SEC Adopts Rules Requiring Compensation Clawback Policies
On October 26, 2022, the Securities and Exchange Commission (“SEC”) adopted long-pending rules requiring the recovery of erroneously awarded compensation as required by Congress in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). The rules will, among other things, require securities exchanges to adopt listing standards that require issuers to develop and implement a policy (usually called a “clawback policy”) providing for the recovery of erroneously awarded incentive-based compensation received by current or former executive officers. The rules require a listed issuer to file the policy as an exhibit to its annual report and to include disclosures related to its recovery policy and recovery analysis where a recovery is triggered.
The new rules implement Section 10D of the Securities Exchange Act of 1934 (the “Exchange Act”), a provision added by the Dodd-Frank Act. New Exchange Act Rule 10D-1 directs national securities exchanges (e.g., NYSE and Nasdaq) and associations to establish listing standards that require a listed issuer to: (1) adopt and comply with a written policy for recovery of erroneously awarded incentive-based compensation received by its current or former executive officers in the event it is required to prepare an accounting restatement due to its material noncompliance with any financial reporting requirement under the securities laws during the three completed fiscal years immediately preceding the date that the issuer is required to prepare an accounting restatement; and (2) disclose those compensation recovery policies in accordance with SEC rules, including providing the information in tagged data format.
When would a clawback of incentive-based compensation be triggered and how would the clawback amount be calculated?
The SEC and the new rules have not provided separate definitions of “accounting restatement” or “material noncompliance” in the context of clawback policies and issuers should look to existing guidance, literature and definitions when assessing accounting errors that would be subject to clawback of incentive-based compensation. Notably, the recovery rules encompass both “Big R” restatements (when an error is material to prior period financial statement(s) and must be corrected by restating such financial statements) and “little r” restatements (when an error is immaterial to prior period financial statement(s) but would result in a material error in the current period) as both types are caused by material misstatements that either already exist or would exist in the current period. More specifically, the issuer must recover from any current or former executive officers incentive-based compensation that was erroneously awarded during the three years preceding the date such a restatement was required. The rules would not require compensation recovery to be triggered by out-of-period adjustments to correct a prior error that is recorded in the current period when such error is: (1) immaterial to the previously issued financial statements; and (2) immaterial to the current period.
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. The rules define “incentive-based compensation” to be any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure. In other words, clawback policies must capture cash and non-cash incentive-based compensation. Erroneously awarded compensation must be calculated without respect to tax liabilities that may have been incurred or paid by the executive.
The SEC has provided the following guidance for issuers for calculating erroneously awarded compensation:
- Cash awards paid from bonus pools – the erroneously awarded compensation is 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.
- Other cash awards – the erroneously awarded compensation is 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 equity awards:
- if shares, options or stock appreciation rights are still held at the time of recovery – the erroneously awarded compensation is 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); or
- if options or stock appreciation rights 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 stock appreciation rights (or the value thereof).
Incentive-based compensation that is derived from performance measures calculated under GAAP, non-GAAP financial measures as well as other measures, metrics and ratios are captured under the rules. This would include performance metrics like total shareholder return, stock price, same store sales, return on average capital employed, revenue per user and cost per employee. The relevant metric need not be presented in an issuer’s financial statements or SEC reports for incentive-based compensation linked to it to be clawed back.
The SEC acknowledges that the means of recovery may vary from issuer to issuer and may depend on the type of compensation arrangement with the relevant executive. The new rules allow for issuers to exercise discretion in how to accomplish recovery, so long as issuers act in a manner that effectuates the purpose of the rules to prevent current or former executive officers from retaining compensation received but to which they were not entitled after the issuer’s restatement.
Who will be subject to clawback policies?
The new rules require clawback policies to cover current and former executive officers during the three year lookback under the new rules. In connection with Section 10D under the Exchange Act, Congress used the term “executive officer” without qualification, as opposed to other provisions of the Dodd-Frank Act that provide for a narrower scope of the term (such as a “named executive officer”). Notably, the rules do not require that the officers from whom compensation is being recovered have any culpability or direct involvement with the restatement or underlying issue causing the restatement. Congress’s broader intention in this context was to generally encourage issuers and their executive officers to devote more resources to the production of high-quality financial reporting, reduce the likelihood of inadvertent misreporting and reduce the financial benefits to executive officers from failures to accurately account for the issuer’s results. Furthermore, because officers with policy making functions or important roles in preparing financial statements help set a “tone at the top,” requiring an issuer’s recovery policy to apply to any executive officer may help achieve those policy aims. Many companies with existing clawback policies will need to revise those policies to comply with the new rules as current policies in place are likely focused on clawing back compensation in connection with wrongdoing or direct involvement with preparation of financial measures.
The rules will apply to all listed issuers, including smaller reporting companies, foreign private issuers and emerging growth companies. The rules contain only limited exceptions where: (1) direct expenses paid to third parties to assist in enforcing the policy would exceed the amount to be recovered and the issuer has made a reasonable attempt to recover; (2) recovery would violate home country law that existed at the time of adoption of the rule, and the issuer 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.
Disclosure requirements as a result of the new rules
The final rules require specific disclosure of the listed issuer’s policy on recovery of incentive-based compensation and information about actions taken pursuant to such recovery policy. The rules also require all listed issuers to: (1) file their written recovery policies as exhibits to their annual reports; (2) indicate by check boxes on their annual reports whether the financial statements included in the filings reflect correction of an error to previously issued financial statements and whether any of those error corrections are restatements that required a recovery analysis; and (3) disclose any actions they have taken pursuant to such recovery policies. Issuers will be required to use Inline XBRL to tag their compensation recovery disclosure.
What’s next and what should issuers do?
Stock exchanges will be required to file proposed listing standards no later than 90 days following publication of the release of the SEC rules in the Federal Register and the listing standards must be effective no later than one year following such publication. Issuers subject to such listing standards will be required to adopt a recovery policy no later than 60 days following the date on which the applicable listing standards become effective. This will afford issuers who already have clawback policies some transition time to amend such policies to adhere to the new rules that will be imposed by the stock exchanges. Since the new rules will require all issuers to have a policy, issuers that do not yet have a clawback recovery policy should consider planning with securities and corporate governance counsel to adopt a new clawback policy before the stock exchange rules are effective.
Issuers should review their existing compensation arrangements to determine if any revisions are needed to accommodate clawback policies. Issuers may wish to include fee and cost shifting provisions in employment agreements with executive officers in the event that an executive resists a meritorious recovery attempt. Notably, however, indemnification for recovered amounts is not permitted under the new rules. In addition, issuers should consider requiring their executive officers to acknowledge and agree in writing to such clawback policies. Issuers also may want to consider changing how they structure incentive-based compensation in order to facilitate the potential need to recover erroneously awarded compensation in the future. For example, stock options or grants may be easier to recover than cash compensation. Issuers’ disclosure controls and procedures should also be reviewed to make sure they are designed to analyze clawback issues in the event of a restatement. Finally, clawbacks of incentive-based compensation may have complicated tax implications for both the issuer and the executive from whom compensation is recovered. Issuers may therefore wish to consult with tax counsel in connection with any attempt to claw back incentive-based compensation.
If you would like further information regarding the new incentive-based compensation recovery rules, please contact the lawyers at Sullivan & Worcester LLP with whom you regularly consult or any of the lawyers listed above.