Governance and disclosure requirements regarding the executive compensation practices of publicly-traded companies are changing in many countries. During the last several years, the U.S. Securities and Exchange Commission (SEC) has adopted say-on-pay rules requiring a shareholder vote on executive compensation, prescribed independence requirements for board compensation committees and their advisers, required disclosure of the “pay ratio” between the CEO’s compensation and that of the median company employee, and proposed disclosure comparing executive pay to performance. Other countries have taken different approaches to compensation oversight and disclosure. In recognition of those differences, the SEC has traditionally exempted non-U.S. companies with securities trading in the United States—referred to as foreign private issuers or FPIs—from its rules related to executive compensation.
The SEC recently broke from that tradition and proposed to require all companies—U.S. and foreign—that are listed on a U.S. stock exchange to adopt policies requiring the recovery or “clawback” of incentive compensation paid to executives if the financial statements on which the compensation was based are restated. For many FPIs, compliance with the SEC’s clawback rules could create significant problems.
Securities Exchange Act Rule 10D-1, proposed on July 1, would direct U.S. stock exchanges to require each listed company to adopt a compensation recovery policy. The policy would have to provide that, in the event of a restatement to correct a material accounting error, the company will recover all incentive-based compensation executive officers received during the prior three fiscal years that exceeds the amount that the officers would have received under the restatement. A company would be subject to delisting if it failed to adopt or to enforce the recovery policy.
Key features of the proposal include:
- Current and former executive officers would be subject to the clawback, regardless of responsibility for the error that caused the restatement. “Executive officer” includes the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, and any other person who performs policy-making functions.
- Incentive compensation would include payments tied to attaining any measure that is based on the accounting principles used in preparing the financial statements. Incentive compensation would also include compensation based on stock prices or on total shareholder return.
- A company could decline to pursue recovery if its compensation committee (or a majority of the independent directors) determined, after reasonable attempts to collect, that further recovery efforts would entail undue cost.
An FPI would only be excused from enforcing the clawback if doing so would violate its home country law. To invoke this exception, the company would need to furnish the stock exchange with an opinion of home country legal counsel stating that recovery would violate local law and that the law in question was already in effect prior to the July 2015 publication date of the proposed rule.
In the release proposing the clawback rule, the SEC raised the possibility of broadly exempting FPIs. In their comments on the proposed rule, foreign companies and their representatives rule urged the SEC to do so. Arguments made in support of an FPI exemption include:
- Other countries are also developing clawback rules. Unless the proposed rule is changed, many FPIs will be subject to potentially inconsistent clawback regimes.
- The ability to recover previously paid compensation is problematic under the employment and contract laws of some countries.
- The home country legal opinion exception ignores collection problems that may arise under “common law” (i.e., law created by courts applying general legal principles). Also, in many cases, clawback collectability will be determined by the law of the country in which the executive resides, rather than by the law of the company’s home country.
Non-U.S. companies that are listed, or considering listing, in the U.S. should be aware of the clawback proposal and follow its progress. It is possible that the SEC will change course and decide to exempt FPIs. If the final rule does apply to FPIs, companies may wish to consider ameliorating its impact by revising executive compensation agreements so that:
- Incentive compensation is tied to operational measures (which would not be affected by a restatement).
- Bonuses are paid at the discretion of the board, rather than based on the attainment of targets tied to accounting measures or stock prices.
- Clawbacks required by U.S. listing requirements are expressly permitted. Such a contractual term may reduce the risk that the company will become embroiled in litigation with its executives if it seeks to enforce a clawback in order to maintain its U.S. listing.