On July 1, 2015, the Securities and Exchange Commission issued proposed rules to implement the mandatory recovery of erroneously awarded compensation (or clawback) provisions of Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Public companies and their advisers have been waiting since 2010 for answers to key questions about how the Dodd-Frank Act clawback requirements will operate. The SEC's initial answers are finally here, but they're not exactly in line with what much of corporate America thought would suffice as clawback arrangements. The proposed rules are convoluted in some cases. In addition, it will be costly and time-consuming for public companies and their advisers to implement a conforming policy if the proposed rules are adopted in anything like their current form.
- The proposed rules reflect an unfortunate lack of trust in boards of directors as to when pursuing clawback may be in the best interests of the issuer and its shareholders.
- The clawback requirements as proposed could influence companies to move away from incentive compensation that is tied to financial performance metrics (as opposed to subjective or operational metrics) to avoid the clawback issue altogether.
- The proposed rules do not address potential significant tax ramifications for executive officers who experience a substantial clawback on a pre-tax basis years after the officer has paid income taxes on that compensation (an especially harsh result for a nonculpable individual).
- Clawbacks of incentive compensation based on stock price or total shareholder return may necessarily require the board to estimate (rather than mathematically calculate) the excess compensation that should be clawed back, which is likely to result in disputes or even litigation between affected current (or former) executive officers and employers.
We expect that the comment period with respect to the proposed rules will be contentious. Further, if the proposed rules are adopted in their present form, every public company will need to revise its previously adopted clawback arrangements to ensure compliance with the SEC's new rules.
The Proposed Rules
In very general terms, the proposed rules require national stock exchanges to adopt listing rules that will require issuers to adopt and comply with a written policy ("Compensation Recovery Policy") for the recovery of "excess" incentive-based compensation received by current and former executive officers during the three completed fiscal years preceding the date on which the issuer concludes (or reasonably should have concluded) that an accounting restatement is required due to a material error in previously published financial statements. In addition, each listed issuer will be required to disclose information about the contents and operation of its Compensation Recovery Policy.
At a high level, the key elements of the proposed rules are as follows:
Must All Issuers Comply with the Proposed Rules? Most listed issuers, including emerging growth companies, smaller reporting companies, foreign private issuers, controlled companies, and issuers of only debt or preferred securities, must comply. Excluded issuers include those who list only certain securities futures products or standardized options, unit investment trusts, and certain registered investment companies.
Who Will the Compensation Recovery Policy Cover? The Compensation Recovery Policy must cover all "executive officers" who held such offices at any time during the relevant performance periods. This will require the issuer to determine the applicable recovery period; which specific elements of incentive-based compensation were granted, earned, or vested during that recovery period; and which persons served as its "executive officers" at any time during these performance periods. For purposes of the proposed rules, the definition of "executive officer" is modeled on the definition an issuer would use to identify its Section 16 officers (if the issuer's officers were in fact subject to Section 16).
What Kinds of Accounting Restatements Will Trigger Clawback? An issuer will trigger application of its Compensation Recovery Policy when it becomes required to revise previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements. A series of corrections of immaterial errors may be material for purposes of triggering the Compensation Recovery Policy. The proposed rules include examples of retrospective financial statement changes that would not be considered error corrections—including application of a change in accounting principle, revision of reportable segment information due to a change in the structure of the issuer's internal organization, reclassification due to a discontinued operation, or revision for stock splits.
What Forms of Compensation Will Be Subject to Clawback?"Incentive-based compensation" potentially subject to clawback consists of any compensation granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure. Financial reporting measures consist of all measures determined and presented in accordance with the accounting principles used to prepare the issuer's financial statements (or other measures derived wholly or in part from these measures) plus stock price and total shareholder return. Financial reporting measures would generally not include metrics that are not derived from financial information (for example, opening a specified number of stores or obtaining regulatory approval of a product, etc.).
Under this definition, incentive-based compensation must be determined by issuers in a principles-based manner but may generally consist of non-equity incentive plan awards, bonus pool payouts, and equity or equity-based awards (and proceeds received from the sale of shares received from payouts or as the result of awards) that were earned based wholly or in part on the achievement of financial reporting measures.
What Will Be the Applicable Recovery Period for Clawback? An issuer must recover "excess" incentive-based compensation under the Compensation Recovery Policy if the excess (as explained below) is "received" by an executive officer during the three completed fiscal years immediately preceding the date on which the issuer is required to prepare the applicable accounting restatement. For purposes of the proposed rules, incentive-based compensation is considered "received" when the relevant financial reporting measure performance goal is attained (even if the payment or grant occurs later, and regardless of whether such compensation is then nonforfeitable or such attainment has yet been calculated or approved).
Further, the date on which the issuer is required to prepare the applicable accounting restatement ("Trigger Date") will be the earlier of the date on which the board or one of its committees (or one or more authorized officers if board action is not required) concludes, or reasonably should have concluded, that previously issued financial statements contain a material error, and the date on which a court, regulator, or legally authorized body directs the issuer to restate previously issued financial statements to correct a material error.
In turn, the three-year "look back" period for potential clawbacks will cover the three completed fiscal years immediately preceding the fiscal year in which the Trigger Date occurs.
How Much Incentive-Based Compensation Will Need to Be Clawed Back? Issuers must determine the amount of incentive-based compensation that has been received during the look back period that is in "excess" of what would have been received under the accounting restatement, determined on a pre-tax basis. Effectively, this requires the issuer to conduct a mathematical recalculation of applicable financial reporting measures, take into account any discretion exercised by the issuer, and determine whether any executive officer received a greater amount of incentive-based compensation. For forms of incentive-based compensation that are based on stock price or total shareholder return, if this determination cannot be made directly from mathematical recalculation, then the issuer must base the excess determination on a reasonable estimate of the effect of the accounting restatement, which must be disclosed.
Can an Issuer Indemnify or Provide Other Protections for Executive Officers for Clawbacks? Issuers are prohibited under the proposed rules from indemnifying executive officers against their loss of excess incentive-based compensation and paying or reimbursing executive officers for premiums on a third-party insurance policy (obtained by the executive officer) to fund potential recovery obligations.
Will There Be Any Exceptions to Mandatory Clawback? Although the issuer's board will not have general discretion to determine whether to pursue applicable recovery of excess incentive-based compensation, a Compensation Recovery Policy may allow the issuer to decline to pursue recovery if the direct expense paid to a third-party to assist in enforcing the clawback would exceed recoverable amounts or the recovery would violate home country law in existence as of the publication date of the proposed rules. The decision must be made by the issuer's independent compensation committee or (in its absence) a majority of the independent directors, and it will be subject to review by the applicable stock exchange. Issuers, however, should be able to exercise discretion in a reasonably prompt manner as to how they will accomplish recovery from executive officers, as long as recovery efforts are pursued promptly in good faith.
What Disclosure Will Issuers Need to Provide about the Compensation Recovery Policy? Each U.S. listed issuer will be required to file a copy of its Compensation Recovery Policy as an exhibit to its Annual Report on Form 10-K. In addition, issuers generally will be required to provide the following disclosure if, during the prior fiscal year, either a restatement triggering the Compensation Recovery Policy was completed or there was an outstanding balance of excess incentive-based compensation from application of the Compensation Recovery Policy to a prior restatement:
- The Trigger Date;
- The aggregate dollar amount of excess incentive-based compensation attributable to the restatement;
- The aggregate dollar value of excess incentive-based compensation remaining outstanding at the end of the prior fiscal year;
- The estimates used to determine excess incentive-based compensation if involving stock price or total shareholder return;
- The name of each person subject to clawback with respect to whom the issuer determined during the prior fiscal year to forgo recovery (including the amount and reasons); and
- The name of, and amount due from, each person for whom clawbacks had been outstanding for at least 180 days after the issuer determined the amount of the excess incentive-based compensation.
Some of these initial answers provided by the SEC are consistent with other SEC disclosure guidance and rules and may be relatively easy for public companies to implement. Other answers significantly complicate the task of understanding and implementing the clawback requirements.
We already expect that one or more of the following points will be raised during the SEC comment period:
- A pervasive theme reflected by the proposed rules is a lack of trust in issuers' boards of directors. The proposed rules allow very little discretion in terms of pursuing clawbacks and require detailed disclosures that will likely embarrass executive officers if an issuer forgoes pursuing clawback or an executive officer is unable to repay recoverable amounts. The proposed rules could have been written, consistent with the Dodd-Frank Act, so as to allow the board to make decisions about when a clawback is in the best interest of the issuer.
- Although the Dodd-Frank Act and the proposed rules use the word "restatement" to describe the trigger for application of the Compensation Recovery Policy, the proposed rules go further in suggesting that "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." This perhaps reflects the SEC's recognition that revisions to correct immaterial errors that are not disclosed on a Current Report on Form 8-K now account for nearly 70 percent of all restatements reported, according to a report cited in the proposed rules. The problem with that line of thinking is that these types of revisions have already been found by the issuer to be immaterial, and thus should not be grist for the clawback mill.
- The SEC's emphasis on the "no fault" nature of the Dodd-Frank Act clawback provisions, which presumably led it to propose that any clawback be on a pre-tax basis, will leave all executive officers whose compensation is subjected to a pre-tax clawback in a worse position than they would have been if the issuer had correctly calculated their incentive-based compensation in the first place, an especially harsh result for nonculpable individuals.
- The clawback requirements could lead to further reevaluation of how issuers compensate executive officers to avoid the clawback issue altogether. Although most everyone seems to agree that performance-based compensation should align closely the interests of company leaders and shareholders, the proposed rules could cause issuers to consider designing incentive compensation that is less likely to trigger clawbacks, even if those new designs produce less direct management/shareholder alignment, or to consider reducing incentive compensation in favor of higher base pay or other nonincentive compensation. The proposed rules impose essentially "strict liability" clawbacks against executive officers and then require detailed reporting (including executive officer names) when the directors decide against pursuing collection efforts or collection efforts are unsuccessful. This drastically increases the financial, professional, and personal risks to executive officers in such a way that many may desire nonincentive-based and/or guaranteed compensation, even if at lower amounts, to avoid even the possibility of a clawback.
- Further to this point, imagine a senior leader of a sales unit who falls within the scope of the proposed rules and is subject to a clawback because of an honest but material error committed by the accounting department or even the outside auditors (Commissioner Gallagher provided further examples in his dissent to the proposed rules). This is not a far-fetched situation. If a driving force for the clawback rules is to improve financial reporting, then it is at a minimum unclear how imposing strict liability on an executive officer with no role over financial reporting will further that goal. Moreover, revision restatements represent a large share of all restatements, and these immaterial errors are most often the result of honest accounting mistakes. Where the proposed rules may hold executive officers liable for accounting and reporting errors when those areas are completely outside their control, nonfinancial executives may seek to bargain for different types of compensation. This is further compounded by the prohibition on the company indemnifying or reimbursing for insurance that might cover clawbacks.
- The proposed rules require clawback of excess incentive-based compensation based on financial reporting measures as well as stock price and total shareholder return. However, determining the effect of a restatement on stock price is not easy. It almost always requires expensive and time-consuming third-party studies that usually give only a range of possible impacts. As a result, issuers that utilize stock price or total shareholder return for incentive awards will not have an easy (or inexpensive) way to determine "excess" incentive-based compensation but instead must make estimates of the excess. It is conceivable that litigation by executive officers against the issuer could result from these situations.
Proposed Implementation Period
Under the proposed rules, the stock exchanges must file with the SEC their proposed listing rules within 90 days after the final rules are published in the Federal Register. These listing rules must then be approved by the SEC and made effective within one year after publication of the final rules. Each listed issuer must then adopt a Compensation Recovery Policy within 60 days following the effectiveness of the stock exchanges' listing rules. An issuer will be required to claw back excess incentive-based compensation from executive officers for any performance period ending on or after the effective date of the final rules under its Compensation Recovery Policy if excess incentive-based compensation is received by the executive officers on or after the effective date of the final rules. Disclosure related to Compensation Recovery Policies will be required in all applicable SEC filings required on or after the effective date of the stock exchanges' listing rules.