On July 1, 2015, the Securities and Exchange Commission (SEC) issued proposed rules that would require national securities exchanges and associations to establish listing standards requiring companies to adopt policies that require executive officers to pay back incentive-based compensation that was awarded erroneously. The proposed new Rule 10D-1 would also require disclosure of listed companies’ recovery policies and of their actions under those policies. These proposed rules are mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and are the last of the compensation-related rules required by the Dodd-Frank Act.

Highlights of Proposed Rules

• A “clawback” under the proposed rules would be mandatory in the event that a company is required to restate a financial statement to correct material noncompliance with a financial reporting requirement.
• A “clawback policy” would require the company to recover excess incentive-based compensation received by its current and former executive officers during the three-fiscal-year period prior to the date for which the company is required to prepare the restatement.
• The proposed rule would apply to all current and former executive officers who earned incentive compensation during a three-year look-back period.
• Recovery of the excess incentive-based compensation must be enforced on a no-fault basis, i.e., a company, in enforcing the policy, may not consider the responsibility or misconduct of the executive officer.
• All listed companies would be required to implement a clawback policy, including smaller reporting companies.

Definition of Incentive Compensation

The proposed 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. “Financial reporting measures” include measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measures derived wholly or in part from such financial information, and stock price and total shareholder return.

Incentive-based compensation does not include base annual salary, compensation awarded solely on service, such as time-based vesting awards; or compensation awarded on a discretionary basis or upon attainment of strategic objectives, such as attainment of a certain market share.

Definition of Executive Officer

For purposes of the proposed rules, the definition of “executive officer” includes a 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 at the company. This definition mirrors the definition of “executive officer” under Section 16 of the Securities Exchange Act of 1934.

Trigger Events

Under the proposed rules, a clawback under a listed company’s recovery policy would be triggered in the event that the company was required to prepare a restatement to correct a material error in its previously issued financial statements. Furthermore, 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.

Several types of changes in or restatements of an issuer’s financial statements do not represent error corrections under accounting standards and accordingly would not trigger the recovery policy. Examples of changes that would not trigger the recovery policy include:

• retrospective application of a change in accounting principle;
• retrospective reclassification due to a discontinued operation;
• retrospective revision to reportable segment information due to a change in the structure of an issuer’s internal organization;
• retrospective application of a change in reporting entity, such as from a reorganization of entities under common control;
• retrospective adjustment to provisional amounts in connection with a prior business combination; and
• retrospective revision for stock splits.

Determination of Amount to Be Recovered

Upon a trigger event, a listed company would be required to recover the amount of incentive-based compensation received by an executive officer that exceeds the amount that the executive officer would have received if the incentive-based compensation had been determined based on the accounting restatement (i.e., not the whole amount of incentive-based compensation granted, earned, or vested). The amount of excess compensation to be recovered is calculated on a pre-tax basis. With respect to incentive-based compensation based on stock price or total shareholder return, the excess amount is calculated based on the issuer’s reasonable estimate of the effect of the restatement on the issuer’s stock price. Issuers must maintain appropriate documentation of the process used in determining such estimate and would be required to disclose the estimates used.

In the event that incentive-based compensation is paid out of a bonus pool, the bonus pool would need to be redetermined based on the financial restatement, and the executive officer’s pro-rata portion of the excess bonus pool paid would be the amount recoverable under the proposed rules.

Exception to Clawback

The proposed rule would require a public company to clawback excess incentive compensation from each covered executive upon a trigger event, provided that companies can determine not to clawback the excess compensation if the direct expense of enforcing the clawback would exceed the amount to be recovered, or, in the case of a foreign private issuer, it violates home country laws.

Three Year Look-Back

A clawback policy must require recovery of excess incentive-based compensation received during the three fiscal years prior to the year in which an accounting restatement is required. Incentive-based compensation is deemed to have been received during the fiscal year in which the performance measure that forms the basis of the award is attained, not when the award is granted, vested, or paid. The date on which a company is required to prepare a financial restatement under the proposed rules is the earlier of

• the date that the company’s board of directors or a similarly authorized decision-making body concludes, or reasonably should have concluded, that the company’s previously issued financial statements contain a material error; or
• the date on which a court, regulator, or other similarly authorized body causes the issuer to restate its financial information.

Covered Entities

Every company listed on a national securities exchange or association would be subject to the proposed rules, including smaller reporting companies, foreign private issuers, and, in certain cases, management investment companies.

Disclosure Requirements

Under the proposed rule, listed companies would be required to file their clawback policies as an exhibit to their Annual Reports on Form 10-K. Furthermore, if at any time during a listed issuer’s last completed fiscal year, either (i) a restatement that required recovery of excess incentive-based compensation pursuant to the issuer’s compensation clawback policy was completed, or (ii) there was an outstanding balance of excess incentive-based compensation from the application of that policy to a prior restatement, the listed issuer would be required to disclose the following:

• for each restatement, the date on which the issuer was required to prepare an accounting restatement, the aggregate dollar amount of excess incentive-based compensation attributable to the accounting restatement, and the aggregate dollar amount that remains outstanding at the end of its last completed fiscal year;
• the estimates used to determine the excess incentive-based compensation attributable to such accounting restatement, if the incentive payment related to a stock-price or total-shareholder-return metric;
• the name of, and amount due from, each person from whom, at the end of the issuer’s last completed fiscal year, excess incentive-based compensation had been outstanding for at least 180 days since the date that the issuer determined the amount the person owed; and
• the name of each person subject to recovery of excess incentive-based compensation attributable to an accounting restatement from whom the issuer decided during the last completed fiscal year not to pursue recovery (if any), the recovery amount forgone for each such person, and a brief description of the reason the issuer decided in each case not to pursue recovery.

Under the proposed rules, any amounts recovered from a named executive officer pursuant to a listed issuer’s clawback policy would reduce the amount of compensation reported in the applicable columns of the issuer’s Summary Compensation Table for the fiscal year in which such amounts were initially reported, and these amounts must be identified in a footnote to the table.

 Overlap with Section 304 of the Sarbanes-Oxley Act of 2002

Section 304 of the Sarbanes-Oxley Act of 2002 provides for a clawback of certain compensation of the chief executive officer and chief financial officer of an issuer if an accounting restatement must be prepared due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement. In cases where recovery from a chief executive officer or chief financial officer would result from both the SEC’s new proposed rules and Section 304, the proposed rules provide for a credit for any amounts recovered through compliance with Section 304.

No Indemnification for Officers

Issuers are not permitted to indemnify officers against any amounts recovered under a clawback policy or to pay premiums on an insurance policy covering an officer’s potential clawback obligations.

Comment Period and Effective Dates

Comments are due on the proposed rule 60 days after publication in the Federal Register. The SEC’s rule proposal also requires the exchanges to file their proposed listing rules no later than 90 days following the publication of the final adopted rules in the Federal Register. The listing rules are to become effective no later than one year following the publication date of the final adopted rules. Each listed company would be required to adopt its recovery policy no later than 60 days following the date on which the listing exchange’s listing rule becomes effective.

For any questions or greater clarity on the proposed rules, please contact the Hinckley Allen attorney with whom you regularly work with.