The Securities and Exchange Commission (SEC) approved final rules (Rule 10D-1) implementing Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act and issued a related fact sheet. The new rules direct national securities exchanges and associations to establish listing standards requiring registrants to implement “clawback” policies to recoup erroneously awarded incentive-based compensation following a material restatement of financial disclosures. The final rules also expand annual reporting and proxy disclosures to allow shareholders to have quick access to the clawback policies, understand if they have been invoked and review how they have affected executive pay.
The final rules largely follow the proposed rules, with updates and clarifications to address some of the questions surrounding how these “no-fault” Dodd-Frank clawback policies should be implemented.1 Companies can use reasonable estimates for stock-based compensation to determine how much is to be clawed back and will have the option not to pursue recovering such compensation if the direct expense of doing so would exceed the amount to be recovered.
The following Q&As are intended to help companies as they start to consider how to implement these policies.
The final clawback rules apply to all listed companies, including emerging growth companies, smaller reporting companies, foreign private issuers and controlled companies. The final rules also adopt the limited exemptions included in the proposed rules for certain security futures products, registered investment companies that have not awarded incentive compensation and registered unit investment trusts.
It is likely that companies will need to have a compliant clawback policy in place before the end of 2023. The timeline for implementation of the Rule 10D-1 requirements is as follows (note, there is a difference between the effective date of the final regulations and the effective date of the listing standards):
The mandated clawback policy must apply to any incentive-based compensation that is received by current or former executive officers on or after the effective date of the applicable listing standard. As a result, grants made before the listing exchange rule’s effective date will be subject to the clawback policy if they are dependent on a financial measure attained after the effective date.
The clawback requirement covers only accounting restatements due to the company’s material noncompliance with any financial reporting requirement under the securities laws. According to the SEC, the final rules do not include a definition of “material noncompliance” because it can be found in existing accounting standards and related guidance.
The SEC’s final rule expanded on the proposed rules outlining the types of restatements that are subject to the clawback requirement. Under the final rule, the clawback requirement may apply as a result of an accounting restatement that corrects two types of errors:
Companies, in consultation with their accountants and attorneys, will be required to determine when the materiality threshold has been met and whether a clawback should be invoked.
The new rules require companies to adopt a compliant clawback policy and to disclose certain aspects of such policies and their application in annual reports and proxy statements. Compliance with the disclosure requirements is required in the first annual report, information statement or proxy that must be filed after the effective date of the new listing standards. For calendar-year companies, this could mean the 2023 annual report and the 2024 proxy.
The disclosure regime is as follows:
The rules cover both current and former executive officers, with “officers” defined in regulations issued under the Securities Exchange Act. This includes the company’s:
Note that this is often a broader group than covered by a company’s existing clawback policies, which tend to focus on officers listed in the proxy.
Individuals in these roles are only considered an executive officer subject to recovery if they serve as an executive officer at any time during the recovery period (described below), and the recovery is only required for incentive compensation received while the individual served as an executive officer.
The statute provides that, regardless of when the restatement takes place, only incentive compensation received during the three-year period before the restatement is “required” is subject to being clawed back. This three-year lookback period begins when the board, compensation committee or officers authorized to take such action conclude or reasonably should have concluded (or a court or regulator determines) that a material error existed in prior financial statements.
The regulations define incentive compensation as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.” “Financial reporting measures” are defined as:
Incentive compensation does not include equity awards for which vesting is contingent solely upon completion of a specified employment period and/or attaining one or more nonfinancial reporting measures.
The amount that must be recouped is the difference between the amount of incentive-based compensation earned by an executive during the three-year lookback period and the amount the executive would have received based on the restated financial statements. This is the case even if amounts are paid after the end of the fiscal year when the financial reporting measures are attained, which is the rule as to how cash compensation is measured when calculating summary compensation table total compensation.
Deciding how this amount is to be calculated is left up to each individual company. Regardless, erroneously awarded compensation must be calculated without taking into account any tax liabilities that may have been incurred or paid by the executive.
For many incentive plans with financial hurdles, the calculation of the recoverable amount can be made by comparing the before and after information presented in the financial statements. For incentive-based compensation based on TSR or stock price, companies will need to make a reasonable estimate of the impact of the restatement and seek expert advice on determining reasonable methods for performing the calculation.
Once those calculations are completed, companies will be required to disclose the amount of erroneously awarded compensation attributable to any accounting restatement, including an analysis of how the compensation was calculated, and document the relevant exchange.
Enforcement can be avoided only in very limited circumstances. If a company’s executive compensation committee — or in the absence of such a committee, a majority of the independent directors serving on the board — determine that the cost of recovery would exceed the amount to be recovered, they would have the discretion not to pursue the clawback. Their reasoning must be discussed in the CD&A. A foreign private issuer would not be required to pursue recovery if it receives a legal opinion that doing so would violate local country law as in effect when these rules were finalized. The final rules also allow companies to forgo recovery for amounts deferred under tax-qualified retirement plans, although the SEC doesn’t expect this situation will arise very frequently; however, erroneously awarded incentive-based compensation contributed to plans limited only to executive officers, supplemental executive retirement plans, or other nonqualified plans and the resulting benefits would still be subject to being clawed back.
It is up to each company to determine how to recover any compensation in a manner consistent with the purpose behind the statute. Companies also must act “reasonably promptly,” with the SEC noting that directors and officers should pursue the most appropriate balance of cost and speed in determining the appropriate means to seek recovery. The SEC notes that companies could explore such methods as withholding from future pay, withholding from incentive awards earned but not paid, or cancelling unvested equity and non-equity awards.
No. The final rules specifically prohibit companies from entering into indemnity agreements with executives or purchasing insurance on behalf of executives to indemnify them against the financial effects of a clawback; however, the final rules do not directly prohibit executives from obtaining their own insurance against financial loss from clawbacks.
Now that the clawback rules have been finalized, companies should consider taking the following steps to prepare:
1 For more information on the proposed rules, see “SEC requests additional comments on Dodd-Frank clawback rules,” Insider, July 2022.
|Insider November 2022