On July 1, 2015, the SEC proposed a new rule, and rule and form amendments (the Proposal), to implement the provisions of Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which added Section 10D to the Securities Exchange Act of 1934 (the Exchange Act).
Section 10D requires the SEC to adopt rules directing national securities exchanges and securities associations (Exchanges) to establish listing standards requiring each issuer to adopt, disclose and enforce a policy (Recovery Policy) providing for the recovery of incentive-based compensation (including stock options awarded as compensation) from the issuer’s current or former executive officers in the event that the issuer is required to prepare an accounting restatement due to the issuer’s material noncompliance with any financial reporting requirement under the securities laws, to the extent such incentive-based compensation exceeds the amount that would have been payable based on the restated information.
Proposed Exchange Act Rule 10D-1 sets forth the listing requirements that the Exchanges would be directed to establish pursuant to Section 10D. The Proposal also includes rule and form amendments to require disclosure of the listed issuer’s Recovery Policy, and information about actions taken pursuant to such policy. Under the Proposal, an issuer would be subject to delisting if it does not: (i) adopt a Recovery Policy that complies with the applicable listing standard; (ii) disclose the policy in accordance with SEC rules, including providing the information in tagged data format; or (iii) comply with the policy’s recovery provisions.
Issuers and Securities Subject to Proposed Rule 10D-1
Other than exemptions for specified security futures products and standardized options, and the securities of certain registered management investment companies and unit investment trusts, the Proposal would apply to all issuers (including emerging growth companies, smaller reporting companies, business development companies, controlled companies and foreign private issuers) with listed securities (including listed debt and preferred securities).
Restatements to Which the Recovery Policy Would Apply
The Recovery Policy would be applicable if the issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements. The Proposal defines a restatement 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.” Materiality is undefined in the Proposal, as the determination will be based on the particular facts and circumstances, but issuers are cautioned to consider whether a series of immaterial error corrections, whether or not they resulted in filing amendments to previously filed financial statements, could be considered a material error when viewed in the aggregate. Certain retrospective adjustments, including those resulting from changes in accounting principles, changes in an issuer’s internal structure, and stock splits, would not trigger application of the Recovery Policy.
Executive Officers to Whom the Recovery Policy Would Apply
The Proposal would require the Recovery Policy to provide for recovery of excess incentive-based compensation from “any current or former executive officer of the issuer who received incentive-based compensation.” “Executive officer” would be defined as the issuer’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice president of the issuer in charge of a principal business unit, division or function (such as sales administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer. Executive officers of the issuer’s parents or subsidiaries would be deemed executive officers of the issuer if they perform such policy making functions for the issuer. In addition, if pursuant to Item 401(b) of Regulation S-K the issuer identifies a person as an “executive officer,” such person would be presumed to be an executive officer.
Recovery would be required from an individual who served as an executive officer of the listed issuer at any time during the performance period for that incentive-based compensation, including such compensation derived from an award authorized before the individual became an executive officer, and inducement awards for new-hires, as long as the individual served as an executive officer of the listed issuer at any time during the award’s performance period. Issuer compliance would be required whether or not such compensation is received pursuant to a pre-existing contract or arrangement. Note that the right to recovery extends to former executive officers who left the listed issuer’s employment prior to the restatement date (as defined below).
Incentive-Based Compensation Subject to Recovery Policy
“Incentive-based compensation” would be defined as “any compensation that is granted, earned or vested based wholly or in part upon 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, any measures derived wholly or in part from such financial information, and stock price and total shareholder return. Incentive-based compensation would therefore include, without limitation: (i) non-equity incentive plan awards that are earned based wholly or in part on satisfying a financial reporting measure performance goal; (ii) bonuses paid from a “bonus pool,” the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal; (iii) restricted stock, restricted stock units, performance share units, stock options, and stock appreciation rights that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal; and (iv) proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based wholly or in part on satisfying a financial reporting measure performance goal.
Time Period Covered by Recovery Policy; When Is a Restatement Required and When Is Incentive Compensation “Received”
The Recovery Policy would apply to excess incentive-based compensation received during the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement (with special rules for transition periods for fiscal year-end changes during the look-back period). That “restatement date” would be defined as the earlier to occur of: (i) the date the issuer’s board of directors, a committee of the board, or the officer[s] of the issuer 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; and (ii) 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.
Incentive-based compensation would be “received” in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is achieved, even if the payment or grant occurs after the end of that period, and even if the executive officer has established only a contingent right to payment at that time. Incentive-based compensation would be subject to the issuer’s Recovery Policy to the extent that it is received while the issuer has a listed class of securities.
Determination of Excess Compensation
The recoverable amount for straight cash awards would be the difference between the cash award that was received and the amount that should have been received. For cash awards paid from bonus pools, the size of the aggregate bonus pool would be reduced based on applying the restated financial reporting measure, and if the reduced bonus pool is less than the aggregate amount of individual constituent bonuses, the excess amount of an individual bonus would be the pro rata portion of the deficiency (no recovery would be required if the reduced bonus pool was sufficient to cover all awards made from it). For equity awards, if the shares, options or SARs are still held at the time of recovery, the recoverable amount would be the number received in excess of the number that should have been received applying the restated financial reporting measure. If the options or SARs have been exercised, but the underlying shares have not been sold, the recoverable amount would be the number of shares underlying the excess options or SARS applying the restated financial measure. If the shares have been sold, the recoverable amount would be the sale proceeds received with respect to the excess number of shares (the recoverable amount would be reduced to reflect any applicable exercise price paid).
For incentive-based compensation based on stock price or total shareholder return, where the amount of erroneously awarded compensation cannot be determined directly from the accounting restatement information, the recoverable amount may be determined based on a reasonable estimate of the effect of the accounting restatement on the applicable measure. However, the issuer would be required to maintain documentation of its determination and provide it to the relevant Exchange, and disclosure of the estimates will be required (see “Disclosure of Recovery Policy” below).
The recoverable amount would be determined on a pre-tax basis (i.e., it would not be reduced by income taxes paid or payable by the executive officer). Reimbursement by an executive officer pursuant to SOX Section 304 should be credited to the extent that an issuer’s Recovery Policy requires repayment of the same compensation by such executive officer and recovery under the Recovery Policy would not preclude recovery under Section 304 to the extent applicable amounts have not been reimbursed to the issuer.
An issuer would be required to recover erroneously awarded compensation in compliance with its Recovery Policy except to the extent that pursuit of recovery would be impracticable because it would impose undue costs on the issuer or its shareholders (i.e., where direct costs of enforcing recovery would exceed the recoverable amounts), or would violate home country law and certain conditions are met. With respect to a conclusion of impracticability based on enforcement costs, the issuer must first make a reasonable attempt to recover that incentive-based compensation, document its attempts and provide that documentation to the Exchange. The issuer also would be required to disclose why it determined not to pursue recovery (see “Disclosure of Recovery Policy” below). Before concluding that pursuit of a recovery would violate home country law, the issuer would need to obtain an opinion of home country counsel, not unacceptable to the applicable Exchange, that recovery would result in such a violation. In either case, any such determination would need to be made by the issuer’s committee of independent directors responsible for executive compensation decisions or, in the absence of a compensation committee, by a majority of the independent directors serving on the board. This and all determinations under proposed Rule 10D-1 would be subject to review by the listing Exchange.
Issuers may exercise discretion on how to accomplish recovery. Regardless of the method used however, the recovery should be achieved reasonably promptly. In addition, issuers would not be permitted to pursue differential recovery among executive officers, or to settle for less than the full recovery amount unless impracticable from a cost standpoint (in which case the conditions applicable to a determination to not pursue recovery would apply). The Exchange would determine whether an issuer’s actions constitute compliance with its Recovery Policy, including whether the issuer was making a good faith effort to pursue recovery promptly.
Disclosure of Recovery Policy
The Proposal would require that a listed issuer file its Recovery Policy as an exhibit to its annual report on Form 10-K. An issuer will be a “listed issuer” for this purpose if it has a class of securities listed on an Exchange at any time during its last completed fiscal year.
The Proposal also includes new Item 402(w) of Regulation S-K, which would apply if at any time during an issuer’s last completed fiscal year, either a restatement that triggered the listed issuer’s Recovery Policy was completed or there was an outstanding balance of excess incentive-based compensation from the application of that policy to a prior restatement. In either such event, the listed issuer would be required to provide specified information in its Item 402 disclosure in annual reports on Form 10-K and any proxy and consent solicitation materials, including restatement dates, dollar amounts of excess incentive-based compensation, estimates used to determine such excess if the financial reporting measure related to a stock price or total shareholder return metric, and specified information where an issuer has determined not to pursue recovery. This disclosure would be required to be provided in XBRL format as an exhibit to the relevant filing. Amounts recovered would also reduce the amount reported in the Summary Compensation Table.
Foreign private issuers would be required to provide the same information called for by Item 402(w) in, and to file their Recovery Policies as an exhibit to, their annual reports filed on Form 20-F, Form 10-K and Form 40-F, as applicable. Because securities registered by these listed issuers are exempt from Section 14(a) of the Exchange Act, they would not be required to disclose the information in any proxy or consent solicitation materials. In general, listed issuers would be required to tag this disclosure in an interactive data format.
Indemnification and Insurance
The Proposal would prohibit a listed issuer from indemnifying any current or former executive officer against the loss of erroneously awarded compensation, or paying or reimbursing such executive for third-party insurance policy premiums to fund potential recovery obligations.
Transition and Timing
The SEC proposes that each Exchange file its proposed listing rules no later than 90 days following publication of the final rule in the Federal Register, that its rules be effective no later than one year following that publication date, and that each listed issuer adopt the Recovery Policy no later than 60 days following the date on which the Exchanges’ rules become effective. The Proposal would also require each listed issuer to recover all erroneously awarded incentive-based compensation received by executive officers and former executive officers as a result of attainment of a financial reporting measure based on or derived from financial information for any fiscal period ending on or after the effective date of Rule 10D-1 and that is granted, earned or vested on or after the effective date of Rule 10D-1 pursuant to the issuer’s Recovery Policy. A listed issuer would file the mandated disclosures in applicable SEC filings required on or after the date on which the Exchanges’ rules become effective.
The Proposal is subject to a 60-day comment period, and notes that Exchanges may adopt listing standards with requirements that are more extensive than those of proposed Rule 10D-1 and that listed issuers may adopt policies more extensive than those proposed, so long as those policies, at a minimum, satisfy the listing standards.