As directed by the Securities and Exchange Commission ("SEC"), the NYSE and Nasdaq have issued proposed listing standards related to the recovery of erroneously awarded executive compensation, commonly referred to as the "clawback" rules. The proposed listing standards closely follow the SEC's Rule 10D-1 issued under the Securities Exchange Act of 1934 (the "Exchange Act") in October 2022.
The Dodd-Frank Act of 2010 added Section 10D to the Exchange Act, which required issuers to develop a recovery policy providing:
- for disclosure of the issuer's policy on incentive-based compensation that is based on financial information that is required to be reported under the securities laws; and
- that, if the issuer is required to prepare an accounting restatement due to material noncompliance with a financial reporting requirement under the securities laws, the issuer will recover from any executive officer who received incentive-based compensation (including stock options) 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 account restatement.
The SEC issued a proposed rule under Section 10D on July 1, 2015, which languished until the SEC re-opened the comment period on October 14, 2021, and again on June 8, 2022. After consideration of the comments received, the final rule was published in the Federal Register on November 28, 2022.
Which Issuers Must Adopt a Clawback Policy?
All issuers with listed securities must adopt a clawback policy, including emerging growth companies, smaller reporting companies, foreign private issuers and controlled companies. There are limited exceptions for the listing of:
- A security futures product cleared by a clearing agency registered under Section 17A of the Exchange Act;
- A standardized option issued by a clearing agency that is registered under Section 17A of the Exchange Act;
- Any security issued by a unit investment trust; and
- A security issued by a management company that is registered under Section 8 of the Investment Company Act of 1940, if the management company has not awarded incentive-based compensation to any executive officer in the last three fiscal years.
What is the Deadline for Adopting a Clawback Policy?
Each national securities exchange was required to issue a proposed listing standard implementing Rule 10D-1 by February 27, 2023, and both the NYSE and Nasdaq filed their proposed rules with the SEC on February 22, 2023. On April 24, 2023, the SEC published notices extending the period for consideration of the proposed rules from April 27, 2023 to June 11, 2023. On or before that date, the SEC will approve or disapprove, or institute proceedings to disapprove, the proposed rules. Each issuer must adopt its clawback policy within 60 days after the effective date of the listing standard. If the listing standards are approved by the SEC on June 11, 2023, the clawback policy must be adopted by August 10, 2023. It is possible that the deadline could be further extended, but under the SEC's final rule, the listing standards must be effective no later than November 28, 2023
What is the Consequences if the Issuer Fails to Adopt a Clawback Policy?
Any new securities will not qualify to be listed, and any securities that are listed are subject to delisting.
Which Executive Officers Must be Subject to the Clawback Policy?
The executive officers that must be covered by the issuer's clawback policy include, at a minimum, the following officers:
- Principal financial officer;
- Principal accounting officer (or if no accounting officer, the controller);
- Any vice president in charge of a principal business unit, division or function;
- Any other officer who performs a policy-making function; or
- Any other person who performs similar policy-making functions for the issuer.
The policy is not limited to officers who are "at fault" or who are involved in the preparation of the financial statements.
What Types of Restatements Trigger Recovery of Erroneously Paid Compensation?
Rule 10D-1 and the proposed listing standards require recovery under the issuer's clawback policy to be triggered if there is:
- an accounting restatement that corrects an error in the previously issued financial statement (a "Big R" restatement); or
- an accounting restatement that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period (a "little r" restatement.)
In the SEC's view, both types of restatements address material noncompliance of the issuer with financial reporting requirements, as provided in the statutory language.
What is the Recovery Period?
Erroneously paid compensation must be recovered in the three-year period preceding the date on which the issuer is required to prepare an accounting restatement. This period is measured from the earliest of:
- the date the Board of Directors, a Board committee, or authorized officer concludes, or reasonably should have concluded, that the issuer is required to prepare an accounting restatement; or
- the date a court, regulator or other legally authorized body directs the issuer to prepare an accounting restatement.
Is Recovery Limited to Current Executive Officers? Is Incentive-Based Compensation Subject to Recovery if it was Awarded to an Individual who was not an Executive Officer at the Time of Award?
The statute requires recovery from any current or former executive officer. Rule 10D-1 requires recovery of incentive-based compensation received by a person:
- after beginning service as an executive officer; and
- if that person served as an executive officer at any time during the recovery period.
Therefore, incentive-based compensation paid to a former executive officer during the 3-year recovery period is subject to recovery.
Similarly, an award of incentive-based compensation granted to an individual before he/she becomes an executive officer is subject to the recovery policy, if the incentive-based compensation was received by the individual at any time during the recovery period after beginning service as an executive officer.
What Type of "Incentive-Based Compensation" is Subject to Recovery?
Rule 10D-1 and the proposed listing standards define "incentive-based compensation" as any compensation that is granted, earned or vested based wholly or in part on the attainment of any financial reporting measure.
"Financial reporting measures" are measures that are determined and presented in accordance with the accounting principles used in preparing the issuer's financial statements, and any measures derived wholly or in part from such measures. This includes GAAP and non-GAAP measures, as well as other measures, metrics and ratios. It also includes stock price and total shareholder return ("TSR").
Examples of financial reporting measures include:
- Net income
- Operating income
- Financial ratios
- Net assets or net asset value per share
- Return measures (i.e., return on invested capital, return on assets)
Examples of "incentive-based compensation" include:
- Non-equity incentive plan awards that are earned based on satisfying a financial reporting measure performance goal;
- Bonuses paid from a "bonus pool," the size of which is determined on satisfying a financial reporting measure performance goal;
- Other cash awards based on satisfaction of a financial reporting measure performance goal;
- Restricted stock, restricted stock units, performance share units, stock options and stock appreciation rights that are granted or become vested on satisfying a financial reporting measure performance goal; and
- Proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested on satisfying a financial reporting measure performance goal.
Examples of compensation that is not "incentive-based compensation" for this purpose include:
- Discretionary bonuses
- Non-equity plan awards earned solely upon satisfying one or more strategic measures (such as consummation of a merger) or operational measures (such as opening a specific number of stores); and
- Equity awards for which the grant is not contingent on achieving a financial reporting measure performance goal and vesting is contingent solely on completion of a specified employment period (i.e., subject to time-based vesting) and/or attaining one or more non-financial reporting measures.
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.