For executive officers, the new Clawback Rule increases financial risks of participating in an incentive-based compensation program regardless of whether the officer is at fault for the financial misstatement.
On October 26, 2022, the SEC adopted a new rule requiring stock exchanges to adopt listing standards for recovery of erroneously awarded compensation. The new rule, set forth in new Rule 10D-1 under the Securities Exchange Act of 1934 (aka the Clawback Rule), compels national securities exchanges to require listed issuers to develop and disclose a policy providing for the recovery of compensation based on erroneously reported financial information. The Clawback Rule is the culmination of more than a decade of effort by the SEC to implement compensation recovery rules and fulfill the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
The new disclosure by listed issuers will appear as an exhibit on annual reports and applies equally to compensation received by both active-serving and former executive officers.
In voting in favor or the Clawback Rule, SEC Chairman Gary Gensler stated,
If the company makes a material error in preparing the financial statements required under the securities laws, then an executive may receive compensation for reaching a milestone that in reality was never hit. Whether such inaccuracies are due to fraud, error or any other factor, the [Clawback Rule] would implement procedures that require issuers to recover erroneously rewarded pay, a process known as a “clawback.”
Commissioner Hester Pierce countered Chairman Gensler’s conclusion:
The adopting release… fails to permit listing exchanges to craft workable listing standards and enforce them in a commonsense manner. Likewise, the final rule does not permit company boards, guided by their fiduciary duty, to determine when clawing back compensation makes sense.
These rules and amendments become effective on January 27, 2023, 60 days following publication of the SEC’s final rule released in the Federal Register on November 28, 2022. Exchanges have 90 days to file proposed listing standards and one year following such publication to implement the new standards. Once exchanges implement their listing standards, issuers will have 60 days to comply with the new disclosure requirements on applicable proxy and information statements. Thus, listed issuers will likely have until early in calendar year 2024 to comply.
Issuers should start planning both the procedural and substantive components of their clawback policies for compliance purposes. Specific areas to discuss include existing compensation agreements, restatement determinations and financial reporting procedures. For executive officers, the new Clawback Rule increases financial risks of participating in an incentive-based compensation program regardless of whether the officer is at fault for the financial misstatement. Executives should keep in mind that while the Clawback Rule does not permit issuers to indemnify their executive officers for money clawed back, executive officers are permitted to seek third-party insurance to fund recovery obligations. Further, listed companies or executive officers may consider performance measures that are less prone to error, less dependent on judgment and/or less likely to be affected by a restatement.
This Alert provides a brief overview of amendments to Section 10D’s core obligations for erroneously awarded incentive-based compensation clawback policies and practical considerations for SEC reporting companies.
Accounting Restatements
Material errors on financial statements serve as a new “trigger” for the application of a listed issuer’s compensation recovery policy.
Sections 10D(a) and 10D(b)(2) obligate the SEC to direct exchanges to require listed issuers to implement policies to recover erroneously awarded incentive-based compensation if the issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under securities laws. After receiving comment, the SEC adopted the obligation for an issuer to issue an accounting restatement as a trigger to the Clawback Rule. Issuers should note that SEC interprets Section 10D as applying to both “Big R” and “little r” financial restatements.[1] Therefore, issuers should be prepared to initiate and disclose their clawback policies regardless of whether financial misstatements require the filing of a Form 8-K disclosing that prior financial statements may not be relied upon.
The Clawback Rule is triggered on the earlier of two occurrences: (1) the date the issuer concludes, or reasonably should have concluded, it is required to issue an accounting restatement due to a material noncompliance with financial reporting requirements; or (2) when a court, regulator or other legally authorized entity directs the issuer to prepare an accounting restatement. A key qualifier to this trigger is the materiality of the error to a previously issued financial statement that warrants the need to restate. In making materiality determinations, the SEC encourages issuers to evaluate the quantitative and qualitative effects of the accounting error and to apply holistic, objective judgments from the reasonable investor’s perspective based on the totality of the information the issuer discloses. For the purposes of the Clawback Rule’s applicability, the SEC recommends assessing the materiality of an accounting error based on whether management received an increase in compensation as a result of the error.
Elements of the Disclosure
Details of the recovery policy must be added as an exhibit to yearly reports in Items 402 and 601 of Regulation S-K and Forms 10-K, 20-F and 40-F.
The Clawback Rule’s disclosure obligations apply to the filing of proxy statements and annual reports, including Form 10-K, 20-F and 40-F. Once the obligation to file restated financial statements triggers the clawback of erroneously awarded compensation, the Clawback Rule mandates an issuer filing under the Exchange Act to disclose their clawback policy as an exhibit on an annual report under Item 601 of Regulation S-K. Under Regulation S-K Item 402, the disclosure must include information about how and when the issuer applied their recovery policy, the recovered amount as shown on a summary compensation table, and the aggregate amount of compensation given to present or former executive officials that remains outstanding. The Clawback Rule adds two new check boxes on the cover page of issuer reports: one for indicating whether the financial statements included are a correction of a previously issued statement, and another box to indicate whether any financial restatement required compensation recovery.
The Time Period Incentive-Based Compensation Is Subject to Recovery
Incentive-based compensation is subject to an issuer’s recovery policy if an officer receives it while the issuer has a class of securities listed on an exchange. The Clawback Rule says incentive-based compensation is received in the fiscal period when the incentive-based compensation award is attained, regardless if payment occurs after the end of that period. Furthermore, compensation is received when the relevant financial reporting performance goal is attained, even if the executive officer has only a contingent right to payment of that award.
The period covered for recovery looks back to the three fiscal years immediately preceding the fiscal period the issuer is required to prepare an accounting restatement. Two examples provide clarity: (1) if compensation is based on meeting a performance goal, the compensation is “received” in the fiscal period when the performance goal is satisfied; (2) the vesting of an equity award based on satisfying a financial reporting measure is received in the fiscal period it vests.
Calculating Erroneously Awarded Compensation
The Clawback Rule leaves Section 10D(2)(b)’s definition largely unchanged, but clarifies how to do the calculation.
The essence of Section 10D(2)(b)’s calculation of the clawback for erroneously awarded incentive-based compensation is the excess of what the executive officer received over the amount the executive would have received if an accurate financial statement had been filed. The Clawback Rule incorporates this essence by calculating the clawback as the excess of the total awarded incentive-based compensation less what would have been received had the award been calculated with the accounting restatement.
If the incentive-based compensation is based on stock price, the calculation loses the objectivity of financial statements. In this scenario, the SEC guides companies to calculate the erroneously awarded compensation as a “reasonable estimate” of the effect of the accounting restatement on the applicable measure for which the award was granted. Critically, the issuer must maintain documentation of that “reasonable estimate” and disclose it to the SEC. This flexibility suggests the SEC cares more about the disclosure element of the Clawback Rule rather than the precise mathematical calculation of the clawback.
Discretion in Management’s Decision Not to Recover
The SEC grants management flexibility if the recovery is impracticable, but only in narrow circumstances.
As previously noted, the Clawback Rule was written and adopted based on Dodd-Frank’s legislative history and purpose. The SEC noted the intent of Section 10D is to require executive officers to return money that rightfully belongs to the issuer and its shareholders. The language of Section 10D and the Clawback Rule, the SEC emphasized, should be interpreted by issuers to pursue recovery in most instances, regardless of fault or responsibility for the accounting error.
The Clawback Rule, however, adopts three narrow exceptions to the general clawback rule, dubbed the “Impracticability Exceptions.” A board of directors has discretion to forgo pursuit of erroneously awarded incentive-based compensation in three situations: (1) where the direct cost of recovery would exceed the amount of recovery; (2) where the recovery would violate home country law and additional conditions are met[2]; and (3) when recovery would likely cause an otherwise tax-qualified retirement plant to fail to meet the requirements of the Internal Revenue Code. Before these exceptions are used, issuers are required to make a reasonable attempt to recover erroneously awarded incentive-based compensation.
Discretion in Board’s Means of Recovery
Recovery should be made as soon as practicable, from both a fiduciary and an economic perspective.
The SEC strongly believes boards of directors should have discretion, subject to reasonable restrictions, over the means of recovery. The means of recovery vary by issuer and by type of compensation arrangement. The SEC advises that while boards have ultimate discretion over the means of recovery, a board’s chosen means should reflect the general purpose of Section 10D: to prevent executive officers from retaining compensation that they were not entitled to receive. It is advisable for boards to execute recovery efforts of erroneously awarded compensation as soon as practicable so that the issuer, and thus the shareholders, may capture the time value of the money erroneously awarded, not the executive officer. In this regard, the recapture of money erroneously awarded as compensation is interrelated with board members complying with their fiduciary duties to maximize shareholder value.
For More Information
If you have any questions about this Alert, please contact Darrick M. Mix, Ethan Heller, any of the attorneys in our Capital Markets Group or the attorney in the firm with whom you are regularly in contact.
Notes
[1] “Big R” accounting restatements occur when a firm’s accounting error is material such that the issuer’s previously issued financial statements and auditor’s report are unreliable. “Little r” accounting restatements occur when a firm’s accounting error is immaterial to the prior financial statements. Under U.S. Securities laws, a Big R restatement requires an issuer to, inter alia, file a Form 8-K disclosing the error and correct all prior issued financial statements.
[2] Before concluding it would be impracticable to recover because a recovery would violate home country law, issuers first need to obtain an opinion of home country counsel that recovery would indeed result in a violation of home country law. Further, the home country law must have been adopted prior to the date of publication of Rule 10D-1 in the Federal Register.
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