reporting measure and the amount of incentive-based compensation based on that measure. The company would next need to determine whether, based on that financial reporting measure as originally calculated in reliance on the original financial statements, taking into account any discretion exercised by the compensation committee to reduce the amount originally received, the executive officer received a greater amount of incentive-based compensation than would have been received applying the recalculated financial reporting measure.
In the case of incentive-based compensation based only in part on the achievement of a financial reporting measure performance goal, the company would first need to determine the portion of the original incentive-based compensation that was based on or derived from the financial reporting measure that was restated. The company would then need to recalculate the affected portion based on the financial reporting measure as restated, and recover the difference between the greater amount based on the original financial statements and the lesser amount that would have been received based on the restatement.
In the case of incentive-based compensation based on TSR or stock price, where the amount of erroneously awarded compensation cannot be mathematically recalculated directly from the information in a restatement, the recoverable amount is required to be based on a reasonable estimate of the effect of the restatement on the applicable measure. The company may choose an appropriate method for estimation based on its specific facts and circumstances. If a company uses an estimate in the calculation of recoverable amounts, the company will be required to maintain documentation of the determination of that reasonable estimate and provide it to the company’s listing exchange.
Companies are free to adopt more extensive recovery policies, so long as those policies at a minimum satisfy the requirements of the rules.
Citing the facts and circumstances nature of a company’s determinations of recoverable amounts and the risk of inadvertently establishing de facto standards for what is intended to be a principles-based application of the rules, the SEC provided only the following limited guidance on the calculation of recoverable amounts:
- For cash awards, the erroneously awarded compensation is equal to the difference between the amount of the cash award (whether payable as a lump sum or over time) that was received and the amount that should have been received applying the restated financial reporting measure.
- For cash awards paid from bonus pools, the erroneously awarded compensation is equal to the pro rata portion of any deficiency that results from the aggregate bonus pool that is reduced based on applying the restated financial reporting measure.
- For equity awards, if the shares, options, or SARs are still held at the time of recovery, the erroneously awarded compensation is equal to the number of such securities received in excess of the number that should have been received applying the restated financial reporting measure (or the value of that excess number). If the options or SARs have been exercised, but the underlying shares have not been sold, the erroneously awarded compensation is the number of shares underlying the excess options or SARs (or the value thereof).
Will the board have discretion whether or how to seek recovery of excess compensation?
The company’s board of directors may not exercise discretion over whether to recover any portion of erroneously awarded incentive-based compensation except under three narrowly-crafted exceptions where recovery would be impracticable. The final rules provide exceptions in the following limited circumstances:
- where the direct cost of enforcing recovery would exceed the amount to be recovered and
- for foreign private issuers, where the recovery would violate home country law and certain additional conditions are met.
Additionally, an exception is provided for recovery from tax-qualified retirement plans meeting the requirements of Section 401(a) of the Internal Revenue Code.
Notably, there is no exception available on the basis of inconsistency between the final rules and the terms of existing compensation contracts. Any determination that recovery would be impracticable must be made by the company’s compensation committee or, if no such committee exists, a majority of the independent directors serving on the board. As with all determinations under Rule 10D-1, a company’s determination not to pursue recovery based on any of these exceptions will be subject to review by the company’s listing exchange.
Before concluding that it would be impracticable to recover any amount of erroneously awarded compensation based on costs, a company will first be required to make a reasonable attempt to recover that excess compensation. Additionally, the company will need to document its recovery efforts, provide that documentation to its listing exchange and disclose why it determined not to pursue recovery. In making that determination, only direct costs paid to a third party to assist in enforcing recovery, such as reasonable legal expenses and consulting fees, may be considered.
Similarly, before determining that it would be impracticable to recover because doing so would violate home country law, the issuer would need to obtain an opinion of home country counsel, in a form acceptable to the applicable exchange or association, that recovery would result in such a violation. Any such home country law must have been adopted prior to the date of publication of the final rules in the Federal Register.
Under the final rules, the company’s board will have discretion, however, over how to recover erroneously awarded compensation, so long as the recovery is completed reasonably promptly. Recognizing that what is reasonable may depend on the additional cost incident to various recovery efforts, the SEC declined to define “reasonably promptly” but indicated in the adopting release that it expects that companies will balance cost and speed considerations when determining the most appropriate means of recovery. The choice of recovery method may also take into account the particular facts and circumstances of each executive officer that owes a recoverable amount (for example, recovery may reasonably include a deferred payment plan in appropriate circumstances where earlier repayment would create unreasonable economic hardship for the affected executive officer).
Listing exchanges may adopt more prescriptive approaches to the timing and method of recovery under their rules in compliance with applicable provisions of the Exchange Act, including after they have observed listed issuer performance and assessed the need for further guidelines to ensure prompt and effective recovery.
Can companies mitigate the risk to their officers?
Rule 10D-1 does not allow a company to indemnify its officers against the recovery of erroneously awarded compensation. In addition, while any executive officer may purchase third-party insurance to cover the amount of any potential recovery obligations, the issuer may not directly or indirectly pay the premiums on any such insurance policy.
What are the company’s disclosure obligations?
Each listed company will be required to disclose information about its recovery policy and file the policy as an exhibit to its annual report under the Exchange Act. Additionally, certain required disclosures relating to an issuer’s compensation recovery policy and recovery will need to be tagged in inline XBRL. Additional check box disclosures will also be added on the cover of the Forms 10-K, 20-F, and 40-F.
New Item 402(w) of Regulation S-K will require a listed company to disclose certain information in proxy or information statements that call for Item 402 disclosure and in its Form 10-K (or Form 20-F or 40-F, as applicable) if (1) at any time during or after its last completed fiscal year the company was required to prepare a restatement that required recovery of erroneously awarded compensation pursuant to the company’s compensation recovery policy, or (2) there was an outstanding balance as of the end of the last completed fiscal year of erroneously awarded compensation to be recovered from the application of that policy to a prior restatement. Required disclosures will include:
- The date on which the company was required to prepare an accounting restatement and the aggregate dollar amount of erroneously awarded compensation attributable to that restatement (including an analysis of how the recoverable amount was calculated) or, if the amount has not yet been determined, an explanation of the reasons and disclosure of the amount and related disclosures in the next filing that is subject to Item 402 of Regulation S-K;
- The aggregate dollar amount of erroneously awarded compensation that remains outstanding at the end of its last completed fiscal year;
- If the relevant financial reporting measure related to a stock price or TSR metric, the estimates used to determine the amount of erroneously awarded compensation attributable to the restatement and an explanation of the methodology used for those estimates;
- If the company has determined that recovery would be impracticable, for each current and former named executive officer and for all other current and former executive officers as a group, the amount of recovery forgone and a brief description of the reason the company decided in each case not to pursue recovery, as well as additional information and context regarding the impracticability exception on which the company is relying; and
- For each current and former named executive officer, the amount of erroneously awarded compensation still owed that had been outstanding for 180 days or longer since the date the company determined the amount owed.
Additionally, if at any time during its last completed fiscal year a company prepared an accounting restatement and concluded that recovery of erroneously awarded compensation was not required pursuant to the company’s compensation recovery policy, new Item 402(w) will require the company to briefly explain why application of its recovery policy resulted in that conclusion.
Item 402(w) disclosures will not be deemed to be incorporated by reference into any filing under the Securities Act, except to the extent a company specifically incorporates it by reference.
The disclosures required by Item 402(w) would supplement, rather than replace, these existing Regulation S-K obligations. Item 402(b) of Regulation S-K currently requires that a company disclose, in its Compensation Discussion and Analysis, policies and decisions regarding the adjustment or recovery of awards or payments to named executive officers (defined in Section 402(a)(3) of Regulation S-K to include the company’s principal executive officer, principal financial officer, the three other most highly compensated executive officers, and up to two additional individuals who would have been among the three most highly compensated but for not serving as executive officers at the end of that year) if the company’s performance measures are restated or otherwise adjusted in a manner that would reduce the size of an award or payment. Under the final rules, amounts recovered from named executive officers will also be required to be reflected in the Summary Compensation Table.
What should companies do now to prepare?
The new clawback rules will become effective 60 days following publication of the adopting release in the Federal Register. Exchanges will then be required to file proposed listing standards no later than 90 days following publication of the release in the Federal Register, and the listing standards must be effective no later than one year following such publication. Listed companies will be required to adopt a recovery policy no later than 60 days following the date on which the applicable listing standards become effective and must begin to comply with the new disclosure requirements in proxy and information statements and the issuer’s annual report filed on or after the date the issuer adopts its recovery policy.
Given this timeline, it is likely that companies will have until at least late in the fourth quarter of 2023 to adopt exchange-compliant policies. However, incentive-based compensation received after the effective date of the listing standards, even if prior to the company’s adoption of a policy, will be subject to recoupment in accordance with Rule 10D-1.
Although specific requirements may change based on the form of the final listing standards to be adopted by the exchanges, the general parameters of the new requirements are sufficiently clear for listed companies to begin now to identify and prepare a plan to address the various items that may be impacted by the final rules and listing standards, including, for example:
- Review the company’s existing clawback policy and consider revisions that may be needed to address the new requirements;
- If the company does not currently have a written clawback policy, consider adopting a policy structured to meet the requirements of Rule 10D-1;
- Review any compensation or indemnification agreements with the company’s executive officers to assess whether modifications may be needed;
- Review performance metrics used in the company’s incentive compensation plans and arrangements in light of Rule 10D-1’s requirements to identify potential impacts;
- Consider whether changes to current incentive compensation performance metrics or other elements of the company’s executive compensation practices may be desirable in anticipation of the new requirements; and
- Evaluate whether and what changes to controls and internal processes may be needed to address the requirements of the new rules.
For more information on the content of this alert, please contact your Nixon Peabody attorney.