SEC Adopts Compensation Clawback Requirements

The US Securities and Exchange Commission (SEC) announced on October 26, 2022, that it has adopted new rules directing national securities exchanges, including the New York Stock Exchange and Nasdaq, to establish listing standards requiring companies to implement ”clawback” policies providing for the recovery of incentive-based compensation in the event of a required accounting restatement, and requiring companies to provide related disclosure.

Background

In 2015, the SEC proposed new rules to implement Section 954 of the Dodd-Frank Act, which requires the SEC to adopt rules directing national securities exchanges (exchanges) to establish listing standards requiring companies to develop and implement a compensation recovery (also known as a “clawback”) policy. The policy must provide for the recovery, in certain circumstances, of incentive-based compensation received by current or former executive officers based on financial information required to be reported under the securities laws that was erroneously reported. Read our analysis of the original 2015 proposed rules >

The SEC reopened the comment period for the proposed rules in October 2021 and again in June 2022. The final rules reflect major distinctions from the proposed rules, as described below.

Compensation Recovery Policy

New Rule 10D-1 of the Securities Exchange Act of 1934, as amended (Exchange Act), will require exchanges to adopt listing standards that will apply the disclosure and compensation recovery policy (recovery policy) requirements to all listed companies, with limited exceptions. Companies will be subject to delisting if they do not adopt and comply with their recovery policies.

The rules do not exempt any specific categories of companies, such as foreign private issuers, smaller reporting companies, or emerging growth companies. In this regard, the SEC noted in the adopting release that it expects clawback requirements to encourage reliable financial reporting by these companies.

The SEC also declined to grant exchanges discretion to exempt certain categories of securities from the rules. However, the rules exempt the listing of certain security futures products, standardized options, securities issued by unit investment trusts, and securities issued by certain registered investment companies. Also, the rules will not apply to exchanges that only trade securities pursuant to unlisted trading privileges but do not list securities.

The rules require clawback policies to apply to any current or former executive officer as defined in Rule 10D-1(d),[1] and not just named executive officers for whom compensation disclosure is required in the company’s annual proxy statement. The rules also are not limited to those executive officers who may be “at fault” for the accounting errors that led to the restatement that triggered the clawback. In addition, the rules prohibit companies from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.

Clawback policies must apply to compensation received during the three-year period preceding the date the issuer is required to prepare the accounting restatement. The date on which a company is required to prepare a restatement is the earlier to occur of (1) the date the company’s board of directors (or a committee of the board or authorized officers) concludes, or reasonably should have concluded, that the company is required to prepare a restatement, or (2) the date a court or regulator directs the company to prepare a restatement.

Types of Restatement Covered

The Dodd-Frank Act focused on compensation recovery “in the event that the [company] is required to prepare an accounting restatement due to the material noncompliance of the [company] with any financial reporting requirement under the securities laws.” Under the final rules, clawback policies must mandate compensation recovery in the event a company is required to prepare an accounting restatement due to its material noncompliance with any financial reporting requirement under the securities laws.

The adopting release emphasizes that the new rules cover both “Big R” and “little r” restatements. “Big R” restatements correct errors that are material to previously issued financial statements and require companies to file an Item 4.02 Form 8-K and amend their filings promptly to restate the previously issued financial statements.

In contrast, “little r” restatements correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (1) the errors were left uncorrected in the current filing or (2) the error correction was recognized in the current period. As such, “little r” restatements entail making any corrections the next time the company files the prior year’s financial statements and generally do not require an Item 4.02 Form 8-K.

The inclusion of “little r” restatements is a stark departure from the original 2015 rule proposal. The SEC notes in the adopting release that “both types of restatements address material noncompliance . . . with the financial reporting requirements.”[2] The SEC also conveyed that this expanded approach addresses concerns that companies “could manipulate materiality and restatement determinations to avoid application of the recovery policy.”

In another departure from the proposed rules, the SEC declined to define the terms “accounting restatement” and “material noncompliance,” noting that both are covered by existing accounting standards and guidance.

Incentive-Based Compensation Subject to Recovery Policy

The new rules define “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.”[3]

The new rules define “financial reporting measures” as “measures that are determined and presented in accordance with the accounting principles used in preparing the [company’s] financial statements, and any measures that are derived wholly or in part from such measure.”[4] These include stock price and total shareholder return, as well as non-GAAP financial measures. The rules also specify that a financial reporting measure need not be presented within the financial statements or included in an SEC filing. The SEC opted for a principles-based approach to the definition to “capture new forms of compensation that are developed and new measures of performance upon which compensation may be based.”[5]

Under the new rules, incentive-based compensation will be deemed received for purposes of the recovery policy in the fiscal period during which the financial reporting measure specified in the award is attained, even if the payment or grant occurs after the end of that period. The SEC noted that where an award is subject to multiple conditions, the executive officer need not satisfy all conditions to an award for the incentive-based compensation to be deemed received for purposes of triggering the recovery policy.

Disclosure Requirements

The new rules will require disclosure relating to a company’s recovery policy and any recovery thereunder. Specifically, the rules direct the exchanges to adopt listing standards requiring clawback policy disclosure. The rules also amend Item 402 of Regulation S-K to require disclosure regarding application of the company’s clawback policy.

New Item 402(w) requires disclosure if, at any time during or after a company’s last completed fiscal year, the company was required to prepare an accounting restatement that required recovery of erroneously awarded compensation pursuant to its clawback policy, or if there was an outstanding balance as of the end of the last completed fiscal year of erroneously awarded compensation to be recovered from the application of the clawback policy to a prior restatement.

A company that triggers the disclosure requirement above must disclose the following:

• The date when the company was required to prepare an accounting restatement and the aggregate dollar amount of erroneously awarded compensation attributable to such accounting restatement (including an analysis of how the recoverable amount was calculated) or, if the amount has not yet been determined, an explanation of the reasons and disclosure of the amount and related disclosures in the next filing that contains disclosure responsive to Item 402 of Regulation S-K.
• The aggregate dollar amount of erroneously awarded compensation that remains outstanding at the end of the company’s last completed fiscal year.
• If the financial reporting measure related to a stock price or total shareholder return metric, the estimates used to determine the amount of erroneously awarded compensation attributable to such accounting restatement and an explanation of the methodology used for such estimates.
• If recovery would be impracticable pursuant to the exceptions enumerated in Rule 10D-1(b)(1)(iv),[6] for each current and former named executive officer and for all other current and former executive officers as a group, the amount of recovery forgone and a brief description of the reason the company decided in each case not to pursue recovery.
• For each current and former named executive officer, the amount of erroneously awarded compensation still owed that has been outstanding for 180 days or longer since the date the company determined the amount owed.

The SEC also adopted corresponding amendments to Form 20-F and Form 40-F. Companies will be required to tag their compensation recovery disclosure in Inline XBRL.

Other Requirements

In addition to new disclosure requirements, the new rules amend the cover page to Form 10-K, Form 20-F, and Form 40-F to require check boxes indicating whether the filing reflects the correction of an error to previously issued financial statements, and whether any of those error corrections triggered recovery of incentive-based compensation under the company’s clawback policy.

Further, the rules amend Item 601(b) of Regulation S-K to require companies to file their recovery policies as an exhibit to annual reports on Form 10-K, Form 20-F, and Form 40-F, as applicable.

Effectiveness and Compliance Deadline

The final rules will become effective 60 days following publication of the adopting release in the Federal Register. Exchanges will be required to file proposed listing standards no later than 90 days following publication of the adopting release in the Federal Register, and the listing standards must be effective no later than one year following such publication. Companies subject to such listing standards will be required to adopt a recovery policy no later than 60 days following the date on which the applicable listing standards become effective.

Although the SEC explained that it “would not expect compliance with the disclosure requirement until [companies] are required to have a policy under the applicable exchange listing standard,”[7] the adopting release states that companies “must begin to comply with the disclosure requirements in proxy and information statements and their annual report on Form 10-K on or after the [company] adopts its recovery policy.”[8]

Next Steps

Companies are not required to adopt clawback policies in accordance with the new rules until the exchanges amend their listing standards to require adoption of clawback policies.

In the meantime, companies are advised to review their existing clawback policies to determine what modifications will be needed to comply with the new rules. Potential revisions include those relating to which officers are covered (including covering former officers), the types of compensation covered, the kinds of restatements that trigger compensation recovery, the lookback period, the mandatory nature of clawbacks under the new rules, and the exceptions to compensation recovery.

Companies that currently have clawback policies that cover both a restatement and misconduct may want to continue to allow discretionary clawback in the event of misconduct, in addition to the mandatory clawback in the event of a restatement, as required under the new rules.