The US Securities and Exchange Commission (SEC) adopted new rules in October 2022 that implement the compensation recovery (“clawback”) provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). While most can get behind the primary purpose of the new rules—to prevent executive officers from keeping compensation received based on misstated financials—some have taken issue with the SEC’s prescriptive approach.
A Brief History of the SEC’s Clawback Rules
The Dodd-Frank Act, among other things, mandated that the SEC adopt rules directing the securities exchanges (e.g., the New York Stock Exchange and NASDAQ) to require listed companies to “develop and implement a policy” providing for (i) how they approach incentive-based compensation based on reported financial information; and (ii) the recovery of such incentive-based compensation from any current or former executive officer, to the extent that such compensation was based on reported financial information that has to be restated.
Almost five years passed before the SEC issued proposed clawback rules, which were met with criticism. Because the proposed rules focus on clawback incentive compensation, some speculated that the proposed rules could actually result in driving up base salaries and making it so executives become less aligned with shareholders. The proposed rules effectively lay dormant until June of last year, when the SEC reopened the proposed rules for comment. The SEC ultimately adopted the final rules a few months later.
What follows is high-level summary of key provisions of the final SEC compensation clawback rules (the new rules) that directors and officers of public companies should know. For a comprehensive discussion of the new rules, see this article from Sullivan & Cromwell.
While there are some limited exceptions, nearly all listed companies will need to comply with the new rules.
Affected companies will need to adopt and comply with a written policy providing that, in the event it is required to prepare a “Big R” restatement or a “little r” restatement (explained below), the company will recover compensation from its current and former executive officers. It may recover the amount of erroneously awarded incentive-based compensation received during the three completed fiscal years immediately preceding the date the restatement is required.
A “Big R” restatement occurs when a company must prepare an accounting restatement to correct errors in previously filed financial statements that are material to those financial statements. This also requires the filing of a Form 8-K to restate those financial statements. Compare this to a “little r” restatement where the error is immaterial to the previously issued financial statements, but relevant to the current period financial statements. In those cases, the company must still correct the error, but the company may do so in the period the error was identified, thus avoiding the larger production of a “Big R” restatement.
While both restatements are methods of correcting errors, in practice, including “little r” restatements unnecessarily complicate the new rules. Specifically, since “little r” restatements are generally reserved for the correction of immaterial errors, the clawback requirement may be triggered when the error did not lead to erroneous compensation, or it may require a clawback of a de minimis amount.
The scope of individuals potentially subject to the new rules is broad. “Executive officers” include the company’s:
“Executive officers” may also include officers of the company’s parent(s) or subsidiaries if they perform similar policy-making functions for the company.
Compensation clawback will be on a “no-fault” basis. That is, there will be no regard to any misconduct or responsibility on the part of the executive officer for the misstated financial statements.
Incentive-based compensation includes any compensation that is granted, earned, or vested, based wholly or in part upon the attainment of any financial reporting measure. Potentially subject to clawback would be the company’s current or former executive officers’ incentive-based compensation (including stock options awarded as compensation) received during the three completed fiscal years preceding the date a restatement is required, based on erroneous data, in excess of what the executive officer would have been entitled to absent the reporting error. The SEC’s final rules include the following illustrative example:
“…assume a situation in which, based on the financial reporting measure as originally reported, the amount of the award was $3,000. However, the issuer exercised negative discretion to pay out only $2,000. Following the restatement, the amount of the award based on the corrected financial reporting measure is $1,800. Taking into account the issuer’s exercise of negative discretion, the amount of recoverable erroneously awarded compensation would be $200 (i.e., $2,000 – $1,800).”
Examples of compensation generally not subject to clawback are:
Companies will be required to recover erroneously awarded incentive compensation, unless (i) doing so would be impracticable—such as the direct cost of recovery exceeding the amount of recovery, and the company has made a reasonable attempt to claw back; (ii) the recovery would violate home country laws that existed at the time the rules are effective, and the company provides a legal opinion to that effect to the securities exchange; or (iii) the clawback would likely cause an otherwise tax-qualified retirement plan (e.g., 401(k) plan) to fail to meet the requirements of the Internal Revenue Code.
Further, companies will be required to recover erroneously awarded incentive compensation “reasonably promptly.” The SEC didn’t adopt a definition of “reasonably promptly” but expects companies and “their directors and officers, in the exercise of their fiduciary duty to safeguard the assets of the issuer (including the time value of any potentially recoverable compensation), will pursue the most appropriate balance of cost and speed in determining the appropriate means to seek recovery.” Boards will have discretion as to the means of recovery (e.g., setting up a deferred payment plan for executive officers to repay owed erroneous compensation).
In the SEC’s discussion of the final rules, it contemplates that although “an executive officer may be able to purchase a third-party insurance policy to fund potential recovery obligations, the indemnification provision prohibits an issuer from paying or reimbursing the executive officer for premiums for such an insurance policy.” (Note: At this time, carriers are not lining up to sell insurance policies of the type the SEC creatively contemplated.)
Also prohibited would be any such indemnification or reimbursement through modification to current compensation arrangements or other means that would equate to indemnification (e.g., granting the executive officer a new cash award, which the company could then look to for purposes of recovering outstanding amounts subject to a clawback).
Incentive-based compensation awarded to executive officers prior to the effective date of the listing rules of their securities exchange is subject to potential clawback if it’s received after the effective date.
Companies will be required to disclose their clawback policies as an exhibit in their annual report on Form 10-K, or Form 20-F for foreign private issuers. Companies will also need to disclose, among other things, how they have applied the policy, including, as applicable:
Affected companies that fail to comply with the new rules as adopted in the listing rules of their securities exchange will be subject to delisting.
The rules and amendments became effective on January 27, 2023, which started the clock for the securities exchanges to file proposed listing standards with the SEC. The New York Stock Exchange and NASDAQ filed their proposed listing standards with the SEC on February 23, 2023, and February 22, 2023, respectively. November 28, 2023, is the latest date the listing standards must become effective. Companies will have to adopt a compliant clawback policy within 60 days of that date. While it is conceivable that applicable listing standards become effective in January 2024, companies would be wise to anticipate an earlier deadline and prepare accordingly.
Directors and officers should consider the following when it comes to clawbacks:
For companies that do not have a clawback policy, consider adopting a clawback policy that makes an effort to meet the standards of the new rules. Rationale is a function of good corporate governance, which was an area of focus in a recent Department of Justice (DOJ) memo on corporate criminal enforcement that emphasizes the role clawback policies can play when it comes to deterring misbehavior.
Clawing back of executive compensation is generally a rare occurrence outside of those examples that make headlines. Cooley covered one such example in an article in early 2022. That case involved a company issuing a “Big R” restatement and had some interesting facts, which makes it a worthy read. The new rules change the game in that “little r” restatements would trigger a clawback analysis and likely the clawback of executive compensation.
These new rules will undoubtedly add more complexity to the structuring of executive officer compensation, analysis of financial reporting errors, and the board’s and/or compensation committee’s oversight role. Planning with the above considerations in mind should help avoid headaches down the road.
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