SEC Proposes Clawback Rules


SEC Proposes Clawback Rules

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Lauralyn G. Bengel

On July 1, 2015, the Securities and Exchange Commission (SEC) issued a proposed rule that implements the clawback provisions of the Dodd-Frank Act.

Dodd-Frank Clawback Requirement

Section 954 of the Dodd-Frank Act added a new Section 10D to the Securities Exchange Act that requires the SEC to adopt rules directing each national securities exchange to prohibit the listing of the securities of any issuer that does not comply with Section 10D’s clawback policy requirements. The statutory clawback requirement set forth in Section 10D(b)(2) is as follows:

“In the event 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, the issuer will recover from any current or former executive officer of the issuer who received incentive-based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.”

Details of the Proposed Rule

The proposed rule spells out a company’s obligations to adopt, enforce and disclose a clawback policy.

Companies Affected. The proposed rule applies generally to all issuers of securities listed on U.S. stock exchanges, including emerging growth companies, smaller reporting companies, foreign private issuers and controlled companies. There are exemptions for issuers of security futures products or standardized options, securities of registered investment companies (if no incentive compensation has been paid to an officer in any of the last three years) and unit investment trusts.

Material Noncompliance. Under the proposed rule, “material noncompliance” with the financial reporting requirements that triggers the application of a clawback policy exists if a company’s financial restatement is necessary to revise “previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements.” Materiality is to be determined based on the particular facts and circumstances, and a series of individually immaterial errors may be viewed as material in the aggregate.

The following retroactive adjustments would not be considered error corrections that would trigger the clawback requirement: a change in an accounting principle; a revision to reportable segment information due to a company’s restructuring; a reclassification due to a discontinued operation; a change in reporting entity; an adjustment to provisions amounts in connection with a prior business combination; or a stock split.

Trigger Date for the Three-Year Look-Back Period. Section 10D requires the recovery of excess incentive compensation “during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement.” Under the proposed rule, this date is the earlier of (i) the date the company’s board, board committee or authorized officers (if board action is not required) conclude, or reasonably should have concluded, that the previously issued financials contain a material error, or (ii) the date a court, regulator or other legally authorized body directs a restatement to correct a material error.

Executive Officers. Section 10D does not define “executive officers”. The proposed rule contains a definition based on the definition in Rule 16a-1(f) under the Exchange Act, and includes the issuer’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division or function (such as sales administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer. Executive officers of the issuer’s parents or subsidiaries would be deemed executive officers of the issuer if they perform such policy making functions for the issuer.

The proposed rule clarifies that the clawback requirements apply to any incentive compensation received by an individual who served as an executive officer at any time during the 3-year look-back period, even if the award was authorized before he/she became an executive officer.

Incentive-Based Compensation. Section 10D requires the recovery of incentive compensation that is “based on financial information required to be reported under the securities laws.” The proposed rule, rather than identifying each specific type of compensation required to be covered by the clawback policy, provides that incentive-based compensation is “any compensation that is granted, earned or vested wholly or in part upon the attainment of any financial reporting measure.” In turn, “financial reporting measures” means (i) measures that are determined and presented in accordance with the accounting principles used in preparing the financial statements, (ii) any measures derived wholly or in part from such financial information and (iii) stock price and total shareholder return. Issuers would be permitted to use reasonable estimates when determining the impact of the restatement on stock price and total shareholder return. Incentive-based compensation would not, for instance, include any plan award that is granted, earned or vested based solely on non-financial events, such as operating a specified number of stores, obtaining regulatory approval of a product, or completing a merger, divestiture or restructuring.

Three-Year Look-Back Period. Under the proposed rule, the three-year look-back period would be the three completed fiscal years immediately preceding the date the issuer is required to prepare a restatement.

When Incentive Compensation is Received. Incentive compensation will be deemed received in the fiscal period during which the financial measure specified in the award is attained, even if the payment or grant occurs after the end of the period. For example:

  • If the grant of an award is based on satisfaction of a financial measure, the award is deemed received in the fiscal period when the measure was satisfied.
  • If an equity award vests upon satisfaction of a financial measure, the award is deemed received in the fiscal period in which it vests.
  • A cash award earned upon satisfaction of a financial measure is deemed received in the fiscal year the measure is satisfied (regardless of the fiscal year in which it is actually paid).

Amount of Recovery. The amount of excess incentive compensation that must be recovered is the amount of incentive compensation received by the current or former executive that exceeds the amount that would otherwise have been received had it been determined based on the accounting restatement. The amounts must be determined on a pre-tax basis. In determining the recovery of compensation based on stock price or total shareholder return, the proposed rule permits a reasonable estimation, if calculated pursuant to the various methodologies set forth in the rule. The rule gives various examples of how to determine the recoverable amount based on the type of award.

Discretion to Seek Recovery. The proposed rule generally follows the “no-fault” mandate of Section 10D, so the extent to which an executive may be responsible for financial statement errors or even involved in the financial reporting process is irrelevant. However, there is a limited exception when the direct costs of enforcing recovery would exceed the recoverable amounts or when recovery would violate home country law.

Disclosure of Policy. A listed company would have to file its clawback policy as an exhibit to its Form 10-K. A company would also have to report in the Form 10-K and in proxy materials detailed information relating to its use of the policy, including identity of persons subject to recovery, the amount of the recovery (including the previously paid incorrect amount), any amounts that were not yet recovered at the end of the fiscal year, and the company’s efforts to recover the amounts. This disclosure requirement applies with respect to all executive officers and not just named executive officers. The information would need to be provided in interactive data format using XBRL and using block-text tagging.

No Indemnification. The proposed rule would prohibit a company from indemnifying any executive against loss of erroneously awarded compensation or from paying or reimbursing the executive for premiums on an individual indemnity insurance policy.

Effective Date. The SEC has solicited comments on a number of topics. Comments are due 60 days after publication of the proposed rule in the Federal Register (which is expected to be sometime in September 2015). Each exchange would be required to file its proposed listing rules no later than 90 days following publication of the final SEC rule, and those rules would have to become effective within one year after publication. Companies would then be required to adopt a clawback policy within 60 days after the date on which the applicable exchange’s rules become effective.