The Dodd-Frank Act required the Securities & Exchange Commission (SEC) to adopt rules that direct national securities exchanges (such as the NYSE and NASDAQ) to require listed companies to implement and disclose their recovery policies (clawback policies) for incentive-based executive compensation. On July 1, 2015, the SEC proposed Rule 10D-1.
Details of the Proposed Rule
The proposed rule directs the national securities exchanges and associations to require that each listed issuer:
- Establish an incentive-based executive compensation recovery policy that requires the company to recalculate incentive-based executive compensation awarded over the last three fiscal years and claw back incorrectly calculated incentive compensation if the company is required to file an accounting restatement because of a material financial error.
- Disclose its executive compensation recovery policy and compliance related actions.
- If a company chooses not to pursue recovery against an executive, the company must list the names of the executives, the amounts due from each person and the reasons the company did not pursue recovery.
- Companies must also disclose the names of any executives who are subject to clawback recovery and have excess compensation outstanding for more than 180 days.
Key Takeaways for Public Companies
- Many public companies have adopted a more limited and narrow clawback policy and will need to expand the scope to comply with the final rule.
- Implementing the rule will not be easy. Determining whether and how much compensation will need to be clawed back in each situation will be difficult.
- Many aspects of the rulemaking are fairly contentious, so we expect a significant number of comments and likely some revision to the final rule.
- Other than submitting comments, if desired, issuers need take no other action until the final rules are adopted.
- Given the complexities and judgments involved in implementing a clawback, it seems certain that companies will face litigation whenever a restatement occurs and a clawback is triggered.
- Changing executive compensation to game the system and avoid the reach of the clawback rule would be the tail wagging the dog. There are many other factors (business objectives, proxy advisory firm/investor preferences, etc.) that will drive the design and operation of compensation programs, and those factors have far more practical impacts than the relatively remote risk of an accounting restatement.
- Market solutions to mitigate the risk of a clawback likely will develop, such as insurance that executives can purchase. While the rule prohibits companies from paying for or reimbursing the cost of the premiums for such insurance, the SEC acknowledged that competitive executive compensation may end up increasing to effectively cover the cost of any such coverage.
- Because of the time required for the rulemaking process, the rules will not take effect for the 2016 proxy season.
Frequently Asked Questions
Which companies are covered?
The policy applies to all listed issuers, but exempts issuers that list only the following securities: security futures products, standardized options, and the securities of certain registered investment companies that are externally managed.
Who is an executive?
Current and former officers who received incentive-based compensation. Executive officers are the same as Section 16 “officers” and include 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, any other officer who performs a policymaking function and any other person who performs similar policymaking functions for the issuer.
What is a material financial error?
The SEC did not propose a specific definition of “material” but referred to existing concepts of materiality. The SEC did note that multiple immaterial financial corrections, which individually may not require an amendment, could together constitute a material error.
What is incentive-based compensation?
Any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure. This does not include compensation based on non-financial performance measurements (for example opening a certain number of new stores). While base salary is generally not incentive-based, an increase in base salary that was earned based on attainment of a financial measure would be incentive-based. The proposed rules provide guidance on how to determine the amount of incentive-based compensation that was received when discretion was used in determining the amount received or that was derived from a “bonus pool.”
What is the time period of the recovery policy?
The three completed fiscal years preceding the date on which the company is required to prepare an accounting restatement (with special rules applicable to issuers who transition fiscal periods during that period). Any incentive compensation received during that period is subject to recovery, and compensation is considered received when the financial reporting goal is met, not when the compensation is actually paid.
What is the date on which the company is required to prepare an accounting restatement?
On the date that the board of directors or other authorized body concludes or reasonably should have concluded that the previously issued financial statements contain a material error or the date a court, regulator or other legally authorized entity directs the issuer to restate its previously filed financial statements.
What is the amount of the recovery?
The amount of incentive-based compensation awarded that exceeds the amount that the executive would have been paid had their incentive-based compensation been based on the financial information contained in the accounting restatement. The recoverable amount is calculated on a pre-tax basis. An executive’s incentive-based compensation is subject to clawback for any material financial error without regard for the fault of the executive.
How should a company determine the amount of recovery when the incentive-based compensation was tied to the stock price or total shareholder return?
The SEC acknowledges that this will require a complex analysis that will “require significant technical expertise and specialized knowledge, and may involve substantial exercise of judgment in order to determine the stock price impact of a material restatement.” For example, companies may be required to retain an advisor to conduct an “event study” of the likely impact of the restatement on the company’s stock price. The SEC will allow issuers to use “reasonable estimates” to determine stock price impact and will require disclosure of those estimates. Where shares were received by an executive under earned incentive-based compensation that becomes subject to recovery and the shares have been sold, the amount to be clawed back would be the sale proceeds.
Are there any circumstances when a recovery is not triggered?
Yes, recovery is not triggered when the cost of enforcing recovery would exceed the amount of the erroneously paid incentive-based compensation or when a foreign corporation’s home country prohibits recovery.
What is the penalty for not adopting or not complying with the recovery policy?
De-listing from the national securities exchange.
Timing of Effectiveness
- Rule 10D-1 was proposed on July 1, 2015, and comments are due 60 days after the proposed rule is published in the Federal Register.
- No more than 90 days after the final rule is published in the Federal Register, the national exchanges must propose their listing rules, which will become effective no later than one year after the Federal Register publication date. There is no deadline for how quickly the national exchanges must actually adopt their final rules.
- After the exchange rules become effective, listed issuers will have 60 days to adopt a clawback policy.
- According to the proposed rule, the clawback policy must apply to incentive-based compensation that is based on or derived from financial reporting periods that end on or after the rule’s effective date.