United States: Get Ready To Be Clawed, With The SEC's Blessing, And It May Cost You Dearly

Imagine you are a former executive of a public company, where your role was unrelated to the preparation of its financial statements, and you are notified years after leaving the company that it will be pursuing the return of substantial portions of your incentive-based compensation, which you might have already spent for your children's college education or otherwise, since the compensation was based on financial statements that were, in fact, incorrectly reported. If the Securities and Exchange Commission's ("SEC" or the "Commission") currently proposed rules from earlier this summer on "clawing back" incentive compensation that is based on misstated financial statements are adopted as they are currently proposed (the "Proposed Clawback Rules" or the "Rules"),1 this situation may be a common occurrence. Is that fair or appropriate? We guess that depends on your point of view. Clearly the majority of the SEC's Commissioners think so.

By way of background, the SEC was directed to draft the Proposed Clawback Rules by Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank"), which added Section 10(D) to the Securities Exchange Act of 1934 (the "Exchange Act").2 The Proposed Clawback Rules were the SEC's final executive compensation proposal that was required by the statute.3 Both Section 954 of Dodd-Frank and the Proposed Clawback Rules require national securities exchanges and associations to prohibit listing the security of an issuer who has not adopted, disclosed, and complied with "clawback" policies for recovering incentive-based compensation that is based on erroneously reported financial information that was later corrected in an accounting restatement.4 Thus, the responsibility to "claw back" this excess incentive-based compensation from current and former executives is ultimately placed on the companies themselves. The Proposed Clawback Rules would apply to "all issuers," and would include emerging growth companies, smaller reporting companies, and foreign private issuers, as the SEC reads the language of Section 954 of Dodd-Frank as "generally calling for a broad application of the mandated listing standards."5

In the five months since the SEC approved the Proposed Clawback Rules, by a 3-2 vote,6 various parties have raised a number of concerns about the ambiguities and problematic areas related to the Rules.7 For instance, in a comment letter on September 21, 2015, the Corporate Governance Coalition for Investor Value, an advocacy group whose members include the Securities Industry and Financial Markets Association, the American Bankers Association, the American Insurance Association, and the U.S. Chamber of Commerce, wrote that it believes the Proposed Clawback Rules are "overly prescriptive and, in several important respects, simply unworkable."8 With the comment period having closed in mid-September of 2015, it is likely that the Proposed Clawback Rules will be finalized in the coming year. Co-author and BakerHostetler Partner Marc D. Powers last month addressed how many of these issues may impact executives and companies based on the currently drafted Rules, and how the SEC may potentially address these issues in finalizing the Rules, at a panel that included former SEC General Counsel Ralph C. Ferrara and was sponsored by Wolters Kluwer and Above the Law at the Harvard Club on November 12, 2015.9 An overview of these issues is provided below.

The Proposed Clawback Rules Apply to Any Executive With a "Policy-Making" Function and Without Regard to Fault

Section 954 of Dodd-Frank requires national securities exchanges and associations to adopt listing standards that require issuers to adopt and comply with policies that provide for recovery of excess incentive-based compensation from "any current or former executive officer of the issuer who received incentive-based compensation."10 However, Section 954 does not define "executive officer."11 The Proposed Clawback Rules take an expansive view in defining executive officers, as they apply to "all executive officers of the issuer," as long as the executive officer served in his or her position at any time during the performance period related to the incentive-based compensation.12

The definition of "executive officer" in the Proposed Clawback Rules is modeled on the definition of "executive officer" under Section 16 of the Exchange Act, and would include, in addition to the president, principal financial officer, and principal accounting officer, any vice president in charge of an official business unit or any officer "who performs a policy-making function" for the issuer.13 It is noteworthy that the category of executives subject to the Proposed Clawback Rules is much broader than those subject to clawback actions by the SEC under Section 304 of the Sarbanes-Oxley Act ("SOX"). SOX actions only apply to the chief executive officer and chief financial officer, who have to certify the financial statements and have the greatest interest in ensuring they are accurate.14

Another important and controversial piece is that the Proposed Clawback Rules would apply regardless of the fault of the executive officer. They would apply "without regard to an executive officer's responsibility for preparing the issuer's financial statements.15 Thus, the Proposed Clawback Rules are essentially a "no fault" policy, and would apply as long as the executive officer served in his or her position and received incentive compensation at any time during the award's applicable performance period, even if the award was authorized before the individual became an executive officer.16

The SEC believes that both executives with policymaking functions and executives who have an important role in the preparation of financial statements "set the tone for and manage the issuer," and thus applying a clawback recovery policy to these employees would effectively realize the statutory goals of Section 954 of Dodd-Frank.17 The majority also believes that if a financial restatement occurs, persons who have wrongly received compensation based upon wrong financials should have to return those monies to the company. However, the ambiguity in the phrase "policy-making function" may lead to employees who have policy-making functions but do not "set the tone for and manage the issuer," or play any role in preparing financial statements or in the financial aspects of the business, being unexpectedly subject to clawback actions. Such employees may include the head of human resources or the head of information technology. What if they have already spent the monies years earlier under the belief it was theirs to use? Must all former employees of public companies now keep a portion of the monies received aside, in a sort of trust fund, in the random and rare event that their former company issues a financial restatement?

In finalizing the Proposed Clawback Rules, the SEC has indicated it is possible that it may either expand the definition of executive officer or make it more limited. In its request for comment, the SEC inquired whether the proposed definition of executive officer should be expanded to specifically name any other positions, such as chief legal officer, or include any other officers that would not fall in the proposed definition.18 At the same time, the Commission also requested comment on whether the current definition is "too broad," if the definition is currently appropriate, and if there are other means of simplifying the definition of "executive officers."19 So we shall have to wait and see.

Issues Surrounding the Bringing and Settling of a Clawback Action

Section 954 of Dodd-Frank states that if an 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," an issuer must recover incentive-based compensation that is based on erroneously reported financial information from any current or former executive officer who received this incentive-based compensation during the three-year period preceding the date on which the issuer is required to bring an accounting restatement.20 However, there are numerous ambiguities contained in the language of both Section 954 of Dodd-Frank and the Proposed Clawback Rules related to actually bringing a clawback action:

  • "Material Noncompliance": The Proposed Clawback Rules define the "material noncompliance" language from Section 954 of Dodd-Frank as "an error that is material to previously issued financial statements."21 An accounting restatement is further defined as "the result of the process of revising previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements."22 The Commission explicitly would not describe any type or characteristic of an error that would be considered material for purposes of the listing standards required by Section 954 of Dodd-Frank, since materiality is "a determination that must be analyzed in the context of particular facts and circumstances."23 However, the SEC did outline instances that would not be material, such as a retrospective application of a change in an accounting principle.24 Given the lack of guidance as to what a "material error" would be, this is likely an area that could be extensively litigated, particularly by former executives who disagree with whether the issuing of an accounting restatement was, in fact, "required." There may also be disputes about the correct amount or valuation of the attempted clawed compensation emanating from a particular restatement.
  • "Reasonably Conclude": An issuer is required to prepare an accounting restatement upon the earlier of (1) the date the issuer's board of directors or officers authorized to take such action (if board action is not required) concludes or reasonably should have concluded that the issuer's previously issued financial statements contain a material error, or (2) the date a court, regulator, or other legally authorized body directs the issuer to restate its previously issued financial statements to correct a material error.25 Thus, the three-year lookback period is not triggered when the restatement is actually filed.26 This is again in contrast to Section 304 of SOX, which allows compensation to be clawed back in the 12-month window before the issuance of the accounting restatement.27 The SEC does not provide any benchmarks or guidance that can be used to define the date as to when a board of directors would actually "reasonably conclude" that previously issued financial statements contain a material error.
  • "Reasonably Promptly": An issuer must pursue recovery of an issuer's excess incentive-compensation "reasonably promptly," since "undue delay" would constitute noncompliance with the recovery policy.28 Even though a clawback action must be brought "reasonably promptly," the Rules are silent as to any statute of limitations which might apply. Is it the state law statute of limitations for the claims themselves, such as six years for unjust enrichment or breach of contract? Or is it based upon some statutes of limitations or repose applicable to federal securities laws? Will derivative claims be allowed? Where should or can these actions be brought, and in state or federal courts? Can employment contracts provide for all of these disputes to be handled in confidential arbitrations?
  • "Reasonable Attempt" and "Impracticable": Further, the Proposed Clawback Rules make it mandatory for erroneously awarded compensation to be pursued unless the issuer has made a "reasonable attempt" at recovery and determined that it would be "impracticable" to do so. However, the Rules provide no guidance as to what constitutes a "reasonable attempt," and only a limited definition as to what would be considered impracticable.29 The Proposed Clawback Rules define recovery as impracticable if it would impose undue costs on a company, meaning the direct costs of enforcing recovery would exceed the recoverable amounts, or would violate a foreign company's home country laws, provided certain other conditions are met, such as obtaining an opinion of counsel that practices in the home country that recovery would result in a legal violation.30 An issuer essentially has no discretion to not attempt to recover compensation, as in order to determine impracticability that issuer must still follow the mandated recovery process to conclude it is impracticable. This is again more stringent than Section 304 of SOX, which allows for the SEC to exempt from a clawback action "any person...as it deems necessary and appropriate." Moreover, there does not seem to be any discretion afforded a company's board of directors to settle a clawback action for less than the full amount claimed. That will presumably be a major problem as these cases are brought and unfold in the coming years, as it will be more likely former, rather than current, officers who fight these actions. Notably, Chairman Mary Jo White indicated that she is interested in receiving comments on how boards would make such a determination of impracticability.31 Commissioner Daniel Gallagher, in his dissenting statement on the Proposed Clawback Rules, noted that he unsuccessfully requested that the Rules provide additional discretion to an issuer's board of directors in determining whether to pursue a clawback, as he feels the Rules as they are currently drafted reflect a "view that a corporate board is the enemy of the shareholder, not to be trusted to do the right thing." 32

Looking Forward

The Proposed Clawback Rules would apply to any awards granted, earned, or vested on or after the effective date of Rule 10(D)(1) of the Exchange Act.33 As this includes awards that are earned or vested after the effective date, and as many awards have substantial vesting periods, the finalized rules can potentially impact awards that were granted prior to the effective date. Issuers would be required to adopt a compliant clawback policy no later than 60 days following the effective date of the applicable exchange adopting final listing rules.34 Many, such as the Corporate Governance Coalition for Investor Value, have advocated that when the Proposed Clawback Rules are finalized they should not have retroactive effect, and should only apply to awards that were granted after the effective date of the final rules.35

As the Proposed Clawback Rules as currently drafted do not apply to certain types of compensation that are unrelated to accounting-related metrics or stock price and total shareholder return metrics, such as bonuses paid solely at the discretion of a company's board of directors or equity awards that vest solely upon completion of a specified employment period, issuers will likely seek to modify existing executives' compensation agreements in order to avoid the impact of any new rule.36 However, issuers are prohibited from engaging in an end-run around the clawback policy by indemnifying any current or former executive officer against the loss of erroneously awarded compensation.37 Additionally, issuers are prohibited from paying the premiums on an insurance policy that would cover an executive's potential clawback obligations.38 But an executive is permitted under the Rules to pay his or her own premiums on insurance related to clawbacks.39 Some, such as Commissioner Piwowar, have speculated that this may lead to companies increasing executives' compensation.40

Chairman Mary Jo White indicated that she was "very interested" in receiving public comment on the Proposed Clawback Rules and recognized that there will be complexities in putting the Rules into practice.41 She now has them in. So while the Proposed Clawback Rules in their current state have considerable ambiguities related to their application, and some unfairness to them, the Rules may ultimately address some of these issues in their final form. Either way, there will be a new cottage industry for these kinds of litigations in the legal field.

Footnotes

1 SEC Proposes Rules Requiring Companies to Adopt Clawback Policies on Executive Compensation, Press Release 2015-136 (July 1, 2015), available at http://www.sec.gov/news/pressrelease/2015-136.html; Listing Standards for Recovery of Erroneously Awarded Compensation, Securities Act Release 33-9861; Exchange Act Release No. 34-75342, 80 Fed. Reg. 41144 (July 14, 2015), available at http://www.gpo.gov/fdsys/pkg/FR-2015-07-14/pdf/2015-16613.pdf.

2 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, § 954, 124 Stat. 1376.

3 SEC Proposes Rules Requiring Companies to Adopt Clawback Policies on Executive Compensation, Press Release 2015-136 (July 1, 2015), available at http://www.sec.gov/news/pressrelease/2015-136.html.

4 Proposed Clawback Rules at p. 6-8.

5 Proposed Clawback Rules at p. 10-11. There are "limited exceptions" for security futures products, standardized options, and the securities of certain registered investment companies. Id. at 10.

6 For additional background on the Proposed Clawback Rules, please see John M. Gherlein, SEC Proposes Clawback Rules (July 30, 2015), available at http://www.bakerlaw.com/alerts/sec-proposes-clawback-rules.

7 SEC, Comments on Proposed Rule: Listing Standards for Recovery of Erroneously Awarded Compensation, http://www.sec.gov/comments/s7-12-15/s71215.shtml.

8 Comment Letter from the Corporate Governance Coalition for Investor Value to SEC Commissioners re: Proposed Rules on Listing Standards for Recovery of Erroneously Awarded Compensation (Release Nos. 33-9861, 34-75342, IC-31702; File No. S7-12-15) at 1, Sept. 21, 2015, available at http://www.sec.gov/comments/s7-12-15/s71215-61.pdf.

9 A video of the panel can be found here: https://www.brainshark.com/WKLB/ATL1?DM=1.

10 Exchange Act § 10(D)(2).

11 Proposed Clawback Rules at p. 32.

12 Proposed Clawback Rules at p. 33, 35-36.

13 Proposed Clawback Rules at p. 34.

14 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 304, 116 Stat. 745.

15 Proposed Clawback Rules at p. 34-35.

16 Proposed Clawback Rules at p. 35-36 (emphasis added).

17 Proposed Clawback Rules at p. 34.

18 Proposed Clawback Rules at p. 36.

19 Proposed Clawback Rules at p. 36-37.

20 Section 10(D)(2) of the Exchange Act. Section 304 of SOX has similar language related to an issuer's "material noncompliance" in connection with financial reporting requirements under the securities laws, while the incentive-compensation that can be clawed back is limited to the 12-month period following the issuance of the restatement.

21 Proposed Clawback Rules at p. 24.

22 Proposed Clawback Rules at p. 24-25.

23 Proposed Clawback Rules at p. 25.

24 Proposed Clawback Rules at p. 25.

25 Proposed Clawback Rules at p. 30.

26 Proposed Clawback Rules at p. 31.

27 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 304, 116 Stat. 745.

28 Proposed Clawback Rules at p. 75.

29 Proposed Clawback Rules at p. 68-70.

30 Proposed Clawback Rules at p. 68-70.

31 Chairman Mary Jo White, Statement at an Open Meeting on Dodd-Frank Act "Clawback" Provision at 1 (July 1, 2015), available at http://www.sec.gov/news/statement/listing-standards-for-clawing-back-erroneously-awarded-executive.html.

32 Commissioner Daniel M. Gallagher, Dissenting Statement at an Open Meeting on Dodd-Frank Act "Clawback" Provision (July 1, 2015), available at http://www.sec.gov/news/statement/dissenting-statement-compensation-clawback-listing-standards.html.

33 Proposed Clawback Rules at p. 99-100.

34 Proposed Clawback Rules at p. 99.

35 Comment Letter from the Corporate Governance Coalition for Investor Value to SEC Commissioners re: Proposed Rules on Listing Standards for Recovery of Erroneously Awarded Compensation (Release Nos. 33-9861, 34-75342, IC-31702; File No. S7-12-15) at 2, Sept. 21, 2015, available at http://www.sec.gov/comments/s7-12-15/s71215-61.pdf.

36 Proposed Clawback Rules at p. 45-47.

37 Proposed Clawback Rules at p. 94.

38 Proposed Clawback Rules at p. 96.

39 Proposed Clawback Rules at p. 96.

40 Commissioner Michael S. Piwowar, Dissenting Statement at an Open Meeting on Dodd-Frank Act "Clawback" Provision (July 1, 2015), available at http://www.sec.gov/news/statement/statement-at-open-meeting-on-clawbacks-of-erroneously-awarded-co.html.

41 Chairman Mary Jo White, Statement at an Open Meeting on Dodd-Frank Act "Clawback" Provision (July 1, 2015), available at http://www.sec.gov/news/statement/listing-standards-for-clawing-back-erroneously-awarded-executive.html.

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