Summary

The US Securities and Exchange Commission has proposed rules that would require issuers listed on US stock exchanges to adopt and disclose a policy to recover, or “claw back”, certain incentive-based compensation. Recovery would be required in the event of an accounting restatement to correct a material error. The SEC is soliciting comments on the proposed rules, and requests that comments be submitted on or before September 14, 2015.

Background

The SEC is mandated, pursuant to the Dodd-Frank Act, to adopt rules that would require companies listed in the United States to recover incentive compensation from current or former executives following a restatement of financials for material non-compliance. The proposed rules would direct US national securities exchanges and national securities associations to adopt listing standards to this end.

Key aspects of the proposed rules

The proposed rules would, via the new listing standards, apply to most issuers listed on US national securities exchanges (including a non-US issuer qualifying as a “foreign private issuer”), with exemptions for certain investment companies. The proposal would require the recovery of incentive compensation awarded to executive officers in the event of a restatement of financials following a material accounting error. The incentive compensation must have been “erroneously awarded” as a result of the error during the three fiscal years preceding the date on which the issuer is required to prepare the restated financials. Incentive compensation erroneously awarded is that which exceeds the compensation that would have been paid based on the restated financials. The amount is calculated without regard to any taxes paid. Where the amount of excess compensation is not clearly determinable (e.g. if an executive is rewarded on the basis of the issuer’s share price), the issuer must make a reasonable estimate. Recovery would be required on a “no-fault” basis, meaning that whether the executive was at fault in causing the accounting error (or still employed by the issuer) would not be relevant in determining what payments must be recovered.

Issuers would be required to recover excess compensation unless it was impracticable, and would not be allowed to indemnify executives against the recovery. Recovery would be considered impracticable only if the issuer’s costs would exceed the amount recoverable or, for foreign issuers, if recovery was prohibited by home country laws. In either case, the issuer’s independent directors would have to confirm whether recovery was impracticable.

Comparison with existing regulations

US law already mandates the claw-back of incentive compensation paid to the CEO and CFO of a US-registered company following an accounting restatement precipitated by misconduct. The incentive compensation at risk of claw-back is that which is awarded during the 12 months following the date of publication of the misstated financials. The new proposed rules are significantly broader in that they would catch current and former executive officers*, not just CEOs and CFOs, and can trigger claw-backs on a no-fault basis. In addition, the compensation at risk of claw-back is potentially higher under the proposed rules in that they would apply to the three years preceding the restatement, versus the 12 months following the original misstated financials in the existing rules.

Effect on non-US issuers

In the event the proposed rules are adopted, non-US issuers that are listed on US stock exchanges or that seek such a listing must be aware of the potential requirements to implement and enforce a claw-back policy. Securities laws and exchange rules outside the United States may not require such claw-back policies, although some issuers have already adopted such policies on a voluntary basis and have disclosed their existence in annual shareholder meeting materials. If the proposal becomes law, cross-listed issuers and non-US issuers listed solely on US exchanges may need to revisit those policies due to the broad scope of the proposed rules.

Compensation subject to claw-back

The proposal provides that an incentive payment is subject to claw-back following a restatement if the payment was “granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.” It can include cash or equity compensation, such as shares and options. “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.”

A measurement can be a financial reporting measure irrespective of whether it is reported in the issuer’s financial statements. For example, the award of cash or securities to an executive based on the achievement of a certain share price or level of EBITDA would be subject to claw-back in the event that it is deemed excess compensation. By contrast, the proposed rules would not catch incentive compensation not based on or derived from financial reporting measures, such as completing a merger or achieving a given level of market share.

Disclosure requirements

Listed issuers would be required to adopt a claw-back policy reflecting the requirements of the proposal, and disclose the text of this policy in annual reports and proxy materials. If an issuer restated its financials following a material accounting error, then in the following year (and in any year for which excess compensation remains unrecovered) it would have to disclose:

  • the total amount of excess compensation and the amount not yet recovered;
  • any estimates used to determine the amount of excess compensation that was not easily calculable;
  • the name of each executive whose excess compensation had been outstanding for 180 or more days, and the amount of such compensation; and
  • if the issuer decided not to attempt to recover excess compensation from any executive, the name of the executive, the amount forgone and a brief explanation.

Request for comment

As noted, the SEC is soliciting comments on the proposal. Use these links to access The full proposal—together with specific requests for comments and the text of the proposed rules—and the SEC’s news release and fact sheet regarding the proposed rules on the SEC website.