Time To Dig In: SEC Issues Final Clawback Rules For Incentive Compensation

Section 10D of the Securities Exchange Act of 1934 (the "Act") finally has some teeth, or "claws," as the case may be. Originally added to the Act by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Section 10D required the Securities and Exchange Commission (SEC) to issue rules directing the national security exchanges and associations to adopt listing standards that require issuers to develop and implement a so-called "clawback" policy. Following proposed rules in 2015 and several comment periods, the SEC adopted the final implementing rules–New Exchange Act Rule 10D-1–on October 26, 2022 (the "Final Rules"). The Final Rules generally apply to all listed issuers, including foreign private issuers, smaller reporting companies, emerging growth companies, controlled group companies, and debt-only filers.

What Are the Basic Changes in the Final Rules?

Generally, the Final Rules direct national securities exchanges and associations to establish listing standards that require a listed issuer to:

• Adopt a written "clawback" policy for the recovery of certain erroneously awarded incentive-based compensation received by current or former executive officers in the event the issuer is required to prepare an accounting restatement; and
  
  
• Disclose those compensation recovery policies in accordance with SEC rules, including providing the information in tagged data format.

Further, the Final Rules require disclosure of the listed issuer's clawback policy and information about actions taken pursuant to such policy in proxy statements. The Final Rules also require listed issuers to file their policies as exhibits to their annual reports, to indicate on their annual reports whether corrected financial statements are included (and whether those corrections are restatements that required clawback analysis), and to disclose any clawback actions taken in the annual report (either directly or by incorporating the proxy statement by reference).

When Do I Need to Start Worrying?

The Final Rules will become effective 60 days following publication in the Federal Register. The national securities exchanges' listing standards must be effective no later than one year following such publication. Issuers subject to the listing standards must then:

• Adopt a clawback policy no later than 60 days following the date the applicable listing standards become effective;
  
  
• Comply with the clawback policy for all incentive-based compensation received by executive officers on or after the effective date of the applicable listing standards; and
  
  
• Provide the disclosures required by the Final Rules in the applicable SEC filings on or after the effective date of the applicable listing standards.

Can You Provide More Details?

While the basics of the Final Rules are fairly straightforward, there are a lot of nuances that are important to consider and understand:

• Required for both "Big R" and "little r" restatements: Despite receiving many comments to limit the Final Rules to only "Big R" restatements, and in a change from the proposed rules, the SEC decided to have the Final Rules apply with respect to both "Big R" restatements and "little r" restatements. A "Big R" restatement is a restatement to correct an error in previously issued financial statements that is material to the previously issued financial statements. A "little r" restatement, on the other hand, is a restatement to correct an error that is not material but would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period.
  
  
• Covers only incentive-based compensation: The Final Rules only apply to incentive-based compensation, which is defined as any compensation that is granted, earned, or vested based in whole or in part on the attainment of a financial reporting measure. For example, base salary, incentive compensation (tied only to operational metrics), discretionary bonuses (except where the bonus pool is determined based on financial reporting measures), and options or restricted stock (subject only to time-vesting) may not be subject to clawback under the Final Rules. For these purposes, financial reporting measures include stock price, total shareholder return, or any other measures that are determined and presented in accordance with the accounting principles used in the issuer's financial statements (or that are derived from such measures).
  
  
• How far back to claw back: The policy must provide for the recovery of erroneously awarded incentive-based compensation received by current or former executive officers during the three completed fiscal years immediately preceding the date that the issuer is required to prepare an accounting restatement. For purposes of this timing, the date such a restatement is considered to be "required" is the date that the issuer's board (or a committee of the board or certain authorized officers) concludes, or reasonably should have concluded, that the issuer is required to prepare such a restatement or, if earlier, the date a court, regulator, or other authorized body directs the issuer to prepare such a restatement. In addition, incentive-based compensation is deemed to be "received" during this period if the compensation vests during this period due to satisfying the financial reporting measure, regardless of whether the award is actually paid or granted during this period. Unlike the proposed rules, the Final Rules provide that compensation received before becoming an executive officer is not subject to the required clawback. Further, the Final Rules state that the clawback policy only has to apply to compensation received on or after the effective date of the applicable listing standards.
  
  
• Amount of clawback: Under the Final Rules, the amount to be recovered under the clawback policy is the amount of incentive-based compensation received that exceeds what otherwise would have been received based on the restated amounts. Most notably, these amounts must be calculated without regard to any taxes paid (i.e., on a pre-tax basis). The only limitation on the amount to be recovered is where recovery would be impractical due to the third-party expense in enforcing the policy exceeding the clawback amount, the clawback violating existing laws of a foreign country, or the recovery causing a tax-qualified retirement plan (under which benefits are broadly available to issue employees) fail to meet the anti-alienation or nonforfeitable benefit rules.
  
  
• Policy must cover executive officers: The clawback policy must apply to current and former executive officers. An "executive officer" is the issuer's president; principal financial officer; principal accounting officer (or if there is no such officer, the controller); any vice president in charge of a business unit, division, or function; or any other officer or person who performs a policy-making function. Note that this is essentially the same definition as "officer" under SEC Rule 16(a)-1(f).
  
  
• Clawback required regardless of whether restated financials are filed: Under the Final Rules, the issuer's obligation to recover erroneously awarded compensation is not dependent on if or when the restated financial statements are filed.
  
  
• Clawback required regardless of misconduct: The preamble to the Final Rules makes it clear that the clawback policy applies regardless of issuer or executive officer misconduct, and regardless of the role of the executive officer in preparing the financial statements. This makes the Final Rules much broader than most recently disclosed clawback policies (the majority of which, according to the SEC, require executive officer misconduct).
  
  
• Information required in disclosures: The disclosures in the proxy statement and/or the annual report must be made if, during the last completed fiscal year, there was a restatement that required a clawback (or there is still an outstanding balance to be recovered from the prior year). The disclosure must contain the following:
  
  
  • Information regarding each restatement, including the date the restatement was required, the aggregate dollar amount of erroneously awarded compensation, an analysis of how the amount was calculated, any estimates used for stock price or total shareholder return metrics (including the methodology used for such estimates), and any amount or erroneously awarded compensation that remains outstanding at the end of the prior fiscal year;
    
    
  • An explanation of the reasons and disclosure of the required information in the next proxy statement and/or annual report, if the amount of erroneously awarded compensation has not yet been determined;
    
    
  • The amount of recovery forgone and a brief description of the reason in each case not to pursue recovery for each current and former named executive officer and for all other current and former executive officers as a group, if recovery would be impracticable (see the discussion under "Amount of clawback" above); and
    
    
  • The dollar amount due from each current and former named executive officer from whom erroneously awarded compensation has been outstanding for 180 days or longer since the issuer determined the amount owed.

Note that these disclosures are required to be provided in tagged data format using Inline XBRL.

Action Steps

• Information regarding each restatement, including the date the restatement was required, the aggregate dollar amount of erroneously awarded compensation, an analysis of how the amount was calculated, any estimates used for stock price or total shareholder return metrics (including the methodology used for such estimates), and any amount or erroneously awarded compensation that remains outstanding at the end of the prior fiscal year;
  
  
• An explanation of the reasons and disclosure of the required information in the next proxy statement and/or annual report, if the amount of erroneously awarded compensation has not yet been determined;
  
  
• The amount of recovery forgone and a brief description of the reason in each case not to pursue recovery for each current and former named executive officer and for all other current and former executive officers as a group, if recovery would be impracticable (see the discussion under "Amount of clawback" above); and
  
  
• The dollar amount due from each current and former named executive officer from whom erroneously awarded compensation has been outstanding for 180 days or longer since the issuer determined the amount owed.
  
  
  • Forms are also changing: Pursuant to the Final Rules, check box disclosures are being added to the cover pages of the Forms 10-K, 20-F, and 40-F. The check boxes will indicate whether the financial statements in the filing reflect a correction of previous financial statements, and whether any of the corrections are restatements that require a recovery analysis under the issuer's clawback policy. In particular, the check boxes will provide more transparency with respect to "little r" restatements that generally would not otherwise be disclosed or reported as prominently as "Big R" restatements.
    
    
  • Indemnification prohibited: The Final Rules prohibit the issuer from indemnifying any current or former executive officer against the loss of erroneously awarded compensation. The SEC in the preamble states that while executive officers may purchase a third-party insurance policy to help fund a potential clawback obligation, the prohibition on indemnification would prohibit the issuer from paying or reimbursing the premiums of such a policy.
    
    
  • Limited exceptions: Exemptions from the requirements of the Final Rules are limited and include certain security futures products (SFPs) cleared by a clearing agency, certain standardized options issued by a clearing agency, certain unit investment trusts, and certain management companies registered under Section 8 of the Investment Company Act of 1940 that have not awarded incentive-compensation to any executive officers in the last three fiscal years (or since listing if listed for less than three years). Notably missing are emerging growth companies (EGCs), smaller reporting companies (SRCs), and foreign private issuers (FPIs), who are all subject to the Final Rules. As mentioned above, the amount to be recovered may also be limited in rare cases of impracticability (see discussion under "Amount of clawback" above).
    
    
• Although issuers are not required to adopt a clawback policy and make any of the disclosures until after the new listing standards go into effect, it may be advisable to scratch the clawback compliance itch now. Consider doing the following:
  
  
  • Review and become familiar with the Final Rules and SEC guidance.
    
    
  • Review the current clawback policy and determine if it needs to be amended or if a new policy needs to be adopted to account for the Final Rules. If the current clawback policy goes beyond the requirements of the Final Rules (for example, clawback of non-incentive-based compensation for misconduct), determine if it is advisable to keep the more comprehensive policy.
    
    
  • Review new and existing compensation arrangements and agreements (including equity compensation, incentive plans, employment agreements, and severance agreements) and determine which are incentive-based and subject to the Final Rules. Consider if existing arrangements or agreements need to be amended to allow for the clawback to operate, and, if so, review and follow the amendment procedures.
    
    
  • Review indemnification, insurance, and similar arrangements to make sure they do not violate the prohibitions of the Final Rules.
    
    
  • Prepare a working list of executive officers under the Final Rules and consider notifying the officers of these upcoming changes so they can plan accordingly.
    
    
  • Prepare to comply with the disclosure obligations and review and adjust as necessary proxy statement and annual report preparation procedures.

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.