October 7, 2015

Securities and Governance Update - October 2015

On the Road to Recovery: SEC Proposes Rule Requiring Executive Compensation Clawback Policies

By Elizabeth A. Diffley and Robert T. Esposito 

This summer, the SEC proposed a new clawback rule (Proposed Rule 10D-1) to implement Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). Section 954 of Dodd-Frank added a new Section 10D to the Securities Exchange Act of 1934 (the Exchange Act) requiring national securities exchanges and associations to adopt listing standards regarding erroneously paid incentive-based compensation received by any executive officer in connection with an accounting restatement, irrespective of misconduct. Pursuant to Proposed Rule 10D-1, those listing standards would require public companies to develop and implement incentive-based compensation policies providing for the following:

  • Disclosure of the company’s recovery policy regarding incentive-based compensation based on financial information required to be reported under the securities laws; and
  • In the event of an accounting restatement, the recovery of any incentive-based compensation received by any current or former executive officer during the three-year period before the date of the required accounting restatement in excess of what would have been paid to the executive officer had the incentive compensation been determined under the accounting restatement. 

Proposed Rule 10D-1 is broader than the current clawback rule under Section 304 of the Sarbanes-Oxley Act (SOX), which gives the SEC the authority to recover, or “clawback,” certain compensation from CEOs and CFOs of public companies in the event of an accounting restatement due to “material noncompliance” with financial reporting requirements, provided that the noncompliance was a result of misconduct.  Proposed Rule 10D-1 is more expansive, as it would apply to any executive officer receiving incentive-based compensation, not just CEOs and CFOs, and would be triggered by any required accounting restatement due to non-compliance, regardless of issuer or executive misconduct. Moreover, unlike SOX Section 304, which grants boards of directors substantial discretion in determining whether or not to claw back compensation, recovery under Proposed Rule 10D-1 would be mandatory, subject to very limited exceptions. 

The period for public comment on the proposed rule ended on September 14, 2015, and, while it may be modified before it is finalized, given its scope, listed companies are advised to start considering its implications now. Notably, the proposed rule will require the overwhelming majority of listed companies to disclose a compensation recovery policy. According to data recently published by Audit Analytics, the incidence of accounting restatements among NYSE and NASDAQ companies disclosed on an item 4.02 Form 8-K has declined steadily over the past decade, from 919 non-reliance restatements by 10-K filers in 2005 to 185 in 2014.  As a result, while nearly all listed companies will be required to create or revisit their recovery policies, the likelihood that a listed company’s recovery obligations will actually be triggered by the proposed rule may be decreasing.

We discuss below the main provisions of the proposed rule as well as suggestions for listed companies as they begin planning for the requirements imposed by the proposed listing standards.

Covered Issuers and Securities

Covered Issuers

Proposed Rule 10D-1 would require securities exchanges and associations to apply the disclosure and recovery policy requirements to all companies listed on a national securities exchange, except for (i) security futures products, (ii) standardized options, (iii) unit investment trusts, and (iv) certain registered investment companies. Notably, despite the otherwise scaled compensation disclosure requirements applicable to them, Proposed Rule 10D-1 would not exempt emerging growth companies, smaller reporting companies, foreign private issuers, or controlled companies.

Covered Securities

Proposed Rule 10D-1 refers to any security of an issuer, which includes common equity securities, debt securities, and preferred securities.  For example, issuers that only have public debt would be subject to the proposed rule if that debt is listed on an exchange.

Accounting Restatement Triggering Event

Restatements Triggering Application of Clawback Policy

The listing standards would require issuers to adopt and comply with policies requiring recovery in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with financial reporting requirements. For purposes of Proposed Rule 10D-1, an accounting restatement is defined as the result of the process of revising previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements. It is expected that a restatement that would obligate the issuer to file an Item 4.02 Form 8-K disclosing that previously issued financial statements can no longer be relied upon would trigger the application of the proposed rule.

Date on Which an Issuer is Required to Prepare an Accounting Restatement

An issuer’s clawback policy would be required to cover excess incentive-based compensation during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement.  Proposed Rule 10D-1 defines the phrase Date on which an issuer is required to prepare an accounting restatement as the earlier of (i) the date the issuer’s board of directors, a committee of the board or authorized officer concludes, or reasonably should have concluded, that the issuer’s previously issued financial statements contain a material error; or (ii) the date a court, regulator or other authorized body directs the issuer to restate its previously issued financial statements to correct a material error.

Application of Clawback Policy

Covered Executive Officers

Proposed Rule 10D-1 applies to excess incentive-based compensation to “any current or former executive offer of the issuer who received incentive-based compensation.” The term executive officer is defined consistently with Section 16 of the Exchange Act, and includes the issuer’s president, principal financial officer, principal accounting officer or controller, any vice-president in charge of a principal business unit, division or function, or any other officer who performs a policy-making function, as well as executive officers of the issuer’s parent or subsidiaries, if those executive officers perform policy-making functions for the issuer.  Moreover, the proposed rule would require recovery of incentive-based compensation from anyone who was an executive officer at any time during the performance period, including incentive-based compensation derived from an award granted before the individual became an executive officer, and inducement awards granted in new hire situations. If adopted as proposed, the proposed rule could expose individuals serving in executive officer roles on an interim basis to clawback of their incentive-based compensation.

Covered Incentive-Based Compensation

Proposed Rule 10D-1 defines incentive-based compensation as any compensation that is granted, earned or vested based wholly, or in part, on the attainment of any financial reporting measure.  Financial reporting measures, in turn, are defined as (i) any measures that are determined and presented in accordance with the accounting principles used in preparing an issuer’s financial statements; (ii) any measures derived wholly or in part from that financial information; and (iii) stock price and total shareholder return, regardless of whether those measures are included in an SEC filing. In applying the clawback policy, the SEC has proposed permitting issuers to use reasonable estimates when determining the impact of an accounting restatement on stock price and total shareholder return. Notably, the SEC solicited comments on whether non-financial measures (such as the opening of a specified number of stores, or consummating a merger or divestiture) should be included in the definition of “incentive-based compensation.” Assuming Proposed Rule 10D-1 is not modified to include non-financial measures, it is possible that adoption of the proposed rule could lead to increased usage of compensation arrangements based on objective performance measures that are not financial in nature.

Three-Year Look-Back Period

Under Proposed Rule 10D-1, the three-year look-back period comprises the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement. Basing the look-back period on completed fiscal years, rather than the preceding 36-month period, is intended to correspond with issuers’ general practice of awarding incentive-based compensation on a fiscal-year basis.

When Incentive-Based Compensation is Deemed “Received”

For purposes of triggering the clawback policy, incentive-based compensation would be deemed received by an executive officer in the fiscal period during which the financial reporting measure is attained. This temporal determination applies even if payment or grant of the award occurs after the end of that fiscal period, or if the grant of the award is governed by additional time-vesting requirements.

Recovery Process

Determination of Excess Compensation

Under Proposed Rule 10D-1, the recoverable amount of excess compensation is the amount of incentive-based compensation received that exceeds the amount that otherwise would have been received had it been determined based on the accounting restatement, without regard to any taxes paid. As a result, an issuer would be required to recalculate the applicable financial reporting measure and the amount of incentive-based compensation based on that measure, and then determine whether the executive officer received a greater amount of incentive-based compensation than would have been received applying the recalculated measure. 

Board Discretion Regarding Recovery and Manner of Recovery

Section 10D of Dodd-Frank provides that “the issuer will recover” incentive-based compensation, but does not address whether there are circumstances under which an issuer’s board of directors may exercise discretion over the recovery of that compensation. Proposed Rule 10D-1 would provide boards with discretion only where pursuit of recovery would be impracticable because it would (i) impose undue costs on the issuer or its shareholders, or (ii) would violate home country law and certain conditions are met. The SEC’s proposing release indicates that the unqualified “no-fault” recovery mandate of Section 10D will result in issuers pursuing recovery in most cases. In those instances in which the above criteria are applicable, any determination that recovery would be impracticable must be made by the issuer’s independent directors responsible for compensation decisions. In the case of bonus plans in which the size of the bonus pool is determined by reference to financial reporting measures, but the allocation of bonuses from the pool subject to board discretion, boards will not be permitted to pursue different levels of recovery from executive officers that receive bonuses from the pool. Rather, a board would be required to calculate the effect of the restatement on the size of the pool, and recover a pro rata portion of any resulting shortfall from each participating executive.

Board discretion, however, is permitted in the context of the means of recovery. The SEC recognizes that the appropriate means of recovery may vary by issuer and type of compensation to be recovered. As a result, the proposed rule affords issuers discretion in determining how to accomplish recovery, provided that the issuer takes actions that fulfill the purpose of the Section 954, namely, to prevent executive officers from retaining compensation that they received but to which they were not entitled under the restated accounting.

Compliance with Recovery Policy

Under Proposed Rule 10D-1, an issuer would be subject to delisting if it fails to adopt and comply with its clawback policy.  Securities exchanges are vested with the authority to determine whether an issuer has complied with its clawback policy, and in so doing, would need to determine whether the issuer has made a good faith effort to promptly pursue recovery.

Disclosure of Incentive-Based Compensation Policy

The proposed disclosure requirements would (i) require a listed U.S. issuer to file its clawback policy as an exhibit to its annual Form 10-K and (ii) amend Item 402 of Regulation S-K to add Item 402(w), which would require certain disclosure about the issuer’s application of those policies in the event of an accounting restatement. Companies would also be required to block tag the disclosure in an interactive format using XBRL.

Indemnification and Insurance

In light of the fact that an indemnification arrangement might be used to avoid recovery required by Section 10D, Proposed Rule 10D-1 would prohibit an issuer from indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation. Where an executive officer purchases third-party insurance to fund potential recovery obligations, the issuer would be prohibited from paying or reimbursing the executive for premiums associated with that insurance policy.

Transition and Timing

For Exchanges

Proposed Rule 10D-1 would require that each exchange file its proposed listing rules no later than 90 days following publication of the final adopted version of Rule 10D-1 in the Federal Register, and that its listing rules take effect no later than one year following that publication date.

For Issuers

Under the proposed rule, each issuer must adopt a clawback policy no later than 60 days following the date on which the applicable exchange’s rules take effect. Issuers would be required to recover all erroneously awarded incentive-based compensation (i) for any fiscal period ending on or after the effective date of Rule 10D-1 and (ii) that is granted, earned or vested on or after the effective date of Rule 10D-1. Importantly, the effective date of Rule 10D-1 would be the date the SEC’s final rule is published in the Federal Register as opposed to the date on which the exchanges adopts their rules.  Issuers would be required to file the required disclosures in applicable filings on or after the date on which the exchange rules take effect.


The comment period for Proposed Rule 10D-1 ended on September 14, 2015, with the rule eliciting more than 60 comment letters.  Commenters raised a variety of concerns, including the proposed rule’s retroactive applicability, the expansive definition of executive officer, and the failure to carve out an exception in situations where recovery would violate state law.  Many commenters also sought increased board discretion in determining whether to recover incentive compensation, greater clarity with respect to the definition of accounting restatement, and more guidance on the calculation of recoverable amounts, particularly with respect to changes in stock price and total shareholder return.

Suggestions and Guidance

It is not clear when Proposed Rule 10D-1 will ultimately be adopted or what changes it may undergo prior to adoption, but in light of the current proposal, we recommend that all listed companies not exempted from the proposed rule consider the following:

  • Follow the Developments of Proposed Rule 10D-1.  General counsel and other members of management should brief the board of directors and compensation committee members on the proposed rule and begin discussing how the clawback policy and recovery requirements may impact the company’s compensation arrangements within the framework of the company’s overall compensation strategy.
  • Review Corporate Governance Documents.  Review and consider necessary changes to the compensation committee charter to incorporate its new responsibilities with respect to oversight and implementation of the clawback policy. Consider whether changes to the company’s bylaws, indemnification policies, or indemnification agreements are merited in light of the proposed limitations on a company’s ability to indemnify executive officers for the loss of erroneously awarded compensation.
  • Review the Company’s Existing Clawback Policy, If Any.  If the company has an existing clawback policy, consider any amendments that would be necessary to comply with Proposed Rule 10D-1 and whether to maintain more than one clawback policy applicable to different scenarios and different categories of employees. If the company does not have an existing clawback policy, work with general counsel and outside counsel to draft a policy in accordance with Proposed Rule 10D-1.
  • Review Employment Agreements and Compensation Plans and Agreements.  General counsel and compliance personnel should review the company’s existing agreements, plans, forms of agreements and related communications to determine what revisions may be needed to incorporate the requirements of Proposed Rule 10D-1.
  • Annual Board Determination of Executive Officers.  Because the definition of executive officer requires some exercise of judgment, boards should determine and document qualifies as the company's executive officers for purposes of federal securities laws on an annual basis. In addition, companies should keep careful records of executive officers, including who they are, when they became or ceased to be executive officers and the details of incentive-based compensation they have or may be eligible to receive. Boards and compensation committees should work in conjunction with Human Resources to establish accurate and updated contact information for current and former executive officers, if not already in place. 

In addition, the anticipated finalization of Proposed Rule 10D-1 presents an opportunity for all listed companies to reconsider the structure and performance measures in their form employment agreements and incentive plans. As currently drafted, the proposed rule is applicable only to erroneously awarded incentive-based compensation that is based on the attainment of any financial reporting measure. If finalized in its current form, the proposed rule would not cover incentive-based compensation that is based on non-financial metrics. The limited scope of the propose rule’s clawback policy and recovery requirement is particularly relevant to technology and “new economy” companies that are increasingly measuring, and tying executive compensation to, unconventional metrics and attainment of milestones such as number of active users, number of unique visitors, number of mobile application downloads, bookings, etc. It is also relevant to the increasing number of social enterprise organizations and traditional for-profit corporations that employ various environmental, social and governance (ESG) metrics in their performance measures. The use of non-financial objective performance measures may benefit both the company and stakeholders alike and, in light of Proposed Rule 10D-1, listed companies might consider reevaluating the use of these innovative measures in their incentive-based compensation policies. 


SEC Adopts Final CEO Pay Ratio Disclosure Rule Mandated by Dodd-Frank

By William L. Carr, Chanda A. Miller, and Ryan T. Costa


In August 2015, the SEC adopted its final rule implementing Section 953(b) of Dodd-Frank, which requires public companies to disclose the “pay ratio” between their chief executive officer’s annual total compensation and the annual total compensation of their “median” employee.

Although the Pay Ratio Rule incorporates several changes to the previously proposed iteration in an effort to lessen some of the administrative burden placed on companies, compliance is still likely to prove onerous. Companies should not wait to start assessing what compliance with the Pay Ratio Rule will require and formulate a strategy for moving forward.

The Final Rule

As required by Section 953(b) of the Dodd-Frank Act, the SEC’s final Pay Ratio Rule amends Item 402 of Regulation S-K to require disclosure of:

  • the median of the annual total compensation of all employees of the company, excluding the CEO;
  • the annual total compensation of the company’s CEO; and
  • the ratio of the median of the annual total compensation of all employees, excluding the CEO, to the annual total compensation of the CEO (CEO Pay Ratio).

Companies must begin disclosing CEO Pay Ratios with their first full fiscal year starting on or after January 1, 2017. This disclosure requirement applies to all U.S. public companies required to provide a summary compensation table disclosure under Item 402(c) of Regulation S-K (in annual reports on Form 10-K, registration statements, and proxy statements). It does not apply to emerging growth companies, smaller reporting companies, foreign private issuers, Multijurisdictional Disclosure System filers, or registered investment companies.

In general, the Pay Ratio Rule requires a company to identify its median employee only once every three years. If, however, there has been a change to the median employee’s circumstances or to a company’s employee population or employee compensation levels that the company reasonably believes would result in a “significant” change to the CEO Pay Ratio, the company must reassess and re-identify its median employee. If not, and the median employee is carried over from the prior year, a company must disclose its use of the same median employee for the CEO Pay Ratio and briefly describe its reasonable basis for believing that a significant change has not occurred.

A company may select any date within the last three months of the last completed fiscal year to identify its median employee. The Pay Ratio Rule defines “employees” to include all full‑time, part-time, seasonal, and temporary employees of a company and its consolidated subsidiaries, whether or not the employee is located within or outside the United States. The employees of joint ventures and unconsolidated subsidiaries are excluded. Independent contractors and “leased” workers serving a company are also excluded, but only if those individuals are employed by an unaffiliated third party and their compensation is determined by that third party. A company may annualize compensation for its permanent employees (both full‑ and part-time) who were not employed during the entire fiscal year, but may not make full‑time equivalent adjustments for part-time employees and may not annualize the compensation of its seasonal or temporary employees.

Non-U.S. employees are generally included in the definition of “employee,” but the Pay Ratio Rule does provide two exemptions under which companies may exclude them. First, it permits a company to exclude non-U.S. employees employed in jurisdictions with data privacy laws or regulations that, despite reasonable efforts, prevent the company from obtaining the necessary information without violating those data privacy laws or regulations. Second, the Pay Ratio Rule has a de minimis exemption that allows a company to exclude (i) all non-U.S. employees, if they account for 5% or less of the company’s total employees; or (ii) up to 5% of its total employees who are non-U.S. employees, if the company’s non-U.S. employees exceed 5% of its total employees. These exemptions are accompanied by a number of restrictions and disclosure requirements, so companies should take care when determining whether to invoke them.

Once the employee universe has been established, the Pay Ratio Rule affords a company some flexibility in selecting its method for identifying the median employee. A company may identify the median employee using (i) the company’s entire employee population, (ii) a statistical sampling, or (iii) other reasonable methods. Further, when determining the median employee, a company does not have to calculate each employee’s compensation under Item 402(c)(2)(x) of Regulation S-K, as is required for named executive officers. Rather, a company may identify the median employee using annual total compensation or any other compensation measure (such as compensation amounts reported in payroll or tax records), as long as the method is consistently applied to all employees included in the calculation. Once the median employee is identified, however, for purposes of determining the ratio, that person’s annual total compensation must be calculated using the Item 402(c)(2)(x) standard.

The Pay Ratio Rule requires disclosure of the CEO Pay Ratio in any annual report, proxy or information statement, or registration statement that already requires executive compensation disclosure under Item 402. In addition to the CEO Pay Ratio, companies must disclose the methodologies, material assumptions, estimates, and adjustments used in identifying the median employee and the calculation of that employee’s annual total compensation. Companies are not required, but are granted discretion to further supplement their CEO Pay Ratio disclosure with a narrative discussion or additional ratios that may, for example, provide greater context. This additional information must be clearly identified, not misleading, and not presented with greater prominence than the CEO Pay Ratio.

Moving Forward

While many speculate that the Pay Ratio Rule will be challenged in court or that Congress will amend the underlying statute before companies must comply, companies adopting a wait and see approach do so at their own peril. Companies subject to the Pay Ratio Rule should be proactive in assessing what compliance will require and formulating a plan for meeting these potentially onerous requirements. In doing so, companies should consider doing the following in the coming months and years:

  • Engage counsel early to help navigate compliance. To the extent that the company has non-U.S. employees working in jurisdictions that are potentially subject to the data privacy exemption, this engagement should also include foreign counsel.
  • Carefully weigh the potential risks and benefits of identifying the median employee by surveying the entire employee population versus using “other reasonable methods.” While other seemingly reasonable methods may be cheaper and less burdensome to carry out than assessing the entire employee population, a company will have to be prepared to defend its chosen method to the SEC (and potentially in court), at least until better guidance is given regarding what methods the SEC deems “reasonable.”
  • Evaluate potential testing dates given that the Pay Ratio Rule allows companies to select a date within the last three months of its fiscal year.  This will be of particular interest for companies with large seasonal work forces, but may be worth considering for other companies as well.
  • Prepare a plan for engaging with shareholders regarding the CEO Pay Ratio disclosure. This may include, but should not be limited to, taking advantage of the Pay Ratio Rule’s provision allowing companies to provide context for the ratio in their disclosures.
  • Engage the company’s Human Resources personnel in the process. Upon public disclosure of the CEO Pay Ratio, half of the company’s employees will discover that they make less than a majority of their colleagues. The company should involve Human Resources to help address potential morale issues that may result.
  • Review and assess any CEO Pay Ratio disclosures made by peer companies as well as the SEC’s, investors’, and the public’s reactions to those disclosures.


Update on SEC’s Interpretative Guidance for Whistleblower Retaliation Protections

By Mary P. Hansen, William L. Carr, and Daniel E. Brewer

In August 2015, the SEC issued interpretative guidance to clarify that an individual’s status as a whistleblower for purposes of the employment retaliation protections provided by Dodd-Frank does not require that the whistleblower report potential violations to the SEC.

Since its legislative rulemaking in 2011, the SEC has taken the position that individuals may qualify as whistleblowers entitled to Dodd-Frank’s employment-retaliation provisions, even if they do not report potential misconduct to the SEC.  In its rulemaking, the SEC identified a potential ambiguity with the scope of the employment-retaliation protections in Dodd-Frank. On the one hand, Congress provided a broad catchall provision that prohibits employers from “discharg[ing], demot[ing], suspend[ing], threaten[ing], harass[ing], directly or indirectly, or in any other manner discrimat[ing], against, a whistleblower in the terms and conditions of employment because of a lawful act done by the whistleblower . . . in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002.”  15 U.S.C. § 78u-6(h)(1).  On the other hand, Congress narrowly defined the term whistleblower as “any individual who provides . . . information relating to a violation of the securities to the Commission, in a manner established, by rule or regulation, by the Commission.”  15 U.S.C. § 78u-6(a)(6).

In recognition of this ambiguity, in its rules, the SEC adopted the two separate definitions of “whistleblower:”  one to provide protection from employment retaliation and another to provide eligibility for a whistleblower award.  17 C.F.R. § 240.21F-2.  The latter is in line with Congress’s definition of whistleblower and requires the individual to follow detailed procedural rules to submit a tip to the SEC and qualify for an award. 

In Asadi v. G.E. Energy (U.S.A.), L.L.C., 720 F.3d 620, 630 (5th Cir. 2013), however, the Court of Appeals for the Fifth Circuit found that the SEC’s definitions were inconsistent and rejected the SEC’s “expansive interpretation of the term ‘whistleblower’ for purposes of the whistleblower-protection provision” under Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).  In its recent guidance, the SEC acknowledged the Asadi decision and clarified its position that Dodd-Frank's employment-retaliation protections apply to any individual who makes a broad disclosure and that an individual’s status as a whistleblower does not depend on adherence to the reporting procedures to recover an award.

In September 2015, in Berman v. Neo@Ogilvie LLC & WPP Group USA, Inc., slip op. at 2 (2d Cir. Sept. 10, 2015), the Court of Appeals for the Second Circuit rejected the decision in Asadi and gave deference to the Commission’s reconciliation of the conflicting provisions on the scope of whistleblower retaliation protections.  The majority in Berman acknowledged the SEC’s August 2015 guidance.  The Asadi and Berman decisions create a circuit split that could end up before the Supreme Court in the near future.


Companies should be cautious in taking any action that could be perceived as retaliation against an individual who has reported misconduct internally to the company.  A violation of the anti-retaliation procedures of  Dodd-Frank could result in some harsh penalties against a company, including reinstatement of the whistleblower, double back pay, and payment of attorneys’ fees and other litigation costs.  Companies cannot rely on the employee’s failure to also report the alleged misconduct to the SEC to justify their adverse employment action against a whistleblower.

Services and Industries

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