On October 26, 2022, the Securities and Exchange Commission (the “SEC”) adopted a new rule and certain amendments to existing rules (collectively, the “New Rules”) aimed at increasing accountability and transparency around the recovery by issuers of erroneously awarded executive compensation, commonly known as “clawbacks.” The New Rules mandate that national securities exchanges and associations implement standards requiring listed companies to adopt and disclose clawback policies consistent with the provisions of the New Rules. In addition, the New Rules impose new disclosure obligations related to clawback policies and actual recoveries undertaken. The full text of the New Rules can be viewed here.

Background

Federal clawback rules have been under consideration for over ten years. In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), section 954 of which added Section 10D of the Securities Exchange Act. Pursuant to Section 10D, the SEC was obligated to require securities exchanges to include adopting and disclosing a clawback policy among their company listing standards. The SEC’s initial set of proposed rules to implement this mandate were published in July 2015. Numerous comment periods followed – most recently in June 2022.

Rule 10D-1 Clawback Policy Requirements

The New Rules include the adoption of new Exchange Act Rule 10D-1 (“Rule 10D-1”), which requires that virtually all listed companies adopt and disclose clawback policies that meet strict criteria.

Under Rule 10D-1, a clawback policy must include:

Triggering Application of the Policy

The New Rules require recovery of erroneously awarded compensation: (i) when a company corrects an error in previously issued financial statements that is material to the previously issued financial statements (e., a “Big R” restatement); and (ii) when a company corrects an error that is not material to previously issued financial statements, but that would result in a material misstatement if: (a) the error was left uncorrected in the current report; or (b) the error correction was recognized in the current period (i.e., “little r” restatements). An “out-of-period adjustment” – where the error is immaterial to the previously issued financial statements and the correction of the error is also immaterial to the current period – would not trigger the recovery policy, and neither would changes to prior period financial statements that do not arise due to error corrections (e.g., retrospective revisions due to changes in accounting principles).

For either trigger, the associated “recovery period” runs from the earlier of: (i) the date the company’s board of directors, committee of the board, 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 restatement due to the material noncompliance with any financial reporting requirement; or (ii) the date a court, regulator, or other legally authorized body directs the company to prepare an accounting restatement.

Covered Employees

Current and former “executive officers” are subject to clawback of incentive-based compensation. “Executive officer” includes 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 policy-making functions for the company, whether or not involved in preparing of the company’s financial statements. Recovery of compensation received prior to becoming an executive officer is not required, although compensation received during the recovery period by former executive officers is included.

Scope of “Incentive Compensation”

“Incentive-based compensation” means any compensation granted, earned or vested based in whole or in part on the attainment of any financial reporting measure. “Financial reporting measures” are measures that are determined and presented in accordance with the accounting principles used in preparing the company’s financial statements, and any measures derived in whole or in part from such measures, as well as stock price and total shareholder return, regardless of whether such measure is actually presented in the company’s financial statements or included in an SEC filing. Incentive-based compensation does not include compensation that is based solely on continued employment for a specified period of time (g., time-vesting awards, including time-vesting stock options), unless such awards were granted or vested based in whole or in part on a financial reporting measure. Incentive-based compensation also does not include base salary, compensation awarded solely at the discretion of the board or upon the achievement of subjective, strategic or operational measures (i.e., not financial reporting measures).

Incentive-based compensation may be subject to clawback if it was received by the executive during the three-year period preceding the date on which the company was required to prepare an accounting restatement – the “recovery period”. Incentive-based compensation is considered “received” in the fiscal period during which the applicable financial reporting measure is attained, even if the payment or grant occurs after the end of such period, and even if such delayed payment or grant is a result of additional time-based vesting criteria.

Clawback Amount Calculation

The clawback amount must be equal to the amount of incentive-based compensation received by the executive in excess of what would have been received based on the restated financial statements. For incentive-based compensation based on stock price or total shareholder return, such excess amount must be based on a reasonable estimate of the effect of the restatement on the applicable measure. The clawback amount must be calculated without respect to tax liabilities that may have been incurred by the executive.

Minimal Enforcement Discretion

A company is obligated to recover erroneously awarded compensation in compliance with its policy under almost all circumstances. The New Rules identify only three narrow instances in which a company’s board may determine that recovery is impracticable: (i) if the direct costs of recovery would exceed the amount of recovery; (ii) in the case of a foreign private issuer, if recovery would violate home country law (based on an opinion of counsel); or (iii) if recovery would cause a tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code.

Recovery is evaluated without regard to whether any misconduct occurred or whether an executive bears responsibility – i.e., on a “no-fault” basis.  Executives may not be indemnified for the clawback, nor may companies insure against an executive’s potential clawback obligations.

Disclosure Requirements

The New Rules include disclosure requirements, the key elements of which are:

Clawback Policy Exhibit Requirement

Each listed company must file its clawback policy as an exhibit to its annual report on Form 10-K, 20-F, 40-F or N-CSR, as applicable.

New Item 402 Disclosures

Item 402 of Regulation S-K now requires companies to disclose any applications of their recovery policies in the prior fiscal year. In the event that the company either completed a restatement that required recovery, or there was an outstanding balance of excess incentive-based compensation relating to a prior restatement, the company must disclose, for each restatement in any Form 10-K or proxy or information statements that includes executive compensation disclosure: (i) the date of and amount of erroneously awarded compensation attributable to the accounting restatement; (ii) any estimates that were used in determining the amount; (iii) the amount that remains to be collected; and (iv) the names of, and amounts owed by, executive officers where amounts due are owed or forgone.

The New Rules also add a new instruction to the Summary Compensation Table to require that any amounts recovered, pursuant to a company’s recovery policy, reduce the amount reported in the applicable column, as well as the “total” column” for the fiscal year in which the amount recovered initially was reported, and that the recovery be identified by footnote.

New Cover Page Check Boxes on Forms 10-K, 20-F and 40-F

Companies must indicate by check boxes on their annual reports whether the financial statements included in the filings reflect a correction of an error to previously issued financial statements and whether any such corrections are restatements that required a recovery analysis.

Criticism

The New Rules were passed by a 3-to-2 vote and are not without critics. Commissioner Hester M. Peirce published an objection to the New Rules, in which she highlighted several concerns. First, she objected on the basis that the New Rules are overly broad in scope: applicable to too many employees, at virtually all listed companies without any exceptions based on filer type, and triggered by too large a set of filings. She also criticized the overly prescriptive nature of the New Rules, which in her opinion, deprive exchanges and issuers of the discretion needed to craft appropriately-contoured policies. Lastly, she argued that shareholders will ultimately suffer from the New Rules, due to the increased complexity and related cost of issuer compliance, undermining both the professed intent of the New Rules and the mandate of the SEC.  The full text of Commissioner Peirce’s objection can be viewed here.

Key Dates and Deadlines

The following table highlights certain key dates and deadlines in the New Rules:

How to Prepare

Under the New Rules, compensation awarded under existing compensation plans could be subject to clawback under a company’s policy.  In other words, existing compensation plans are not “grandfathered” out of compliance with the New Rules.  Listed companies should therefore begin to evaluate their current executive compensation plans and policies so that they are prepared to assess areas of compliance and deficiency once the required listing standards are adopted.  Once those standards are available, companies will need to either supplement their existing clawback policies or, if no such policies are in place, draft and adopt acceptable versions.

In the meantime, issuers should continue to clearly and thoroughly review and document decisions related to executive compensation, including through board oversight, market analysis and other industry-accepted best practices.

For additional information related to New Rules, please contact one of the authors listed above, or any member of our Securities Law and/or Labor & Employment Practice Groups. Click here for a complete list of our Securities Law attorneys, or click here for Labor & Employment.