- Another split Commission vote with Gallagher and Piwowar dissenting
- Proposed rules impose clawback requirement on all executive officers for three-year period prior to restatement
On July 1, 2015, as mandated by the Dodd-Frank Act, the SEC voted to propose new rules and rule amendments directing the national securities exchanges to adopt listing standards requiring listed companies to adopt clawback policies and provide extensive disclosures about the policy and related practices. Proposed Rule 10D-1 and proposed amendments to Items 402, 404 and 601 of Regulation S-K and Item 22 of Schedule 14A would implement the provisions of Section 954 of the Dodd-Frank Act, which added Section 10D to the Securities Exchange Act of 1934 (the "Exchange Act"). The proposed rule is the last executive compensation rule required of the SEC by the Dodd-Frank Act. The proposing release may be found here.
The SEC approved the proposal in a divided 3-2 vote, with Commissioners Gallagher and Piwowar issuing strong dissents. The comment period for the proposed rules will be 60 days after publication.
Summary of the Proposed Rules
Current rules, including Section 304 of the Sarbanes-Oxley Act of 2002 and Item 402(b) of Regulation S-K, require clawbacks and disclosures in only a limited range of circumstances involving executive misconduct. Under Section 304, the SEC may recover incentive-based compensation awarded to CEOs and CFOs on the basis of financial statements that are subsequently restated due to misconduct. The proposed Rule 10D-1 expands clawback requirements to allrestatements on a "no-fault" basis (i.e., restatements issued due to error rather than misconduct) and, unlike Section 304, is not limited to incentive compensation received in the preceding 12-month period. The proposed rules would reach back three full years and apply not just to the CEO and CFO, but toall current and former executive officers who received incentive-based compensation during the prior three-year period. Finally, the proposed rules would require that the issuer enforce its clawback policy with very little discretion afforded to issuers with respect to pursuing a repayment claim from an affected executive officer.
The proposed rules are intended to address the sweeping requirements of Section 10D(b) of Dodd-Frank. Section 10D(b) requires the Commission to adopt rules directing the exchanges to establish listing standards to require each issuer to develop and implement a policy providing:
"(1) for the disclosure of the issuer’s policy on incentive-based compensation that is based on financial information required to be reported under the securities laws; and
(2) that, 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, the issuer will recover from any of the issuer’s current or former executive officers who received incentive-based compensation (including stock options awarded as compensation) during the three completed fiscal years preceding the date the issuer is required to prepare the accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement." (emphasis added)
Under the proposed rules, an issuer would be subject to delisting if it does not (1) adopt a compensation recovery policy that complies with the applicable listing standard, (2) disclose the policy in accordance with Commission rules, or (3) comply with the policy’s recovery provisions.
As proposed, the rules require each listed company to adopt a compensation recovery policy and to file that policy as an exhibit to the company’s annual report on Form 10-K. If an issuer files a financial restatement and the clawback is triggered, the issuer would be required to make certain disclosures in those filings where executive compensation disclosure is required pursuant to Item 402 (e.g., proxy statements).
Required proxy statement disclosure when a clawback has been triggered would include:
- the date the issuer was required to prepare the restatement;
- the aggregate dollar amount of "excess" incentive-based compensation and any amount that remained outstanding at the end of the last completed fiscal year;
- any estimates used in determining the amount of excess incentive-based compensation;
- the name of each person subject to recovery of excess incentive-based compensation as of the end of the fiscal year from whom the company decided not to pursue recovery, the amount in question, and a brief description of the reason the company decided not to pursue recovery; and
- the name of each person from whom, as of the end of the fiscal year, excess incentive-based compensation had been outstanding for 180 days or longer since the company determined the amount owed and the amount due.
The SEC’s proposed amendments include requiring Summary Compensation Table disclosures to adjust compensation amounts reported for the fiscal year in which the amount recovered was initially reported with those amounts identified in footnotes.
Because Section 10D requires that the rules apply to "any current or former executive officer" of the issuer, the proposed rules expand required clawbacks beyond the current application (CEOs and CFOs) to cover past and current "executive officers," defined in the proposed rules to track the definition of "officer" for purposes of Section 16 of the Exchange Act. This includes a company’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president in charge of a principal business unit or function, and any person who performs policy-making functions, including the executive officers of the issuer’s parents or subsidiaries if they perform such functions.
Restatements Triggering the Clawback
As described in the proposing release, the clawback policy must provide for recovery of excess incentive compensation when an issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements. Materiality must be considered with regard to particular facts and circumstances, and even a series of immaterial error corrections may be considered a material error. Material noncompliance would not include retrospective changes to financial statements including retrospective application of a change in accounting principle, retrospective application of changes in reporting entities due to reorganization of entities under common control, or changes in reportable segments due to internal organization, as they are not considered error corrections.
Amount Subject to Recovery
The amount subject to recovery under the proposed rules is based on the amount of incentive-based compensation received by the issuer’s executive officers. Instead of identifying the specific types or form of compensation that would be subject to the rules, the proposal is intended to be based on a principles-based approach. As proposed, "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." In addition to those financial measures that are derived from the financial statements, the proposed definition of "financial reporting measures" would include performance measures based on stock price or total shareholder return.
The amount subject to recovery under the proposed rules would be that amount of incentive-based compensation that exceeds what the executive officer would have received based on the accounting restatement.
If incentive-based compensation is based only partially on a financial reporting measure, the issuer must determine the excess received for the affected portion of the compensation. For incentive-based compensation based on stock price or total shareholder return, issuers must use a "reasonable estimate" to determine the amount to be recovered and maintain documentation of the determination of that reasonable estimate to be provided to the relevant exchange. If due to a restatement a bonus pool must be reduced to less than the aggregate amount of individual bonuses paid from the pool, recovery would be pro rata from each executive based on the size of the original reward, with no discretion afforded the issuer in making those determinations. For equity awards, the recoverable amount would be the number of shares, options, or SARs received in excess of the number that should have been received based on the restatement. If shares have been sold, the sale proceeds for the excess number of shares would be recoverable. Recoverable amounts would be calculated on a pre-tax basis.
The proposed rules require issuers’ policies to mandate recovery of excess incentive-based compensation "during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement." The date on which the issuer is required to prepare a restatement would be defined as the earlier of the date a board of directors (or committee thereof) concludes or should have concluded that a previously issued financial statement contains a material error or the date a court, regulator, or legally authorized body directs the issuer to file a restatement to correct a material error.
Under the proposed Rule 10D-1, issuers would be prohibited from indemnifying executives in any way for loss of incentive-based compensation due to a clawback, including by paying premiums on insurance policies that would cover amounts clawed back.
Exemptions and Board Discretion
The proposed rules would apply to all listed companies except registered investment companies that do not provide incentive-based compensation. There is no carve out for emerging growth companies, smaller reporting companies, or foreign private issuers.
The proposing release discusses at some length the issue of board discretion in pursuing recovery under the required policies. On balance, the SEC determined to allow very limited discretion, concerned that allowing discretion whether to recover excess compensation could undermine the purpose of the statute. Accordingly, the proposed rule would provide for mandatory recovery except to the extent the pursuit of recovery would be impractical because it would impose undue costs on the issuer or when the recovery would violate the home country law of a foreign issuer. Before concluding that it would be impractical to pursue recovery, however, an issuer would first need to make a reasonable attempt to recover incentive-based compensation. Before concluding that it would violate home country law, an issuer would need to obtain an opinion of home country counsel. Finally, any such decision not to pursue recovery would need to be made by the compensation committee of the board of directors, or other fully independent committee of the board responsible for executive compensation decisions, and would be subject to review by the listing exchange. These decisions would then need to be disclosed, along with the reasons the issuer made its decision not to pursue recovery.
SEC Chair, Mary Jo White, said the ability to recover compensation should "increase accountability and bring greater focus to the quality of financial reporting." Voting in favor of the proposals, Commissioner Kara Stein noted that clawbacks are not a new concept as it has been reported that at least 90 percent of Fortune 100 companies have voluntarily adopted a clawback policy. Commissioner Stein also commented that by requiring the issuer to recover incorrectly awarded compensation, the burden will not be on shareholders to pursue expensive litigation to recover such compensation.
SEC Commissioners Daniel Gallagher and Michael Piwowar dissented. Commissioner Gallagher objected that the proposed rules do not permit corporate boards sufficient discretion in deciding how and when to pursue clawbacks. He was opposed to the broad scope of executives covered by the proposed rules and the no-fault nature of the proposals. He also argued that smaller reporting companies, emerging growth companies, foreign private issuers, and investment companies should be excluded in the initial implementation of the proposed rules. Commissioner Piwowar predicted that executive salaries may be increased to provide for more guaranteed compensation rather than incentive-based compensation so that companies and executives can mitigate the risk of clawbacks.
If adopted, exchanges would be required to propose listing rules in compliance with the new rules within 90 days of publication of the final adopted version of Rule 10D-1 in the Federal Register. The listing rules must be effective no later than one year following that publication date. Issuers would be required to adopt compliant clawback policies within 60 days of the effective date of the listing exchange’s rules.
Furthermore, issuers must comply with the recovery requirements for financial information for any fiscal period ending on or after the effective date of Rule 10D-1. Thus, compliance is required whether or not the incentive-based compensation is received based on a pre-existing contract or arrangement, or an arrangement entered into after adoption of Rule 10D-1. Issuers must then comply with disclosure requirements on or after the date on which the applicable exchange’s listing rules become effective.
The SEC proposal acknowledges that one result of implementation of incentive-based recovery policies may be that executive officers demand incentive-based compensation be a smaller portion of their total compensation. As incentive-based compensation typically aligns the interests of executive officers and shareholders, less incentive-based compensation may move shareholder and executive interests in opposing directions. On the other hand, the proposal noted that to the extent executives may affect the preparation of financial statements, incentive-based compensation may give executives an incentive to influence the statements in ways that increase the financial reporting measure to which their incentive-based compensation is tied, which may also be adverse to shareholder interests.
The SEC proposal reported that in calendar year 2012, only approximately three percent of the population of issuers had a restatement. The analysis concluded that as the number of restatements is typically small, restatements leading to clawbacks under the proposed rules and rule amendments, would be "relatively infrequent."
Notwithstanding this underlying assumption, we expect extensive comments will be filed with the Commission in respect of the proposed rules. The sweeping scope of potential compensation that must be recovered, the near complete lack of discretion that may be exercised by boards of directors and the "no fault" reach of the clawback trigger will undoubtedly raise great concern and give rise to substantial objections. It is unclear whether institutional investors will regard the proposed rules as important protections for shareholders or as undermining the recent positive focus on pay for performance. The comment period will run for 60 days from the date of publication in the Federal Register.