The SEC has proposed rules requiring listed issuers to adopt and comply with written “clawback” policies. These policies would need to provide that, if a listed 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, then the issuer will recover the amount of any incentive-based compensation erroneously awarded to an executive officer. The listed issuer would also be required to disclose its clawback policy, disclose information about actions taken pursuant to its policy, and file its policy as an exhibit to its annual report.

Listed Issuers Subject to Proposed Rules

The proposed rules would apply to all listed issuers, with only limited exceptions for security futures products, standardized options, and the securities of certain registered investment companies. No exemptions were proposed for emerging growth companies, smaller reporting companies, foreign private issuers or controlled companies, because the SEC believes the objective of recovering excess incentive-based compensation applies with equal relevance to these listed issuers.

Accounting Restatements Triggering Clawbacks

An accounting restatement due to a material noncompliance means the issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements. For example, under GAAP, a restatement would be required for a material error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of GAAP, oversight or misuse of facts that existed at the time the financial statements were prepared, or a change from an accounting principle that is not generally accepted to one that is generally accepted. The “materiality” of error is determined under the standards of materiality otherwise applicable under the securities laws (e.g., a reasonable investor would consider it important to an investment decision, it impacts the total mix of information).

Persons Whose Compensation Must be Subject to Clawback

Clawback policies would need to cover all incentive-based compensation received while the issuer had a class of listed securities by an individual who served as an executive officer during the performance period for the incentive-based compensation. “Executive officers” include any person serving as the 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. This is modeled after the definition of “officer” in Rule 16a-1(f). The individual may be a current or former executive officer provided the individual received the compensation during the three completed fiscal years immediately preceding the date the issuer is required to prepare the restatement.

Incentive-Based Compensation

The SEC proposed a principles-based definition of “incentive-based compensation” that includes any compensation (specifically including options and other equity awards) granted, earned or vested based upon the attainment of any “financial reporting measure.” A “financial reporting measure” includes any measure determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, measures derived wholly or in part from such financial information, and stock price and total shareholder return. “Incentive-based compensation” would not include awards that are granted, are earned or vest based solely upon the occurrence of non-financial events, such as opening a specified number of stores, obtaining regulatory approval of a product, consummating a merger or divestiture, or completing a restructuring plan or financing transaction.

When Incentive-Based Compensation Is “Received”

Incentive-based compensation would be deemed “received” in the fiscal period during which the applicable financial reporting measure is attained, even if the payment or grant occurs after the end of that period. Ministerial acts or other conditions necessary to effect issuance or payment, such as calculating the amount earned or obtaining the board of directors’ approval of payment, would not affect the determination of the date received. Such incentive-based compensation would need to be subject to clawback policy to the extent it is received while the issuer has a class of listed securities. Incentive-based compensation granted to an executive officer before the issuer lists a class of securities would need to be subject to the clawback policy, so long as it was received by the executive officer while the issuer had a class of listed securities.

Erroneously Awarded Compensation

The clawback policy would need to recover the amount of incentive-based compensation received by a current or former executive officer in excess of what otherwise would have been received had it been determined based on the accounting restatement, calculated on a pre-tax basis. In most cases, this means that after an accounting restatement the issuer would recalculate the amount of incentive-based compensation that should have been paid using the corrected financial reporting measure, compare it to the amount previously paid, and clawback any excess amount.

If stock price or total shareholder return are the applicable measure triggering the overpayment of incentive-based compensation, it may not entail a simple mathematical recalculation directly from the information in an accounting restatement. In this case, the recoverable amount may be determined based on a reasonable estimates, which would need to be disclosed.

Executive officers would be credited for any amount they reimburse an issuer pursuant to Section 304 of the Sarbanes-Oxley Act of 2002 for the same compensation that would also be subject to the issuer’s clawback policy. However, indemnification arrangements may not be used to avoid or nullify required clawbacks.

Limited Discretion as to Recovery of Compensation

The SEC indicated that recovery pursuant to clawback policies should occur in most instances, even when the individual was not at fault or responsible for the errors requiring the restatement and when the recovery would be inconsistent with existing compensation contracts. The rules would only permit an issuer not to recover erroneously awarded compensation to the extent that pursuit of recovery would be impracticable because it would:

  • impose undue costs on the issuer or its shareholders or
  • violate home country law and certain conditions are met.

Before concluding it would be impracticable to recover erroneously awarded compensation based on undue costs, the issuer would need to make a reasonable attempt to recover the compensation. The issuer would need to document these attempts, provide the documentation to the exchange and disclose why it determined not to pursue recovery. Impracticability due to violation of home country law would require the issuer to obtain an opinion of home country counsel. Any determination that recovery would be impracticable would need to be made by the issuer’s compensation committee or other committee of independent directors responsible for executive compensation decisions.

Issuers would have discretion in how to accomplish recovery depending on the issuer and the type of compensation arrangement. However, exchanges would need to determine whether an issuer’s steps constitute compliance with its recovery policy, including whether the issuer is making a good faith effort to promptly pursue recovery.

Disclosure Regarding Clawback Policies

Listing standards would need to require issuers to disclose their clawback policies and file these clawback policies with the SEC. Proposed Item 402(w) of Regulation S-K would require listed issuers to disclose how they have applied their clawback policies if in their last completed fiscal year either a restatement that required clawback was completed or there was an outstanding balance of erroneously awarded compensation from application of the clawback policy to a prior restatement. The disclosure would need to include specified information regarding the date the restatement was required, the amount of excess compensation, the amount outstanding, any estimates used in calculating the amount and the executive officers involved.

Any amounts clawed back would reduce the amount reported for the executive officer in the applicable column of the Summary Compensation Table for the fiscal year in which the amount recovered initially was reported, with an explanation by footnote. The information must be block-text tagged using XBRL.

Conclusion

These proposed rules took approximately five years to propose since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 first mandated that the SEC adopt them. In part, this is because the rules raise many complex issues that are likely to continue impacting the overall timing of the proposal.