You Are Running Out of Time to Adopt a Clawback Policy
June 07, 2023
The SEC has approved listing standards adopted by the NYSE and Nasdaq that require companies to implement policies to recover compensation awarded to executive officers that later turns out to be erroneous as a result of a material financial restatement. This brings us to the final stages of what has been a long road to implementation of rules that were called for over a decade ago under the Dodd-Frank Act.
The Road to Final Clawback Rules
For reasons that I don’t fully understand, the SEC apparently can’t just make a rule that all public companies have to implement a clawback policy. Instead, Dodd-Frank directs the SEC to mandate that US securities exchanges include a clawback policy requirement in their listing standards. As a result, finalizing these rules has been a multistep process. Here’s where we’re at:
Step 1: The SEC adopts rules directing US securities exchanges to promulgate standards requiring listed companies to implement clawback policies as described by the SEC. The SEC adopted these rules in October 2022.
Step 2: The US exchanges propose the new listing standards as required in step #1. These standards were proposed in February of this year.
Step 3: The SEC approves the listing standards proposed by the exchanges. This just happened, on June 9.
Step 4: The listing standards become effective. This will occur on October 2 of this year.
Step 5: Companies have 60 days from the effective date to adopt clawback policies that comply with the new rules. With an effective date of October 2, companies have until December 1 to implement their clawback policies. Some of you may be ahead of the game and already have a fully compliant clawback policy in place; others of you may still be working on your policy. If you are in the latter category, it’s time to get going.
Background of the Proposed Rules on Compensation Recovery
As noted above, the listing standards require companies to implement policies under which incentive-based compensation paid to executive officers will be clawed back if payments were based on financial measures that have since been materially restated.
The intent behind this requirement seems logical. Say that a company makes a payment to an officer based on the company having achieved a specified financial result. Then, after making the payment, the company discovers an error that causes it to restate its financials and, under the restated financials, the officer would not have earned the previously paid compensation. This section of Dodd-Frank is intended to ensure that the officer has to return the compensation that wasn’t earned. In theory, this seems reasonable. If the officer didn’t earn the compensation, should they be able to keep it?
But, in practice, recovering compensation in this circumstance is challenging, for a host of reasons. The requirements here are also much broader than the current clawback rules that are in effect under the Sarbanes-Oxley Act (which require misconduct and apply only to the CEO and CFO).
Which Companies Are Subject to the New Clawback Rules?
Because the clawback rules have been implemented in the form of listing standards, they apply to all companies listed on the NYSE and Nasdaq.
Comments on the SEC’s proposed rules suggested excluding emerging growth companies, smaller reporting companies, and foreign private issuers but the SEC chose not to do so; thus, even newly public companies will need to have a clawback policy in place.
Which Officers Are Subject to the Rules?
Clawback policies will be required to apply to all current executive officers (generally the same officers who are subject to Section 16) and former executive officers.
What Compensation Is Subject to Recoupment?
Only incentive compensation that is granted, earned, or vested contingent upon financial measures will be required to be subject to recovery. The final rules, however, interpret this to include both GAAP and non-GAAP measures, and total shareholder return or stock price targets.
Some commenters argued that stock price targets and TSR should not be considered financial measures but failing to include them would have given companies a loophole to avoid complying with the requirement. The SEC notes in the adopting release that:
Stock price and TSR are frequently used incentive-based performance metrics for executive compensation, such that excluding them could lead issuers to alter their executive compensation arrangements in ways that would avoid application of the mandatory recovery policy, undermining the objectives of the rule, as well as impacting efficient incentive alignment.
When Is Recovery of Compensation Required?
Companies must implement policies to recover incentive-based compensation when required to issue a restatement as a result of material noncompliance with financial reporting standards, regardless of whether intent, fraud, or misconduct is involved.
There is a lot of discussion in the SEC’s final rules about “big R” and “little r” restatements. In a big R restatement, the company must issue a Form 8-K and amend its public filings to correct the error. In a little r restatement, there’s no 8-K and the correction is made simply by correcting the prior period results included in the current financial statements. The important thing to know is that, if material, both types of restatements can trigger the recovery requirement. This is a broader interpretation of which restatements can trigger recovery than the SEC initially proposed.
It's also worth emphasizing that recovery is required regardless of intent or the involvement of fraud or misconduct. Thus, companies could be required to claw back compensation even if the restatement is the result of an honest mistake or misunderstanding, or where the executive officer had no control over the reported financials.
How Much Compensation Must Be Recovered?
The amount of compensation that must be recovered is the excess of the amount granted or paid over the amount the officer is entitled to, based on the restated financials. In the context of equity awards, you would compare the number of shares or units that were granted or vested to the number that should have been granted or vested based on the restated financials. The difference between these two amounts is subject to recovery.
This is tricky to determine for awards in which vesting is contingent on TSR or stock price targets. In that case, the company will have to estimate the impact of the error on its stock price and calculate the portion of the award that would have vested based on the estimated stock price. Between this requirement and the pay vs. performance disclosures, valuation consultants should have no shortage of work.
What Is the Recovery Period?
Recovery policies should cover incentive compensation received during the three fiscal years preceding the date that the company first becomes aware that the restatement is necessary, reasonably should have been aware that the restatement would be necessary, or is directed to restate its financials by a court or regulatory agency.
An important nuance here is that compensation is considered to be “received” during the fiscal period that the financial measure is achieved, regardless of when it is actually granted or paid. In the context of stock compensation, this means the following:
- If the grant of an award is based on satisfaction of a financial reporting measure, the award is deemed received in the fiscal period when that measure was satisfied even if not granted until a subsequent period
- If an equity award vests only upon satisfaction of a financial reporting measure, the award is deemed received in the fiscal period when it vests. Conversely, if an award is subject to both service-based and performance-based goals, the award is considered received in the period that the performance-based goals are achieved, even if the award continues to be subject to additional service-based vesting requirements.
The adopting release also notes that “Ministerial acts or other conditions necessary to effect issuance or payment, such as calculating the amount earned or obtaining the board of directors’ approval of payment, do not affect the determination of the date received.”
Are There Any Exceptions?
Probably the most helpful exception to the compensation recovery requirement is that companies are not required to pursue recovery if the expenses they would have to pay to a third party (e.g., outside counsel) to do so would exceed the amount of recoverable compensation. The company would still need to make a reasonable attempt to recover the compensation and provide documentation of that attempt to the exchange.
Disclosures of Compensation Recovery
In addition to requiring companies to implement a clawback policy, the rules require a number of disclosures related to that policy.
10-K Checkboxes: Two checkboxes will be added to the cover of Form 10-K to indicate the following:
- Whether the included financial statements reflect correction of an error to previously issued financial statements.
- Whether those restatements trigger recovery analysis of incentive-based compensation received by the company’s executive officers.
10-K Exhibit: The recovery policy itself will be filed with the SEC as an exhibit to Form 10-K.
Reg S-K Item 402(w): Under new item 402(w), companies will be required to disclose whether a restatement that triggered recovery of compensation has occurred in the past year or there is an outstanding balance of unrecovered compensation as of the end of the last fiscal year. For each such restatement, the company must disclose the following:
- The date on which the company was required to prepare a restatement and the aggregate amount of compensation recoverable as a result of the restatement.
- The aggregate amount of erroneously awarded compensation that remains unrecovered as of the end of the last fiscal year.
- If the recovery relates to TSR or stock price targets, the method used to estimate the impact of the restatement on the company’s stock price.
- The names of and amounts recoverable from current and former officers for whom recoverable compensation remains outstanding for more than 180 days.
- For each named executive officer for whom the company decides not to pursue recovery of compensation, the company would have to disclose the name of the person, the amount recoverable, and a brief description of the reason the company decided not to pursue recovery. For other officers (and former officers), this disclosure shall be made in aggregate without identifying the specific officers.
Summary Comp Table: Where amounts reported in the SCT have been recovered, the reported amounts should be reduced for the recovery and the amounts recovered should be indicated in a footnote.
When Do Companies Have to Comply with These Rules?
There is some good news here. As originally issued, the listing standards would have been effective immediately upon approval by the SEC. But both the NYSE and Nasdaq amended the proposed standards to make them effective as of October 2. Companies then have 60 days to adopt their clawback policies, which gives them until December 1, 2023.
Jones Day has published an A-to-Z guide to the final rules that I found helpful in writing this blog entry.
This memo by Orrick includes a sample of what a clawback policy might look like.
WTW has published a three-part “game plan” on ensuring that your clawback policies comply with the new rules.
And, of course, the session “How to Apply the SEC’s New Clawback Rules” at this year’s NASPP Conference is a great opportunity for you to get answers to your questions as you finalize your own policies.