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Now You See It, Now You Don’t: SEC’s Final Rule on Clawback Policies

The SEC has published its final rule for the recovery of erroneously awarded compensation (“final rule”). The final rule will require national securities exchanges and associations to enact listing standards that require issuers to: (1) Develop and implement policies “for recovery of incentive-based compensation based on financial information” from certain executive officers if the issuer is required to prepare an accounting restatement; and (2) to disclose these compensation recovery policies in accordance with SEC rules. If an issuer fails to adopt and comply with these standards, they will be subject to delisting.

This final rule, which was initially proposed in 2015, was finalized after subsequent comment periods in both 2021 and 2022. This “Clawback Policy” requirement is required by Section 10D of the Securities Exchange Act of 1934, which was added by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Effective Date

The final rule is to become effective 60 days following its publication in the Federal Register. After such time, exchanges are to file proposed listing standards within 90 days following the publication in the Federal Register. These listing standards will need to be effective no later than one year following such publication and issuers will have only 60 days to comply.

Five Considerations for Issuers

  1. Issuers should determine if they have a clawback policy and, if so, whether the policy is in compliance with the final rule. Even though the clawback policy requirement could be a year away from having any impact on issuers, the final rule includes a three-year look back period. Therefore, issuers should be proactive in reviewing their policies and addressing additional policy requirements and should not wait until required to do so. When the rule does become effective, the clawback period will include the current period.

  2. Issuers should also review the compensation plans for officers of the company to see if any incentive-based compensation packages have been provided for officers. Under the final rule, incentive-based compensation is considered to any compensation which is earned based on a financial reporting measure. This is a broad definition. Whether a compensation measure is based on increase in company value, a higher revenue for a period, or a lower expense to a certain cost center, the final rule will include this incentive-based metric.

  3. In making the determination whether these plans are given to the company’s officers, issuers should presume any Section 16 officers will be encompassed by the final rule’s definition of ‘officer’. While the SEC did not adopt the Section 16 definition of an officer, its inclusion of anyone performing a policy-making function for the issuer will certainly include encompass Section 16 officers. The SEC stated that they understood Congress’ intent in enacting Section 10D to have a broad view of officers who are covered.

  4. If an incentive-based compensation package is present for company officers, issuers may consider the possibility of amending those plans. With the expansive definition adopted by the final rule using any financial reporting measure, issuers may consider amending compensation triggers, so officers will not be subject to required clawbacks from compensation earned years prior. While a compensation policy based on a revenue goal may be ideal, such a reward may lead to a recovery in the event of an accounting restatement.

  5. Issuers without a clawback policy should consider enacting one as soon as practical, even if the final rule will not affect them for up to a year. As discussed above, when the rule does become effective, the clawback period will include the current period. 

Issuers and Securities Subject to Clawback Policies

Section 10D of the Security Exchange Act “does not distinguish among issuers or types of securities.” Because of this, the SEC provides only certain limitations of the applicability of the clawback policy requirement. Therefore, in general, almost all listed issuers will be required to adopt a policy that is in compliance with an exchange’s listing standards or be subject to delisting. Further, except for the certain exceptions adopted by the SEC, exchanges do not have discretion to exempt certain categories from their listing standards.

The narrow exceptions provided by the SEC apply to “certain security futures products, standardized options, securities issued by unit investment trusts, and the securities issued by certain registered investment companies from the mandated listing standards”.

Restatements Triggering Application of Recovery Policy

Restatements. Exchanges and associations are to establish listing standards which will require the issuers to develop and implement polices to require recovery in the event the issuer is required to restate its financial statements and the material noncompliance triggering the restatement allowed an executive to receive compensation he or she would not otherwise have earned. The recovery is only triggered when an issuer is required to “prepare an accounting restatement” to correct a material error (“Big R” restatements) or if correcting the error during the current period or leaving the error uncorrected would result in a material misstatement (“little r” restatements). This rule, however, does not define “accounting restatement” or “material noncompliance” even though they trigger the rule. The SEC instead directs an issuer to “existing accounting standards and guidance” which set out the meaning of the terms.

Recovery Period. Recovery of erroneously awarded compensation is required “during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement.” Because of this, the timing of the accounting restatement is critical. Therefore, the SEC has determined that an issuer is required to prepare an accounting restatement upon the earlier of:

1. The date the issuer’s board of directors, a committee of the board of directors, or the officer or officers of the issuer authorized to take such action if board action is not required, concludes, or reasonably should have concluded, that the 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, or

2. The date a court, regulator or other legally authorized body directs the issuer to prepare an accounting restatement.

The SEC adopted this method of determining the proper restatement date, as opposed to a “bright-line or single date standard”, in order to minimize the “incentive for issuers to delay their restatement conclusions” and still provide “reasonable certainly for issuers, shareholders, and exchanges.” The final rule states its determination was to make the rule more difficult to evade.

Executive Officers Subject to Recovery Policy

Policies for erroneously awarded compensation are to be adopted for any current or former executive officer who has received incentive-based compensation. These individuals include a company’s “president, principal financial officer, principal accounting officer, any vice-president of the issuer in charge of a principal business unit, division or function, or any officer performing a policy-making function, or any other person who performs similar policy-making functions for the issuer.” Further, executive officers of an issuer’s parent or subsidiary may be included if those individuals serve a policy making function for the issuer.

Executive officers’ liability will not limited based on fault. This is important point because even if the executive officer was not a part of the accounting error leading to a restatement or did not prepare financial statements, their incentive-based compensation is still subject to recovery.

The SEC also stated that recovery of incentive-based compensation is only required by a person “(i) after beginning service as an executive officer and (ii) if that person served as an executive officer at any time during the recovery period.” If compensation is awarded to an executive officer before starting that position, it is not required that it be covered by an issuer’s policy. 

Incentive-Based Compensation

The rule and the clawback only applies to incentive-based compensation.

The SEC has defined incentive-based compensation as “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure”, a definition broad enough to encompass new forms of compensation that may be used in the future. Additionally, the SEC has further defined “financial reporting measures” to be “measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, and any measures derived wholly or in part from such measures.” This would include, for example, measures based upon revenues, profitability, or the income of an issuer. Again, the final rule’s definition has been drafted broadly and can include measures such as non-GAAP financial measures and stock prices, accordingly issuers should review compensation packages with an eye toward compliance.

Beyond what is considered to be compensation subject to recovery, the determination of when such compensation was received is relevant based upon the 3-year look-back period. The SEC, therefore, determined that it deem compensation to be received “in the fiscal period during which the financial reporting measure in the incentive-based compensation award is attained,” regardless of when the award is paid. As an example, the final rule discusses a situation where an award is based on the “satisfaction of a financial reporting measure performance goal”. Even if the achievement of this goal would result in a payment in a future fiscal period, the award is deemed to have been received during the period where the performance goal was met.

Recovery Process

Recovery is required for incentive-based compensation received which is “in excess of what would have been paid to the executive officer under the accounting restatement.” This amount is to be computed without considering taxes paid. If the incentive-based compensation is based on stock price or total shareholder return, “where the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement,” the amount of erroneously awarded compensation may be determined by a reasonable estimate of the effect of the accounting restatement.

Once the issuer determines the amount subject to recovery, they must recover this compensation in compliance with its recovery policy, unless that recovery would be impracticable. Generally, the issuer should expect to “pursue recovery in most instances” and have almost no discretion. Certain exceptions have been adopted, but the list is small. These “impracticability exceptions” are applicable in several limited circumstances: (1) where the cost of recovery exceeds the about to be returned, provided that the issuer makes reasonable attempts of collecting before concluding that it would be impracticable; (2) where recovery would violate the home country law of the issuer, provided that the home country law must have been adopted prior to publication in the Federal Register and the issuer obtains an opinion by home country counsel; and (3) if recovery would cause a tax-qualified retirement plan to lose its preferential treatment under the Internal Revenue Code.

Therefore, an issuer can be nearly certain that, if incentive-based compensation is erroneously awarded, they will have to pursue that amount awarded beyond what would have been awarded under the accounting restatement. The SEC noted that the purpose of 10D was to return the monies to the rightful party, the issuer and its shareholders.

Unlike the above, discretion is appropriate when determining how an issuer will recover the erroneously awarded compensation, subject to reasonable restrictions. Since different means of recovery may be appropriate for different issuers, discretion can be used in order to accomplish recovery. However, the final rule states that the issuer should act “reasonably promptly”, although the term is left undefined. Still, issuers may not settle for an amount less than full recovery, unless an impracticability exception is met.

Disclosure on Annual Report

In order to ensure that issuers listed on different exchanges are all subject to the disclosure policies set forth in this new rule, all issuers must disclose their policies as an exhibit to their annual report, whether that be on the issuer’s 10-K, 20-F, or 40-F. Beyond this disclosure, issuers will have additional disclosure requirements if an accounting restatement has been made which affects an award of incentive-based compensation. In that case, the issuer’ s annual report must indicate, through check boxes, if the their financial statements “reflect a correction of an error to previously issued financial statements and whether any such corrections are restatements that required a recovery analysis”. If so, the issuer must disclose the following on its Item 402 disclosure regarding their actions taken pursuant to the recovery policy:

  • The date that the issuer was required to prepare the accounting restatement

  • The erroneously awarded amount attributed to the accounting restatement

  • The aggregate dollar amount of the erroneously awarded compensation that is outstanding at the end of the last completed fiscal year

  • If the amount has not yet been determined, an explanation and the related disclosure on the next Item 402 filing

  • If the financial reporting measure was based on a stock price or total shareholder return metric, the estimates used to determine the erroneously awarded compensation

  • If recovery is determined to be impracticable, the amount to not be recovered and the reason

  • Information related to current and former named executive officers and amount of erroneously awarded compensation owed that has been outstanding for 180 days or longer

Indemnification and Insurance

The final rule will “prohibit issuers from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.” And, even if an executive officer purchases an insurance policy from a third-party provider, issuers are prohibited from reimbursing or paying for the premiums of that policy.

Alex Albers also contributed to this article.

© 2023 Dinsmore & Shohl LLP. All rights reserved.National Law Review, Volume XII, Number 342
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About this Author

David J. Lavan, Dinsmore, Corporate Litigation Attorney, SEC Registration
Partner

David is a partner in the Corporate Department who focuses his practice on all aspects of SEC registration, reporting and compliance. He routinely advises clients on public and private offerings of debt and equity, disclosure matters, corporate governance and accounting issues. As a former government bond broker, David provides clients with unique insights into the financial marketplace, counseling them on transactional and regulatory matters, as well as litigation. He represents both public and private companies, as well as independent board and committee members,...

202-372-9122
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