Initial guidance from the Securities and Exchange Commission on implementation of the "clawback provisions" of Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act has finally arrived.  Cue the chorus of contention.  Under Proposed Rule 10D-1, incentive compensation awarded, earned or vested based in any part on a company's attainment of a financial reporting measure, including stock price and total shareholder return, will be required to be recovered from a current or former executive officer in the event of an accounting restatement in connection with a material error in previously published financial statements.  Names of the affected individuals and amounts of recovery will be disclosed in proxy statements and annual reports.

Dodd-Frank Requirements

As background, the clawback rules require that if a publicly-traded company determines that an accounting restatement is required due to a material error in previously published financial statements, then such company must recover incentive compensation previously paid to any current or former executive officer in excess of the amount that would have been paid or awarded if the determination of such incentive compensation had been based on the accounting restatement.  A lookback period of three years prior to the date on which the company is required to prepare the restatement is applied for recovery and disclosure purposes

Proposed Rule

Under new Proposed Rule 10D-1, the national securities exchanges must establish standards that require listed companies to adopt, implement and disclose "excess incentive compensation" clawback policies.  Failure to comply with the standards would result in delisting.

Many of the provisions contained in the proposed rule issued by the SEC fall in line with corporate expectations: 

  • recovery is required from current and former executive officers on a no-fault basis (the definition of executive officer is based on the Section 16 officer definition);
  • the status of a “current or former executive officer” is based on attainment of such status at any time during the performance period, not just at grant date or the first day of the performance period;
  • the recovered amount must equal the difference between the incentive-based compensation received and the amount that would have been received if calculated on the basis of the financial restatement; and
  • companies must disclose recoveries in annual reports and proxy statements.

However, there are also some provisions of the proposed rule that are likely to be vigorously opposed during the SEC comment process which runs through September 14, 2015.  For example, the proposed rules provide no exceptions for small reporting companies, emerging growth companies or foreign private issuers. In addition, the proposed rule provides for the following:

  • disclosure requires a listing of the names of the executive officers and the specific amounts involved in the recovery;
  • foregone recoveries (e.g., the executive officer is unable to repay or the Board decides not to pursue collection) must also be reported in detail;
  • companies may not indemnify executives against the loss of compensation recovered or reimburse them for premiums for any third-party insurance policy against such loss;
  • clawbacks are to be done on a pre-tax basis (meaning that the fact that an executive may have already paid personal income taxes based on inclusion of such amounts in his or her income is ignored);
  • the types of compensation subject to recovery include any incentive-based compensation granted, earned or vested based, in any part, on the attainment of any financial reporting measure, including stock price and total shareholder return; and
  • recovery is mandatory unless (i) the direct cost of enforcement would be greater than the amount of the recovery, or (ii), for private issuers, recovery would violate applicable foreign law adopted before the publication of the final rules and certain other conditions are met.

The proposed rule would apply the recovery rules to, among other things, bonuses earned with respect to a "bonus pool" tied to financial reporting measure performance goals; and stock options, stock appreciation rights, restricted stock, restricted stock units, performance share units and other equity or phantom equity awards which are granted or become vested wholly or in part based upon satisfaction of a financial reporting measure performance goal.  Cash proceeds received from a sale of shares that are granted or become vested based wholly or in part on satisfaction of a financial reporting measure performance goal are also subject to the clawback rules.  It is likely that supplemental retirement plans will be affected if the benefit is calculated based upon compensation which includes incentive-based compensation that is required to be recovered.

The proposed rule explains that an increase in base salary (provided such increase is not tied to the attainment of a financial reporting measure such as an increase in stock price); fully discretionary bonuses; bonuses not tied to financial reporting measure performance goals (for example, a bonus tied to specific strategic or operational goals that are not considered when producing the accounting statement); and equity awards for which neither the grant nor vesting is contingent upon achievement of any financial reporting measure performance goal will not be treated as subject to the clawback rules.  For example, the straight grant of stock options would not be affected as long as vesting is not tied to financial performance (vesting could be time-based), even though the value of the options is affected by fluctuating share value.  It appears, at least under the proposed rule, that retention bonuses tied solely to length of performance of services or bonuses tied solely to consummation of a "change in control" or a termination of employment following a change in control would not be affected.

The proposed rule does not provide much direction as to the manner and means of recovery, other than to specify that the recovery must be "prompt."  Clearly recovery of cash or held shares can satisfy the clawback rules. However, what other sources of recovery might be permitted under the final rule?  Can cancellation of awards not yet vested be made in lieu of a cash payment?  Can a reduction of future compensation or benefits be made to offset the clawback amounts otherwise payable (without a violation of IRC Section 409A)?  Could a "holdback plan" be designed with respect to a portion of some types of incentive-based compensation that would only be paid after the three-year lookback period ends? 

Effective Dates

The stock exchanges are required to issue their proposed listing rules within 90 days after the final rules are published in the Federal Register.  Such listing rules must be approved by the SEC and become effective not later than one year after the final rules are published.  Public companies will be required to adopt a "compensation recovery policy" within 60 days following the effective date of the stock exchange listing rules. Clawback will be required with respect to any incentive compensation related to financial reporting measures based on financial information for any fiscal period which ends on or after the effective date of the final rules if the executive was granted, earned or became vested in such compensation on or after the effective date of the final rules. Disclosure will be required in annual reports and proxy or information statements filed on or after the effective date of the listing rules.  Note that, while unlikely, it is possible that if final rules are published and become effective prior to December 31, 2015, for companies with a fiscal year of the calendar year, a financial restatement for the 2015 year may require recovery of outstanding incentive compensation which is based all or in part on the 2015 financial reporting measures.

So will we see a shift away from performance-based compensation? What provisions will need to be added to existing and new plan documents and grant agreements regarding recovery obligations? Stay tuned and speak with your legal counsel. Companies need to closely monitor the progress of the proposed rule and the exchange listing requirements yet to be issued.