At an open meeting this morning, the SEC voted, three to two, to propose rules implementing Section 954 of Dodd-Frank, the clawback provision. Both Commissioners Gallagher and Piwowar voted against the proposal.

As you may recall, Section 954 required the SEC to direct the national securities exchanges to adopting listing standards requiring each listed company to develop and implement a policy for recouping executive compensation that was paid on the basis of erroneous financial information, the theory being that it is compensation to which the executives were never really entitled in the first place. Under Dodd-Frank, the policy would apply in the event the company had to prepare an accounting restatement due to the company’s material noncompliance with any financial reporting requirement under the securities laws. The policy must provide that the company will recover from any current or former executive officer an amount of incentive-based compensation (including options awarded as compensation) equal to the excess, if any, of the amount that was paid to the executive officer, in the three years preceding the date on which the company was required to prepare the restatement, over the amount that would have been paid to the executive officer based on the accurate financial data. Additionally, the SEC must require each listed company to have a policy providing for disclosure of its policy on incentive-based compensation that is based on financial information required to be reported under the securities laws.  The purpose of the provision was to encourage high quality financial statements (The press release can be found here.)

The proposal would create new rule 10D-1, which would mandate the new listing standards, and amend Reg S-K to require disclosure of the policy and compliance with the recovery provisions.  Companies that did not comply would be subject to delisting. The proposal addressed a number of questions that remained open under Dodd-Frank, and, in the view of the two dissenting commissioners, addressed them improperly.

Under the proposal, the clawback policy would apply to listed companies, including foreign private issuers, smaller reporting companies and emerging growth companies.  In addition, the policy would be required to cover all current and former officers – as defined under Section 16 — who received incentive compensation during the three years preceding the date of the required restatement. The clawback policy would need to be filed as an exhibit to the Form 10-K.  Compensation would be deemed to have been received in the fiscal period when the particular metric was attained, even if the compensation was actually paid at a later time. A restatement would be deemed to have been “required” upon the earlier of (1) the date the board (or committee) concluded (or reasonably should have concluded) that a restatement was required or (2) the date that a court or regulatory body directed the company to restate its financial statements. “Incentive compensation” would mean any compensation granted, earned or vested based wholly or in part on attainment of accounting metrics used in the financial statements (or derived from those metrics, including non-GAAP financial measures), or based on stock price or total shareholder return (TSR).  Incentive compensation would not include salaries, awards that were earned or vested based solely on the passage of time or awarded wholly in the discretion of the board (such as a discretionary bonus) as well as non-equity incentive plan awards earned solely on the basis of satisfying one or more operational measures (e.g., opening a specified number of stores, completion of a project, increase in market share). With two exceptions, companies would be required to recover an amount of incentive-based compensation equal to the excess of the amount that was paid to the officer, in the three years preceding the date on which the company was required to prepare the restatement, over the amount that would have been paid to the officer based on the accurate financial data. No misconduct by the company or fault or responsibility by the officer affected would be required. Where the excess amount is not subject to calculation based on the restated financial statements (e.g., where the metric is stock price or TSR), the recovery amount would be based on reasonable estimates.   Companies would be required to recover the excess amounts unless the board determined that the recovery was “impracticable”—meaning that a majority of independent directors had determined that the cost to recover would exceed the amount to be recovered – or, for foreign private issuers, where the company has obtained an opinion of foreign counsel that the recovery was not permitted under pre-existing home country laws.  Before determining that recovery was impracticable, the company would need to make a reasonable attempt to recover the incentive-based compensation, document its attempts and provide that documentation to the exchange.  To avoid circumvention of the rule, the proposal would prohibit indemnification by the company or payment of premiums by the company on insurance to cover the potential losses to officers.

The proposal would also amend Section 402 of Reg S-K to require certain disclosures where there was either a restatement during that last fiscal year that required a recovery of excess compensation or the existence of outstanding balances owed to the company under the policy. These disclosures would include the date the restatement was required, the estimates in the event stock- or TSR-based metrics were used, the aggregate dollar amount of excess incentive-based compensation attributable to the restatement and the aggregate dollar amount that remained outstanding at the end of the last completed fiscal year, the name of each person from whom the company decided not to pursue recovery, the amounts due from each of those persons, and a brief description of the reason the company decided not to pursue recovery. If amounts of excess compensation were outstanding for more than 180 days, the name of, and amount due from, each person at the end of the company’s last completed fiscal year.  The information would be disclosed in proxy statements and Forms 10-K and data-tagged using XBRL.

Exchanges would be required to file their proposed amended listing standards within 90 days after publication of the SEC’s final rule in theFederal Register and listing rules would have to become effective within a year. Listed companies would be required to comply within 60 days after the effective date of the amended exchange rules and to recover all excess incentive-based compensation received on or after the effective date of the new rule that results from attaining a metric based on financial information for any fiscal period ending on or after the effective date of the new SEC rule.

None of the commissioners objected to the principles underlying the Dodd-Frank provision, although both Commissioners Gallagher and Piwowar voiced the criticism that the time spent developing proposals to implement the compensation-related provisions of Dodd-Frank represented a misallocation of SEC resources, particularly since Dodd-Frank did not include a deadline for this provision and the subject matter, in their view, had nothing to do with the financial crisis. Instead, the time would have been better spent on the disclosure review project or reevaluation of the shareholder proposal rules. If this all sounds vaguely familiar, it’s because it is. See this post. But, according to Commissioner Gallagher, the concept that executives should return compensation that was not really earned and that the policy might cause them to try harder to ensure accurate financial statements “made some sense.”

[Sidebar: Notably, Commissioner Gallagher opined that this provision of Dodd-Frank is not nearly as offensive as the pay-ratio provision, which, he said, the press is reporting will happen next month. So stay tuned.]

Nevertheless, he said, “the devil is in the details.” Both commissioners objected strenuously to the SEC’s proposed implementation of the provision.  Commissioner Gallagher likened the proposal to a tortured and nightmarish Goya.  For his statement, Commissioner Piwowar adopted a Yogi Berra leitmotif: it ain’t over till it’s over, the future ain’t what it used to be, etc.  Both commissioners objected to the inclusion of all but the biggest companies under the rule’s ambit.  Commissioner Gallagher preferred to experiment with larger companies that could more easily bear the costs and then ease in SRCs and ECGs;  Commissioner Piwowar preferred to make compliance voluntary for these smaller companies.

Commissioner Gallagher also objected to use of the broad definition of “officer” as including persons fulfilling policy-making functions, a definition that he argued was not required by the statute.  Similarly, he viewed the “no fault” nature of the proposal as likewise improper to infer from the language of statute and argued that the resulting strict liability, together with the broad definition of officer, created an injustice, especially for lower level officers who may have limited ability to influence events.  He also had apparently advocated during the rulemaking process a broader relief valve that would have given the board broad discretion to decide not to pursue a recovery or to settle or otherwise pursue lower or alternative recoveries. The “baked-in” disclosure requirements would have acted, he argued, as a disciplining mechanism for the board.  However, his alternative was excluded in favor of the narrower prescribed exclusions that, in his view, implied that boards were not to be trusted.  In addition, Commissioner Gallagher found fault with the proposal’s inclusion of stock and TSR-based metrics as “incentive compensation.” Primarily, he observed that it was unclear how to calculate the recovery for these metrics and that they required event studies and analyses involving judgments and assumptions that typically produced a range of outcomes.  As a result, the board would be inviting second-guessing by plaintiffs.  However, he acknowledged that exclusion of these metrics would only a encourage a shift of compensation to the use of TSR, which he views as contributing to short-termism. Ultimately, he had no answer for this conundrum.

Commissioner Piwowar contended that the rule might have the type of unintended consequences that resulted from the adoption of IRC 162(m) — it’s deja vu all over again — in that the uncertainty that would be inherent in the compensation paid would cause executives to demand large increases in their compensation to cover the risk. He also voiced a process complaint because some of the provisions of the rule to which he objected were apparently added late in the process. He also protested the piecemeal adoption of XBRL and questioned whether it might not be better to consider its adoption as a whole.

Chair White contended that the proposal should increase accountability and improve the quality of financial reporting. She recognized that, although the idea of clawbacks is “simple,’ implementation of the statute was complex, and defended the proposal as “a carefully considered approach.” Commissioner Aguilar believed that the new rules were fair and should promote the creation of a “culture of compliance that results in accurate reporting of financial performance.” If executives were permitted to retain compensation based on inflated financial results, the purpose of incentive compensation — to align the interests of management and shareholders – would be undercut and the promised alignment would disappear. He argued that the use of TSR and other stock-based metrics was necessary, given that, as shown in a recent study, 51% of the top 200 companies used TSR-based metrics for their incentive compensation.   He agreed with Commissioner Gallagher that excluding TSR would have created a “perverse incentive” for issuers to move executive compensation arrangements into stock- or TSR-based arrangements to avoid the clawback policy, thereby encouraging short-termism.  In addition, he essentially disputed the notion that this provision of Dodd-Frank had no relation to the financial crisis, noting that various commissions examining the crisis found that incentive-based compensation promoted a focus on the short-term, which led to higher risk business decisions, and that clawback provisions “could help restore symmetry and a longer-term perspective to executive compensation systems.” Similarly, Commissioner Stein referred to a study showing that, in the financial crisis, long-term shareholders suffered substantial losses as a result of companies’ excessive risk-taking while executives were still able to profit. She argued that Dodd-Frank intended to “realign compensation arrangements and structures to concentrate on long-term performance.”