On Oct. 26, the SEC adopted a final rule addressing the obligations of listed issuers or “companies” to recover incentive-based compensation paid to executive officers prior to an accounting restatement. The final rule will require many issuers to (i) adopt more stringent written clawback policies than those currently in place and (ii) provide more extensive disclosures of these policies. The final rule implements these new requirements by directing national securities exchanges to establish listing standards addressing the recovery of overpayments of incentive-based compensation. As a result, issuers will only be required to comply with the final rule after the applicable updated listing standards are effective. Such listing standards (and the final rule) will apply to virtually all public companies or issuers of public debt, including foreign private issuers, controlled companies, small reporting companies and emerging growth companies.

Timing for Implementation of the Final Rule

National securities exchanges must file proposed listing standards with the SEC no later than 90 days after the final rule is published in the Federal Register, and these listing standards must become effective no later than one year after the final rule’s publication. Within 60 days of a national securities exchange’s listing standard becoming effective, issuers must adopt compliant clawback policies and comply with the disclosure requirements described below. As a result, it is difficult to predict an approximate compliance date until listing standards with effective dates are proposed.

Clawback Requirements

The final rule requires issuers to adopt written policies under which they will recover any incentive-based compensation payments made to current or former executive officers if such payments were calculated based on financial statements that were later subject to an accounting restatement to correct an error. Incentive-based compensation includes compensation that is granted, earned or vested based wholly or partially upon attainment of any financial reporting measure. Under this definition, not only would cash or equity awards that are granted or become vested based on (in whole or part) the satisfaction of financial reporting measure performance goals but it would also include bonuses paid from a bonus pool, the size of which is based on financial reporting measures (in whole or in part), would be subject to clawback.

Unlike Section 304 of the Sarbanes-Oxley Act, which allows the SEC to order the disgorgement of incentive-based compensation paid to executive officers and the reimbursement of such funds to the issuer when such payments resulted from an issuer’s misconduct in financial reporting, the final rule broadens the circumstances that will trigger a clawback. Under the final rule, a clawback is triggered if an issuer is required to restate previously issued financial statements to correct an error — including “big R” and “little r” accounting restatements[1] – whether or not such restatement is due to the misconduct or fault of any officer of the issuer.

Issuers will be required to recover any incentive-based compensation paid to executive officers in the three years preceding the restatement that would not have been paid based on the restated financial statements. Notably, incentive-based compensation paid to executive officers who are no longer affiliated with an issuer at the time of a restatement may also be subject to clawback if they received incentive-based compensation within this preceding three-year period.

Executive officers under the final rule include an issuer’s (i) president, (ii) principle financial officer, (iii) principal accounting officer (or if there is no such accounting officer, the controller), (iv) any vice president in charge of a principal business unit, division or function, and (v) any other officer or individual who performs a policymaking function.

The final rule does not include any grandfather provisions. As a result, any incentive-based compensation received by an executive officer on or after the effective date of the applicable listing standard will be subject to clawback without regard to when the agreement on which the compensation was based was entered into. However, compensation received by an individual prior to becoming an executive officer is not subject to clawback under the final rule, even if that individual subsequently becomes an executive officer.

Issuers may not insure (or pay an executive officer’s cost to insure) or indemnify executive officers against compensation that is subject to clawback under the final rule.

Exception to Clawback Policy Requirements

Few exceptions exist to the final rule’s clawback provisions. However, clawback will not be required if an issuer’s compensation committee (or, in the absence of a compensation committee, a majority of an issuer’s independent directors) determines that the recovery is “impracticable,” a term that is narrowly defined. Recovery may be deemed impracticable only if (i) after recovery of the clawback amount is attempted, the issuer determines that enforcing the policy would incur direct expenses that are greater than the amount that the issuer would recover, (ii) recovery of the clawback amount would violate “home country law” of a non-U.S. company, or (iii) recovery would negatively impact an otherwise tax-qualified and broad-based retirement plan.

Disclosure Requirements

The final rule requires issuers to disclose in their proxy statement or Form 10-K, 20-F or 40-F as applicable: (i) the date on which they were required to prepare an accounting restatement, if any, (ii) the aggregate dollar amount of any clawbacks that were required as a result of the restatement and an analysis of how such amount was calculated (including any estimates used to determine clawback amounts related to stock price or total shareholder return), (iii) the aggregate amount that is still unrecovered at the end of the current fiscal year, (iv) if recovery was deemed impracticable, the amount of recovery forgone and why such recovery was deemed impracticable, and (v) for each current and former executive officer, the amount of outstanding and unrecovered excess compensation that has been outstanding for at least 180 days.

Additionally, the final rule adds two new checkboxes to the cover page of the Form 10-K, where issuers will indicate whether the Form 10-K includes financial statements containing any corrections due to errors found in previous financial statements and whether such restatement requires a clawback analysis of incentive-based compensation during the applicable fiscal year.

Next Steps

Public companies can take several steps now to start preparing for compliance. These include:

  • Assessing disclosure controls and procedures and updating them as necessary to ensure issuer compliance
  • Reviewing all existing compensation agreements and plans to identify compensation that comprises incentive-based compensation subject to clawback under the final rule
  • Determining which executives will be subject to clawback under the final rule and informing those executives about the potential clawback of incentive compensation
  • Reviewing existing clawback policies and determining whether amendments will be necessary under the final rule or an entirely new policy is warranted
  • Ensuring that existing indemnification agreements and issuer insurance policies do not violate the final rule by indemnifying/insuring clawbacks under the final rule
  • Evaluating, together with advisers and consultants, if alternative compensation structures that are treated more favorably under the final rule can or should be implemented going forward

 

[1] “Big R” restatements correct errors that are material to previously issued financial statements. “Little r” restatements correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period.