United States: SEC Proposes Dodd-Frank Clawback Rules

On July 1, the SEC issued proposed rules implementing the clawback provision mandated by the Dodd- Frank Act. In broad terms, the proposed rules require the stock exchanges to adopt listing standards that require every listed company to (1) adopt and implement a clawback policy providing for the recovery, under certain circumstances, of incentive compensation paid to executive officers prior to an accounting restatement, and (2) disclose information regarding its clawback policy as required by SEC rules. The listing standard requirement would be codified as new Rule 10D-1 and the disclosure requirements are contained in new Item 402(w) of Regulation S-K as well as amendments to existing provisions.

The rule as proposed would apply to all listed companies, including emerging growth companies, smaller reporting companies, foreign private issuers (with a limited caveat), and controlled companies, as well as companies whose only listed securities are debt securities or preferred stock. (The only exemptions from the rule would be for security futures products, standardized options, and certain registered investment companies.) The stock exchanges would not have discretion to exempt either categories of listed companies or securities.

Under the proposed rule:

  • the stock exchanges would be required to file their proposed listing standards no later than 90 days after publication of final Rule 10D-1 in the Federal Register;
  • the exchange listing standards would be effective no later than one year after publication of final Rule 10D-1; and
  • listed companies would be required to adopt complying clawback policies no later than 60 days after their exchange's listing standard becomes effective.

Clawback would be required of all recoverable incentive compensation (within the meaning of the rule) received for financial performance for any fiscal years ending on or after the effective date of Rule 10D-1. The proposing release states that the clawback policy would apply to any recoverable compensation that is granted, earned, or vested on or after this effective date, including compensation paid pursuant to an agreement entered into before the effective date. The clawback-related disclosures would be required to be provided in all applicable SEC filings required on or after the effective date of the applicable exchange listing standard.

Required Content of Clawback Policy

Trigger for Clawback. Under the Dodd-Frank provision, clawback is required in the event of an accounting restatement due to "material noncompliance" with a financial reporting requirement. The proposed rules clarify the term "material noncompliance" to include any error that is material to previously-issued financial statements. The SEC proposing release clarifies that changes to previously-issued financial statements that are not viewed as error correction under applicable accounting standards -- such as where accounting standards require retroactive application of a change in accounting principles -- would not trigger a clawback. The proposed rule does not address when an error is "material," leaving that determination to be made based on the facts and circumstances. But the SEC release notes that a series of immaterial errors could in some circumstances be considered material when viewed in the aggregate.

The Dodd-Frank provision requires recovery of excess incentive compensation during the three-year period before "the date on which the issuer is required to prepare an accounting restatement." The proposed rule defines this trigger date as the earlier of (1) the date the company's board, board committee, or authorized officers conclude (or reasonably should have concluded) that the previously-issued financial statements contain a material error, or (2) the date a restatement is ordered by a court or regulator to correct a material error. The proposing release notes that the first of these dates is generally the trigger for filing a Form 8-K under Item 4.02(a) to report that previously-issued financial statements should no longer be relied on.

The proposed rule specifies that the three-year look-back period for the recovery of excess incentive compensation is the three completed fiscal years that immediately precede the date the company is required to prepare a restatement. For example, if a calendar year issuer determines in November 2018 that a restatement is required and files the restated financial statements in 2019, the clawback policy would apply to compensation received in 2015, 2016, and 2017.

Officers subject to Clawback. The Dodd-Frank provision requires the clawback policy to apply to current and former "executive officers." The proposed rule defines the term "executive officers" to cover the same individuals who are subject to Section 16. Incentive compensation would be subject to clawback if the individual served as an executive officer at any time during the performance period for that incentive compensation. This would include incentive awards granted before the individual became an executive officer (as well as inducement awards to new hires), so long as the individual served as an executive officer at some time during the performance period. A person who became an executive officer after the end of the performance period, but who is an executive officer at the time clawback is otherwise required for that compensation, would not be subject to the clawback for that compensation.

Compensation subject to Clawback. The proposed rule defines the compensation which is subject to clawback using a principles-based approach. The term "incentive-based compensation" is defined as "any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure." Financial reporting measures are defined as (i) measures that are determined and presented in accordance with the accounting principles used in preparing the company's financial statements, (ii) measures derived wholly or in part from such information, and (iii) stock price and total shareholder return (TSR). A metric meeting this definition would be included even if the amount was not included in the company's financial statements or filed with the SEC. The proposing release gives the example of compensation based on same store sales or regional sales volume; this compensation would be included in the definition of incentive-based compensation -- and subject to clawback in the event of a restatement relating to revenue recognition -- even though the particular sales amount was not disclosed in an SEC filing.

Because the Dodd-Frank Act specifies that compensatory stock options should be subject to clawback, the proposed rule includes as incentive-based compensation stock options and other equity awards, but limits such awards to those whose grant or vesting is based wholly or in part on attainment of metrics based on or derived from financial reporting measures. As a result, most time-vested equity awards would be excluded from the definition. If shares are subject to clawback under this standard, the proceeds from the sale of such shares would also be subject to clawback.

Excluded from the definition of incentive-based compensation is compensation based on performance metrics that are not financial reporting measures. The proposing release gives as examples the opening of a specified number of stores, obtaining regulatory approval of a product, and completion of a merger or divestiture. Similarly, bonuses paid solely at the discretion of the compensation committee would not be subject to clawback. However, discretionary bonuses paid out of a bonus pool whose size is determined wholly or in part based on a financial reporting measure would be subject to clawback. While salaries would not be subject to clawback, the release states that any salary increase earned wholly or in part based on attainment of a financial reporting measure would be subject to clawback.

Amount to be Clawed Back. The Dodd-Frank Act requires clawback of excess compensation "received" in the three years before an accounting restatement is required. Under the proposed rule, incentive-based compensation is deemed received during the fiscal year in which the applicable performance goal for the compensation is attained, even if the payment occurs in a later year. For equity awards whose grant is based on attainment of a performance metric, the award would be deemed to have been received in the year the performance metric was attained; awards whose vesting is based on attainment of a performance metric would be deemed received in the year of vesting. Awards that are subject to additional time-based vesting after attainment of a performance measure would nevertheless be deemed received in the year the performance measure was attained.

The amount of compensation to be recovered by the company is the amount that "exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement." The release explains that the company would first recalculate the applicable performance metric under the restated financials and the amount of incentive compensation based on such metric. The company would then consider the effect of any discretionary increase or decrease to that amount applied by the compensation committee or of any portion of the compensation based on non-financial goals.

The release provides two examples of how this would work. In the first example, an executive is entitled to a payment of $3000 based on the original financial statements, but the company uses negative discretion to reduce the payment to $2000. After the restatement, the corrected financial measurement would entitle the executive to a payment of $1800. Taking into account the company's exercise of negative discretion, the amount to be clawed back by the company is $200 (the $2000 actually paid minus the $1800 to which the executive was entitled under the restated financial statements).

In the second example, the executive is entitled to a payment of $3000 based on the original financial statements, and the company uses positive discretion to increase the payment by $1000, for a total of $4000. After the restatement, the corrected financial measurement would entitle the executive to a payment of $1800. Taking into account the company's exercise of positive discretion, the amount to be clawed back by the company is $1200 ($3000 minus $1800), letting the executive retain the additional $1000, provided that based on the revised financial measurement the additional $1000 payment was still permitted under the terms of the plan.

For awards paid from bonus pools where the size of the pool is determined by a financial reporting measure, the company would first calculate the amount of the pool as determined by the restated financial measure. If the bonus pool as so reduced would have been sufficient to cover all bonuses actually paid, no clawback would be required. If the reduced bonus pool would not have been sufficient, the amount to be clawed back from each executive officer would be a pro rata portion of the deficiency. With respect to equity awards, if the shares, options or SARs are still held by the executive at the time recovery is required, the amount to be recovered would be the number of shares, options, or SARs received in excess of the number that should have been received. If options or SARs have been exercised but the shares received upon exercise have not been sold, the company would recover the number of net shares reflecting the excess options or SARs received by the executive (i.e., only the number of shares reflecting the option spread on the excess options or SARs would be clawed back). If the shares have been sold, the amount to be clawed back would be the sale proceeds received by the executive with respect to the excess number of shares.

For incentive-based compensation that is based on stock price or total shareholder return, the amount of erroneously-awarded incentive compensation cannot be calculated directly from the information in the accounting restatement. In these circumstances, the company would need to determine the recoverable amount based on a "reasonable estimate" of the effect of the accounting restatement on the stock price (or TSR). The proposed rule allows the company discretion to decide the methodology to be used in making this estimate.

The proposing release mentions two possible methods for estimating the effect of a restatement on a company's stock price. One method is an "event study" that uses a complex model to separate the effect of the restatement from changes in the stock price due to market factors or other news affecting the company. A less complex methodology noted in the release involves using publicly available historical estimates of beta to capture the correlation of the stock's return with the overall return of the market over a certain period of time.

Under any methodology, the company would need to make assumptions regarding a number of inputs, such as a proxy for market returns, the date and time that investors learned about the restatement, and the length of time it took for the information in the restatement to be reflected in the stock price. Companies would be required to provide their stock exchange with documentation of the estimates used.

The amount to be clawed back is to be calculated on a pre-tax basis (i.e., without regard to any taxes paid by the executive on the larger amount).

Company Discretion regarding Clawback. Under the proposed rule, a company would be required to recover compensation paid based on erroneous financial information unless recovery would be impracticable because the direct costs of enforcing the clawback policy (i.e., amounts paid to a third party, such as legal fees) would exceed the recoverable amount or, in the case of a foreign issuer, the clawback would violate the company's home country law. The release expressly states that neither an executive's lack of responsibility for the financial statement errors nor the clawback policy's conflicts with existing compensation contracts would be a basis for finding recovery to be impracticable. A company would need to make a reasonable attempt to recover the excess compensation and provide documentation of its attempt to the stock exchange. Before concluding that enforcing its clawback policy would violate home country law, a company would need to obtain an opinion of home county counsel to that effect. Any determination that clawback would be impracticable would need to be made by an independent compensation committee and the reasons for that determination would need to be disclosed by the company.

The proposed rule does not mandate a particular means of recovery. The proposing release notes that commenters had suggested a variety of approaches that a company might want to take, including recovery over time or from future pay, through forfeiture of outstanding equity awards, by reduction of deferred compensation, as well as repayment by the executive. The release states that while companies should be able to exercise discretion in this area, recovery should be "reasonably promptly" in order to effectuate the purpose of the clawback provision. The stock exchange on which the company is listed would determine whether the company's actions constitute prompt recovery of the excess compensation.

Disclosure Requirements

U.S. Companies. The proposed rules would require each domestic listed company to file its clawback policy as an exhibit to its annual report on Form 10-K. In addition, Item 402 of Regulation S-K would be amended (by adding a new Item 402(w)) to require listed companies to disclose (in proxy statements and annual reports) how they have applied their clawback policies. This disclosure item would be triggered if during the last completed fiscal year there was either a restatement that required recovery of excess incentive compensation or an outstanding balance of excess compensation that was required to be recovered based on a prior restatement. Specifically, the company would be required to disclose:

  • for each restatement, the date the company was required to prepare the restatement, the aggregate dollar amount of excess incentive compensation attributable to the restatement, and the amount of excess compensation that is unpaid as of the end of the last completed fiscal year;
  • the estimates used to determine the amount of excess incentive compensation related to measures of stock price or total shareholder return;
  • the name of each person subject to clawback from whom the company has decided not to pursue recovery, the amount forgone for each such person, and the reason the company decided not to pursue recovery; and
  • the name of each person from whom, at the end of the last completed fiscal year, excess compensation had been outstanding for 180 days or more since the date the company determined the amount owed by such person, and the dollar amount of excess compensation due from such person.

The disclosure required by Item 402(w) would also be required to be provided in interactive data format, using XBRL with block-text tagging. The interactive data would be required to be provided as an exhibit to the proxy statement and Form10-K.

The Summary Compensation Table would also be revised to require that amounts reported in the table as paid in a prior year be reduced by the amount clawed back, with footnote disclosure of the amount recovered. This disclosure would apply only if the clawback related to compensation paid in a year covered by the table.

Foreign Issuers. Foreign issuers would be required to file their clawback policies as exhibits to their annual reports on Form 20-F. The Form 20-F would also require disclosure parallel to that called for by S-K Item 402(w), including the requirement to tag the disclosure in an interactive data format when the tagging requirement becomes applicable to financial statements of such issuers.

Indemnification and Insurance

The proposed rule would prohibit a listed company from indemnifying any current or former officer against loss of compensation that is required to be clawed back. The proposing release explains that indemnification would undermine the purpose of the statutory provision, which is to prevent an executive officer from retaining compensation that the executive would not have received if the accounting had been done properly.

An executive officer would be permitted to purchase third party insurance to fund potential clawback repayments. However, the release states that the rule's indemnification provision would prohibit the company from paying or reimbursing the executive for premiums for such an insurance policy.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions