This is the second in a three-part series of articles (please see "Related Content" for more from this series) detailing the steps to be taken and decisions to be made as companies adopt Securities and Exchange Commission (SEC)-mandated, Dodd-Frank-compliant clawback policies. This article focuses on how companies may be surprised by all the elements of their executive compensation program that are potentially subject to clawback as incentive compensation. We strongly recommend companies conduct a detailed inventory of precisely what plan documents and other written communications say about pay decisions so they can discern which portions might be subject to clawback upon a financial restatement.
Our working hypothesis is that such documentation does not exist currently in many cases. This review will provide a road map of necessary changes and additional discipline that will need to be adopted by compensation committees, advisors and corporate secretaries to create a smoother process when clawbacks must be exercised.
‘‘Financial reporting measures’’ defined: The SEC defines these as measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements and any measures derived wholly or in part from such measures. This includes ‘‘non-GAAP financial measures’’ as well as other measures, metrics and ratios that are not non-GAAP measures, such as same store sales.
Financial reporting measures may or may not be included in a filing with the SEC and may be presented outside the financial statements, such as in the performance graph or Management’s Discussion and Analysis of Financial Conditions and Results of Operations.
In the adopting release for the final regulations, the SEC provides examples of financial reporting measures, including, but not limited to:
Revenues; net income; operating income; profitability of one or more reportable segments; financial ratios (e.g., accounts receivable turnover and inventory turnover rates); net assets or net asset value per share (e.g., for registered investment companies and business development companies that are subject to the rule); EBITDA — earnings before interest, taxes, depreciation, and amortization; funds from operations and adjusted funds from operations; liquidity measures (e.g., working capital, operating cash flow); return measures (e.g., return on invested capital, return on assets); earnings measures (e.g., earnings per share); sales per square foot or same store sales; revenue per user, or average revenue per user; cost per employee; or any of such financial reporting measures relative to a peer group; and tax basis income.
Determining those elements of pay considered “financial reporting measures”: This will be a very time-consuming process for most companies, in that a complete review will require scrutinizing several documents that pertain to particulate elements of pay. The following is a list of documentation to review, with different documents applicable to different elements of compensation:
- Employment agreements
- Equity plan documents
- Grant agreements
- Bonus plan
- Bonus target communications
- Long-term incentive plan target communications
- Proxy statement, including tables and Compensation Discussion and Analysis (CD&A)
- Compensation committee minutes
- Management presentations
- Compensation consultant report
- Salary adjustment communications
- Performance reviews
- Deferred compensation plan
- Supplemental executive retirement plan (SERP) documents
- 401(k) plan documents
With these documents available, you can begin the painstaking and necessary exercise of understanding the elements of pay that use financial reporting metrics and that can be subject to clawback. A report should be created to clarify what was found and what needs to change in future years.
Salary: The final regulations do not consider salary paid during any year for which a company must issue a restatement as “incentive-based compensation.” However, footnote 194 of the adopting release states that:
“To the extent that an executive officer receives a salary increase earned wholly or in part based on the attainment of a financial reporting measure performance goal, such a salary increase is subject to recovery as a non-equity incentive plan award for purposes of Rule 10D–1.”
Companies should determine if any salary increases will have met this standard, either entirely or in part. In instances where the reason for the salary increase is not discernable, steps should be taken to make sure the compensation committee clearly articulates those reasons in the future, and that those reasons are detailed in the meeting minutes. In short, companies should make it clear precisely why salary adjustments take place so there are no ambiguities later on. If it turns out the adjustment was based on a financial metric, the entire increase may be subject to clawback for multiple years.
Non-equity incentive-based compensation of the summary compensation table (SCT) (annual bonuses): Even though 162(m) no longer applies specifically to named executive officers, bonus plans may still have designs that remain from several years ago, including those whereby the compensation committee exercises negative discretion. Plans usually take one of two designs:
- Single annual plan — where threshold, target and maximum are hardwired. Discretion may be exercised for adjustments sometimes based on subjective or non-financial standards.
- Bonus pool — where the amount of bonus pool is hardwired by formula in a shareholder approved plan. The pool may be divided by formula or by compensation committee using discretion.
In either of these plans, the issue of which financial metric is used should be easy to discern from the documents reviewed. What may be missing is any detailed description of why bonuses have been adjusted to determine which portion may be subject to non-financial factors. If that is missing, the documentation process must be tightened up in writing with clear details on what took place.
For bonus pool plans, recent guidance in the pay versus performance realm suggests that the entire bonus based on a restated financial metric is subject to clawback. That is, allocation based on non-financial factors does not change the fact that funding is based on a financial metric.
Bonus column of the SCT (special bonuses): Often, there are specific references to the reasons behind special bonuses in the CD&A and the compensation committee minutes. Don’t necessarily be lulled into the conclusion that because a bonus is paid to a single executive it is not tied to financial performance. Document your findings.
Stock awards and option awards columns of the SCT (time-based equity): The adopting release states that specific examples of ‘‘incentive-based compensation’’ include, but are not limited to:
Restricted stock, restricted stock units, performance share units, stock options, and stock appreciation rights (‘‘SARs’’) that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal.
Examples of compensation that is not ‘‘incentive-based compensation’’ for this purpose include, but are not limited to:
Equity awards for which the grant is not contingent upon achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more nonfinancial reporting measures.
Companies that use an “economic value” approach to their equity grant practice, so that the number of grants to be made for the annual cycle is based directly on stock value, might have made grants considered to be incentive-based compensation because their grant levels are tied to share price; however, if the year immediately prior to a grant has a restatement, this is likely to depress the share price measured to determine the number of shares granted, with the impact potentially being that more shares should have been granted. Nonetheless, the manner in which grant levels are calculated should be explicitly documented so there is no question as to the potential impact of a restatement on grant levels.
Back when companies sought to meet the “performance-based exception” to the 162(m) million-dollar pay cap, grant levels for restricted shares and units (not options) were more often based on attaining certain financial metrics in the immediately preceding year so that those grants qualified as performance-based. More recently, we see compensation committees adjusting grant levels where stock values are down, particularly those that use an economic value approach, based on the concern that executives would receive a windfall if share values bounced back.
It is important to review the documentation the compensation committee provides for making these downward adjustments in the number of shares granted, to understand if there is a connection to prior year financial reporting measures. It is possible that meeting minutes reflect a litany of reasons for making a downward adjustment or, in years where financial performance is excellent, as a justification for making more grants in the following year.
Finally, if performance-based options are issued, the metrics used will need to be documented.
Stock awards and option awards columns of the SCT (performance shares and retention grants): In many circumstances, not all the financial measures that apply to a performance share grant are disclosed in the Grants of Plan-Based Awards table, so careful scrutiny should be paid to the grant agreements and other communications. Similar issues regarding the use of discretion, as discussed in the non-equity incentive awards section above, may apply here, although it is more likely that most of the performance measures and adjustments made remain incentive-based compensation.
However, there are often performance measures within these grants that are awarded based on discretion, although these rarely use “financial reporting measures,” as defined by the SEC. The portion of grants that don’t use financial reporting measures should not be subject to clawback. Nonetheless, compensation committee minutes should be reviewed to understand the basis for exercises of discretion and, if absent, must be indicated in the future.
The adopting release provides:
As we have previously noted, if an executive officer erroneously receives incentive-based compensation based on stock price or TSR that was inaccurate as a result of an accounting misstatement, that compensation is based on such erroneous data. Being mindful of the statutory language and purpose of Section 10D, we do not see a basis for allowing that executive officer to retain such compensation, given that it was erroneously awarded.
Making sure the precise details of how the total shareholder return (TSR)-based programs work will be crucial to determining precisely how a financial restatement would impact payouts previously calculated under those plans. How these calculations must take place will be discussed in a future article.
Retention grants also need to be closely scrutinized to determine the extent they are time/service-based (and thus not subject to clawback), with their details recorded.
Pension/Nonqualified deferred compensation column of the SCT, 401(k) and SERPs: There is an exception that states clawbacks would not be required if it would be impracticable to do so because recovery would likely cause a retirement plan — for example, a 401(k) plan — to lose its tax-qualified status under the Internal Revenue Code. However, at least for 401(k) plans, if incentive compensation is deferred, it may be appropriate for the company to seek recoupment of those amounts from other sources. A detailed review would require identifying if the source of deferrals includes annual bonuses, as many plans permit.
Qualified pension plans have different nuances in that if the plan accruals are based on incentive compensation, that would be a contribution funded by the company. Yet, the company could still decide, even though it could not recoup accruals from the pension plan, to seek recoupment of that value from other sources. Of course, determining the value of any accrual for any particular year is a complicated analysis, best performed by actuaries.
The SEC also clarified that the clawback rule has broader application to other compensation plans. In Question 121H.04 of its Compliance and Disclosure Interpretations, the SEC stated:
Question: Because the clawback rule applies broadly to incentive-based compensation, would the rules affect compensation that is in any sort of plan, other than tax-qualified retirement plans, including long term disability, life insurance, SERPs, or any other compensation that is based on the incentive-based compensation?
Answer: The rule is intended to apply broadly. For plans that take into account incentive-based compensation, an issuer would be expected to claw back the amount contributed to the notional account based on erroneously awarded incentive-based compensation and any earnings accrued to date on that notional amount. [January 27, 2023]
This suggests that an analysis should take place to determine if any incentive compensation is used in the formula to fund or pay these benefits. Again, this will require some specialized expertise to determine. For SERPs, the restrictive rules of 409A may limit a company’s ability to claw back any accruals funded due to incentive compensation; this is a complicated issue.
Our hope is this guide provides a path to start the necessary review of current processes. Next steps will involve meeting with all stakeholders so they may understand the importance of better documentation and to assure officers that only those dollars whose recoupment is required will be at risk upon a restatement. The compensation committee members also will need to understand their role in creating those assurances and make sure that the process is functioning as it should, without there being any ambiguities.
Our next article will focus on determining the source of money to pay back to the company in the event of a restatement that requires a clawback. Companies have numerous questions to consider that may cause them to rethink when compensation is paid and/or whether the clawback policy specifically delineates the hierarchy of sources of those funds.
