SEC Proposes Clawback Rules

Alerts / July 30, 2015

On July 1, 2015, the Securities and Exchange Commission (“SEC”) proposed long-awaited rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) requiring the national securities exchanges to adopt listing standards mandating that listed companies have a policy to recover from current and former executive officers any incentive-based compensation based on financial information that was subsequently corrected in an accounting restatement.

The highlights of the proposed rules are as follows:

  • The rules would apply to almost all categories of listed issuers, including smaller reporting companies, emerging growth companies, foreign private issuers, and controlled companies, with limited exceptions for registered investment companies that do not use incentive compensation and unit investment trusts.
  • The requirement to recover or claw back erroneously awarded incentive-based compensation would be triggered by an accounting restatement that is attributable to an error that is material to previously issued financial statements. “Wrongdoing” is not required as it is under the Sarbanes-Oxley clawback provision.
  • The recovery policy would apply to each “executive officer” as defined in Rule 16(a) under the Securities Exchange Act of 1934, regardless of whether the executive officer had any role in the preparation of the financial statements.
  • The amount to be recovered would be the amount received by the executive officer that exceeds the amount he or she would have received had the incentive-based compensation been determined based on the restated financial statements.
  • Incentive-based compensation that would be subject to recovery includes compensation granted, earned, or vested based on attainment of any financial reporting measure, on stock price, or on total shareholder return. Equity awards that are strictly time-based would not be covered.
  • The recovery obligation would apply to any excess compensation applicable to performance during the three completed fiscal years preceding the date on which the company is required to restate.
  • The issuer would have very little discretion in deciding whether to pursue recovery of erroneously awarded compensation, and companies would not be permitted to indemnify or reimburse executives for recovered compensation.
  • The recovery obligation would apply to erroneously awarded compensation received by current and former executive officers on or after the effective date of the new rules – not the effective dates of the listing standards implementing the rules – that results from attaining a financial reporting measure based on financial information for any fiscal period ending on or after the effective date of the rules.
Timing of Restatements Requiring Recovery – The Three-Year Look-Back Period

The proposed rules provide that an issuer’s recovery policy must apply to any incentive-based compensation received by current or former executive officers during the three completed fiscal years immediately preceding the date on which the issuer is “required” to prepare a restatement to correct the material error. An issuer is required to prepare an accounting restatement under the proposed rules on the earlier of:

  • The date on which the issuer’s board of directors, a committee of the board, or the officer or officers of the issuer authorized to take such action if board action is not required concludes, or reasonably should have concluded, that the issuer’s previously issued financial statements contained a material error; or
  • The date on which a court, regulator, or other legally authorized body directs the issuer to restate previously issued financial statements to correct a material error.

The proposing release notes that the first proposed date would generally coincide with the occurrence of an event described in Item 4.02(a) of Form 8-K, which requires the filing of Form 8-K if the board, a board committee, or the officer or officers of the issuer authorized to take such action if board action is not required concludes that any previously issued financial statements should no longer be relied upon because of an error.

Because the timing of when a restatement is required forms the basis for calculating the three-year recovery/look-back, any delay in fixing that date that spans the end of a fiscal year may permit some erroneously awarded incentive-based compensation to escape recovery. Accordingly, we expect the SEC staff and private litigants to pay close attention to how that date is established. Meaningful time can pass between a preliminary assessment by management that a restatement may be required and a formal determination by the audit committee that an error is material enough to warrant restatement. It may be appropriate for issuers to make it explicit in their audit committee charters that only the audit committee or the full board of directors has the authority to determine that a restatement should be prepared or that any previously issued financial statements should no longer be relied upon.

Incentive-Based Compensation

Incentive-based compensation potentially subject to recovery under proposed Rule 10D-1 includes compensation that is granted, earned, or vested based wholly or in part on the attainment of a “financial reporting measure.” The proposing release has a nonexclusive list of financial metrics that qualify as financial reporting measures. That list does not contain any surprises. However, stock price and total shareholder return, though not commonly viewed as financial reporting measures, are explicitly included in the statutory definition of financial reporting measures. As a result, a cash incentive program that is tied, in whole or in part, to the issuer’s stock price or a total shareholder return calculation will be incentive-based compensation under the rules.

The definition of incentive-based compensation is quite broad, but the term does not encompass nonfinancial reporting measures that may affect incentive compensation. Statistical or operational measures, such as opening a specified number of stores; obtaining regulatory approval of a product; or completing a restructuring plan, a financing, or an acquisition or disposition, are not financial reporting measures, and compensation based on these measures would not be incentive-based compensation for purposes of the rules.

Section 954 of Dodd-Frank provides explicitly that incentive-based compensation includes “stock options awarded as compensation.” However, under the rules as proposed, incentive-based compensation includes options and other equity awards only if the granting or vesting of those awards would be based in whole or in part on financial reporting measures. Equity that is entirely time-based would not be considered incentive-based compensation under Rule 10D-1.

Recovery Amount

The amount of incentive-based compensation recoverable from a current or former executive officer is the amount that exceeds the amount, determined on a pre-tax basis, that would have been received had it been based on the accounting restatement. When incentive-based compensation is based in part on a financial reporting measure subject to recovery and partially based on other factors, only the portion based on or derived from the financial reporting measure needs to be recalculated and recovered.

The proposing release recognizes that determining the stock price impact of a material restatement will require complex analyses and that it may be difficult to establish the relationship between an accounting error and the stock price. Mindful of these challenges, the proposal permits issuers to use reasonable estimates when determining the impact of a restatement on stock price and total shareholder return. While the staff believes this standard lessens the pressure on companies in determining the amount of compensation subject to recovery, this is likely to be an area of focus by private litigants.

Discretion in Seeking Recovery

The proposed rules provide issuers with very little discretion in determining whether to pursue recovery of erroneously awarded compensation. An issuer must recover erroneously awarded compensation except to the extent it would be “impractical to do so.” The proposing release states that it would be impractical if the direct expense paid to a third party to assist in recovery would exceed the amount to be recovered or if recovery would violate a home country law that was adopted prior to the proposed rule being published in the Federal Register. Before concluding that recovery would be too expensive, an issuer must make a reasonable attempt to recover the erroneously awarded compensation and document that attempt to the applicable stock exchange. As discussed below, disclosure would also be required under proposed Item 402(w) of Regulation S-K if the issuer decides not to pursue recovery. In addition, the proposing release notes, “we are not proposing that issuers settle for less than full recovery.” Presumably, this means that issuers must pursue recovery claims to trial, unless not doing so fits within the “impractical” standard.

The proposed rules provide some discretion in the means of recovery. So long as recovery is pursued reasonably promptly, the issuer should be permitted to recover compensation by direct payment from the recipient, by receiving it over a reasonable period of time, by reducing future pay, or by requiring forfeiture of other awards.

Disclosure Requirements

The proposed rules add a new Item 402(w) to Regulation S-K. Form 10-K or proxy statement disclosure under that item would be required if an issuer completes a restatement that requires recovery of erroneously awarded incentive-based compensation pursuant to the issuer’s recovery policy or if there is an outstanding balance of excess incentive-based compensation from the application of the policy in a previous year. Disclosure would include:

(i) The date on which the issuer was required to prepare the accounting restatement,

(ii) The aggregate dollar amount of excess incentive-based compensation attributable to the accounting misstatement or an explanation as to why that amount has not yet been determined,

(iii) The estimates that were used in determining the excess incentive-based compensation attributable to the accounting misstatement if the financial reporting measure related to stock price or total shareholder return, and

(iv) The aggregate dollar amount of excess incentive-based compensation that remained outstanding and unrecovered at the end of the last fiscal year.

If the issuer decides not to pursue recovery from an executive officer or former executive officer, it must disclose the individual’s name, the amount forgone, and the reason the issuer decided not to pursue recovery. In addition, the issuer must disclose the name of any person who, as of the end of the last fiscal year, had erroneously been awarded incentive-based compensation that was unrecovered for a period of 180 days or longer, as well as the dollar amount of the outstanding compensation.

The disclosure required by Item 402(w) would have to be provided in interactive data format using XBRL and included as an exhibit to the issuer’s proxy statement or annual report on Form 10-K.

Existing Plans and Contracts

The proposing release downplays the challenges issuers may face in seeking to claw back compensation that was awarded and earned pursuant to pre-existing plans and binding contracts. As far as plans are concerned, companies should have adequate time to amend incentive compensation plans before the rules become final to allow for recovery once they become effective. However, issuers are generally not able unilaterally to amend binding employment contracts with executives. The proposing release dismisses this dynamic with the conclusory statement that “issuers can amend their contracts to accommodate recovery.”

Timing and Next Steps

It is difficult to predict when the SEC might adopt final rules in light of the significant commentary expected to be generated by the proposals. The proposals require each exchange to propose its listing standards in response to the rules no later than 90 days following publication of the final adopted version of Rule 10D-1, and those listing standards must be effective no later than one year following that publication date. Therefore, final application of the clawback rules will not occur for quite some time, perhaps not until 2017. However, it is worth noting that the clawback rules will apply to erroneously awarded incentive-based compensation paid or awarded based on financial measures for any fiscal year ending after the date the SEC’s rules are final, not ending after the date the listing standards become final.

Issuers should consider the following:

  • Many issuers have already adopted clawback policies, but they likely do not satisfy the requirements of the proposed rules, unless they simply incorporate into the policy any rules adopted by the SEC. Given the significant areas in which the SEC has asked for comment, it may make sense to delay revising existing clawback policies to comply with the rules until there is greater visibility into what the final rules will look like.
  • Incentive compensation plans and executive contracts should be reviewed to determine whether they contemplate recovery under company clawback policies adopted in accordance with the proposals. While companies may not have the unilateral ability to alter executive employment contracts, there should be ample time to negotiate changes that would comply with likely final rules.
  • Indemnification agreements and insurance coverage should be reviewed to confirm that the company is not protecting executives against the risk of recoupment, which is prohibited by the proposed rules.
  • Issuers should begin reviewing all compensation plans to determine whether they have the right mix of compensation forms, including identifying compensation methods that continue to link a significant portion of executive compensation with company performance while being mindful of the extent to which their executive officers are receiving compensation that may be subject to recovery under the proposed rules.
  • Committee charters should be reviewed and amended as necessary to specify the process for deciding when a restatement is required.
  • It is not too early to reassess who the issuer’s executive officers are for purposes of Rule 16(a) and to document how the board reaches that decision.

If you have any questions about the material presented in this alert, please contact any member of BakerHostetler’s Corporate Governance or Securities Offerings and Compliance teams.

Authorship Credit: John M. Gherlein

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