On October 26, 2022, the Securities and Exchange Commission (SEC) adopted final rules implementing Section 954 of the Dodd-Frank Act by directing national securities exchanges and associations, such as the New York Stock Exchange and Nasdaq, to adopt listing standards that will require listed companies to develop and implement compensation clawback policies.
Under the final rules, listed companies will be required to have written compensation clawback policies that require the recoupment of certain incentive-based compensation received by current or former “executive officers” when an issuer has an accounting restatement. Listed companies will also be required to make certain disclosures about their clawback policies. The listing standards will generally apply to all issuers with a class of securities listed on a national securities exchange or association, including foreign private issuers, controlled companies, smaller reporting companies and emerging growth companies.
The final rules materially expand the scope of the SEC’s original compensation clawback policy proposal published in 2015 as set forth in our client alert at that time. Public companies and their audit and compensation committees, executive officers and outside advisors should begin preparing now to deal with the significant implications of the final rules.
The clawback policies mandated by the new Rule 10D-1 will have to meet various requirements as to their scope and application, as summarized below.
1. Type of Restatement Triggering Recovery of Compensation. The clawback policy will be triggered when an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws. Triggering restatements will include any required accounting restatement to correct an error in previously issued financial statements that is material to the previously issued financial statements, or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period. Thus, in a change from the proposed rule, under the final rule, triggering restatements will include both so-called “Big R” restatements and “little r” restatements.” In determining when a restatement is triggered, the SEC reminded issuers that SEC staff has provided guidance on making materiality determinations in Staff Accounting Bulletin No. 99, Materiality, and Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.
Rule 10D-1 does not define “accounting restatement” or “material noncompliance” as existing accounting standards and guidance set forth the meaning of those terms. Under current accounting standards, certain changes would not constitute an error correction, including the following: retrospective application of a change in accounting principle; retrospective revision to reportable segment information due to a change in internal organization structure; retrospective reclassification due to a discontinued operation; retrospective application of a change in reporting entity; retrospective adjustment to provisional amounts in connection with a prior business combination; and retrospective revision for stock splits, reverse stock splits, stock dividends or other changes in capital structure.
2. Individuals Covered. The clawback policy will be required to apply to any individual who served as an executive officer at any time during the performance period that applied to the incentive-based compensation that the individual received. Accordingly, the policy will apply to both current and former executive officers.
Rule 10D-1 uses a definition of “executive officer” similar to the definition under Rule 16a-1(f) of the Securities Exchange Act of 1934 (Exchange Act), rather than the definition of “executive officer” under Rule 3b-7 under the Exchange Act. This definition generally includes the issuer’s president, principal financial officer, principal accounting officer (or, if none, the controller), any vice-president in charge of a principal business unit, division or function, and any other officer who performs a policy-making function, or any other person who performs similar policy-making functions.
It will not be relevant whether there is any fault on the part of the executive officer or whether the executive officer was involved in preparing the financial statements. Companies will not be able to indemnify officers or pay for insurance to cover amounts that are clawed back.
3. Definition of “Incentive-Based Compensation” Subject to Recovery. The clawback policy will be required to apply to “incentive-based compensation,” which is defined as compensation that is granted, earned or vested based wholly or in part upon the attainment of a “financial reporting measure.” “Financial reporting measure” is defined as a measure that is determined and presented in accordance with the accounting principles used in preparing financial statements, and any measures derived from such measures. This includes non-GAAP financial measures and other measures not presented in the financial statements or SEC filings. “Financial reporting measure” is also defined to include stock price and total shareholder return (TSR).
The SEC noted that “incentive-based compensation” is to be determined in a principles-based manner so that new forms of compensation and new measures of performance will be captured. The SEC provided in the adopting release a non-exhaustive list of examples of “incentive compensation”:
The SEC also provided examples of compensation that is not “incentive-based compensation”:
4. Time Periods Covered. The clawback policy will apply to incentive-based compensation “received” during the three fiscal years (and certain transition periods resulting from a change in fiscal year) preceding the date on which the issuer is required to prepare the accounting restatement. Compensation will be deemed “received” when the performance condition is satisfied, even if the compensation is not actually paid or granted until a later date. The SEC noted in the adopting release that the date of receipt of the compensation depends on the terms of the award and provided the following examples:
The date on which the issuer is required to prepare the accounting restatement will be the earlier of (a) the date the board, committee or authorized officer concludes, or should reasonably have concluded, that the issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement or (b) the date a court, regulatory or other legally authorized body orders a restatement. The SEC noted in the adopting release that the determination an issuer is required to prepare an accounting restatement may occur before the precise amount of the error has been determined. For an accounting restatement for which an issuer is required to file an Item 4.02(a) Form 8-K, the conclusion that the issuer is required to prepare an accounting restatement is expected to coincide with the occurrence of the event disclosed in the Form 8-K. Furthermore, in determining when there should reasonably have been a conclusion to prepare an accounting restatement, the SEC noted that an issuer would have to consider any notice it may receive from its auditor that previously issued financial statements contain a material error.
5. Amount of Recovery. The amount of the recovery will be the amount by which the incentive-based compensation the executive officer actually received exceeds the amount the executive officer would have received based on the restated numbers. The amount of the recovery will be calculated on a pre-tax basis. Where the incentive-based compensation is based on stock price or TSR, reasonable estimates can be used to calculate the excess amount, but the issuer must maintain documentation of the determination of the reasonable estimate and provide the documentation to its national securities exchange or association.
The SEC noted that the definition of erroneously awarded compensation is intended be applied in a principles-based manner but provided the following guidance:
Amounts recovered from the executive under Section 304 of the Sarbanes-Oxley Act of 2002 may be credited as a reduction in the amount required to be recovered under the Rule 10D-1 clawback, but the adopting release states that recovery under Rule 10D-1 will not preclude recovery under the Sarbanes-Oxley Act to the extent any applicable amounts have not been reimbursed to the issuer.
6. Recovery Mandatory Unless Impracticable for One of Three Reasons. Recovery of incentive-based compensation subject to the clawback will be mandatory unless the issuer’s compensation committee comprising independent directors, or a majority of independent directors in the absence of a committee, determine that recovery is “impracticable” for one of the following three reasons:
Boards will be permitted to exercise discretion, subject to reasonable restrictions, as to the means of recovery.
The recovery, however, must be effectuated reasonably promptly. The rule does not define “reasonable promptness,” but the SEC noted in the adopting release its expectation that the issuer and its directors will pursue the most appropriate balance of cost and speed in determining the appropriate means to seek recovery in light of their fiduciary duty to safeguard the assets of the issuer, taking into account the time value of money. The SEC also noted in the adopting release that an issuer may be acting reasonably promptly in establishing a deferred payment plan that allows repayment as soon as possible without unreasonable economic hardship to the executive officer.
The final rules include several disclosure requirements relating to the clawback policy. An issuer’s compliance with the disclosure requirements will be an element of the listing standards.
1. Filing of Clawback Policy. The issuer will need to file the clawback policy as an exhibit to its annual report on Form 10-K.
2. Proxy Statement/Annual Report Disclosures. The rule amends Item 402 of Regulation S-K to require disclosure by listed issuers if at any time during or after the last completed fiscal year the issuer was required to prepare an accounting restatement that required recovery of excess incentive-based compensation or, as of the end of the last completed fiscal year, there was an outstanding balance of excess incentive-based compensation attributable to a prior restatement.
The required disclosure under Item 402 will include:
If the issuer was required to prepare a restatement during or after the issuer’s last completed fiscal year and concluded that recovery of compensation was not required under the issuer’s policy, the issuer must briefly explain why application of the policy resulted in that conclusion.
As long as an issuer provides the new Item 402 disclosure with respect to clawbacks, the issuer need not also make a disclosure under Item 404(a) relating to related party transactions with respect to the clawback activity.
The Item 402 disclosure will need to be provided in XBRL format, but will be required only in annual reports on Form 10-K and proxy statements whenever other Item 402 disclosure is required. The disclosure, therefore, will not be required in registration statements under the Securities Act of 1933. In addition, the disclosure will not be deemed incorporated by reference into any filing under the Securities Act of 1933 unless specifically incorporated by reference.
For any registered management investment company subject to Rule 10D-1, information mirroring the new Item 402 disclosure will need to be included in annual reports on Form N-CSR and in proxy statements and information statements relating to the election of directors. Foreign private issuers will be required to provide the new Item 402 disclosure in annual reports filed with the SEC under Section 13(a) of the Exchange Act.
The Summary Compensation Table rules are amended to require that any amounts recovered under a clawback policy reduce the amount reported in the table for the fiscal year in which the original payment was reported and be identified in a footnote.
3. Form 10-K Checkboxes. The rule adds two new checkboxes to the cover page of Form 10-K relating to whether the financial statements included in the Form 10-K reflect the correction of an error to previously issued financial statements and whether any of those error corrections are restatements that require a recovery analysis of incentive-based compensation received by executive officers.
The national securities exchanges will have to file with the SEC proposed listing standards implementing the rule no later than 90 days after the SEC final rules are published in the Federal Register. Those new listing standards will need to become effective no later than one year after the publication of the SEC final rules.
Issuers then will need to adopt clawback policies no later than 60 days after the exchanges’ listing standards become effective. The clawback policies will need to apply to all incentive-based compensation received by current or former executive officers (after beginning service as an executive officer and who served as an executive officer during the applicable performance period) on or after the effective date of the applicable listing standard. The clawback policy will be expected to apply to such compensation even if the compensation is received under a pre-existing contract or arrangement.
Compliance with the new Item 402 disclosure rule will be required for all applicable filings with the SEC after the effective date of the exchanges’ listing standards.