Background — Dodd-Frank Clawback Requirement
The clawback requirement in Dodd-Frank was not self-executing. Instead, it took the form of an instruction to the SEC to promulgate rules requiring national stock exchanges to implement listing standards that would include mandatory clawback policies. The listing standards must require listed companies to develop and implement policies providing that, in the event of an accounting restatement due to material noncompliance with any financial reporting requirement under the federal securities laws, the company must recover incentive-based compensation paid to any executive officer on the basis of the erroneous data.
The Sarbanes-Oxley Act of 2002 (SOX) also contains a clawback provision, but the standard under Dodd-Frank is stricter in that the SOX clawback applies only to restatements that occur as a result of misconduct, is limited to a company's CEO and CFO, and applies only to the 12-month period preceding the restatement. Dodd-Frank does not set a deadline for the SEC to act on promulgating its new rules on clawbacks and the SEC has no publicly-disclosed timetable for doing so.
Code Section 409A Payment Timing and Clawbacks
Tax rules regarding deferred compensation may conflict with clawbacks in some circumstances. Since 2005, Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”), has prescribed strict rules governing the timing of deferral and payment of nonqualified deferred compensation, which may include incentive compensation that is deferred. Code Section 409A imposes a 20% extra income tax, as well as interest and penalties, on compensation that does not meet its timing requirements. One of these requirements is a general ban, subject to limited exceptions, on accelerating the payment of compensation that has been deferred. None of the exceptions to the ban on accelerating payments apply generally to payments required under a clawback provision.
Although uncertainty remains in the absence of final regulations under Dodd-Frank, it is possible that enforcement of clawback policies could conflict with Code Section 409A’s prohibition on accelerated payments. This may be best illustrated by an example:
The company and the executive may both desire to satisfy the clawback requirement by distributing the deferred compensation to the executive so that he may repay it to the company. However, allowing the executive to access the deferred compensation in Year 3 to satisfy the clawback obligation could be viewed for Code Section 409A purposes as an impermissible “acceleration” of the payment of the deferred compensation. This acceleration would potentially trigger the 20% extra income tax and interest and penalties under Code Section 409A, which would be assessed against the executive on all of the executive’s deferrals under the deferred compensation plan.
To minimize the likelihood of a conflict between the enforcement of a clawback and the tax rules on deferred compensation, we recommend that clawback provisions be drafted to provide that incentive compensation that is deferred and subject to Code Section 409A will be “forfeited” — rather than becoming subject to “repayment” — if the compensation becomes subject to a clawback. Genuine forfeitures of deferred compensation, in contrast to accelerations of payment, are not prohibited by Code Section 409A. Therefore, drafting clawback provisions in policies, agreements or deferred compensation plans in terms of forfeitures, rather than in terms of requiring repayment, to the extent deferred compensation is involved should strengthen the company’s and the executive’s position that the satisfaction of clawback obligations with deferred compensation does not constitute an acceleration of payment prohibited by Code Section 409A.
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Joshua A. Agen
Leigh C. Riley