As explained in a recent alert, now is the time for public companies to adopt compliant clawback policies. This is because the US Securities and Exchange Commission (SEC) recently approved final rules on June 9, 2023, that required national securities exchanges like the New York Stock Exchange (NYSE) and the Nasdaq to implement new listing standards requiring public companies to institute compliant incentive-based compensation clawback policies. The NYSE and Nasdaq rules require listed companies to adopt clawback policies by December 1, 2023, which policies must apply to incentive compensation awarded after October 2, 2023. As public companies prepare to adopt compliant policies before the December 1, 2023 deadline, they should not only consider the clawback policy itself, but also the overlap between that policy and any applicable directors and officers (D&O) liability insurance. Doing so is important to address the potential new exposures created by the new SEC rules.
The New Rules
Broadly speaking, the new rules require public companies to institute policies that allow for the recovery of incentive-based executive compensation that was erroneously awarded based on financial misstatements. The new rules apply to “Big R” financial restatements—i.e., restatements that correct material issues in previously-issued financial statements. The new rules also apply to “Little r” financial restatements that correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period.
The new rules provide public companies with no discretion to determine whether and when to pursue enforcement of their compliant clawback policies. The new rules also have no misconduct requirement. In other words, any erroneously paid compensation must be recouped without regard for whether an executive was at fault. For a full description of the rules and what companies need to do to comply with applicable listing standards before the rules go into effect, please see this recent alert.
Indemnification and Insurance
The new rules prohibit public companies “from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.” The reason for this prohibition, according to the SEC, is that, “[m]any of the benefits” of the rule “would result from an executive officer’s changes in behavior as a result of incentive-based compensation being at risk for recovery.” And those benefits would be “substantially undermined if the issuer were able to indemnify the executive officer for lost compensation.”
Despite the general prohibition on indemnifying or insuring erroneously paid compensation, the new rules acknowledge the possibility that, “insurance market[s] may develop an insurance product that would allow an executive officer, as an individual, to purchase insurance against the loss of incentive-based compensation when the material accounting error is not attributable to the executive.” It remains to be seen whether insurers will offer these personal products in the first place, let alone the form those insurance products may take.
Significance for Policyholders
Given the recent implementation of the rules, there are not yet many hard-and-fast guidelines defining how the new rules will be interpreted and enforced. For example, there are likely to be disagreements about whose compensation can be clawed back given the rule’s application to current and former executive officers or about the calculation of any clawback. The potential issues in this area are even more nascent with respect to indemnification and insurance, largely because the rules contemplate the possible creation of brand-new insurance products. Even in the absence of such insurance products, clawbacks may lead to novel arguments by insureds and insurers alike if clawback claims are submitted for coverage under traditional forms of insurance held by the individual executive officers.
For now, the key takeaway is that the new rules prevent D&O insurers from indemnifying clawed-back executive compensation. Going forward, however, individuals facing potential exposure under the SEC’s mandated listing standards may have new options to protect themselves in the face of this prohibition as insurers adapt to the new regulatory landscape—although at the moment, there may be more questions than answers about new insurance products. For example, would an insurer have an interest in offering this type of product? How much would executives be willing to pay for that product? Might executives only purchase this product if they expect a restatement is probable? Would insurers be willing to offer limits sufficient to account for the often high level of executive incentive compensation at issue?
In sum, these questions (and others) are best addressed through coordination with coverage counsel and seasoned insurance brokers who can help public companies react to new potential exposures.
Alex D. Pappas also contributed to this article.