On July 1, the SEC proposed rules requiring national security exchanges (such as NYSE and Nasdaq) to establish listing standards requiring publicly traded companies to adopt, comply with and disclose written clawback policies. The proposed rules would implement Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) and is the last of the four main executive compensation-related rules that the SEC was required to implement under the Act. The fact that the clawback proposal came last was not unexpected, as it creates some of the more difficult interpretive questions of all of the Dodd-Frank executive compensation rules.

Under the Act, the SEC is required to direct the national securities exchanges to prohibit the listing of any security of a company that fails to adopt and disclose a clawback policy that provides for recovery of any incentive compensation received by any current or former executive officer within three years prior to the date on which the company is required to prepare a restatement of its financials, to the extent the compensation paid was based on erroneous data and exceeds the compensation that would have been paid under the restatement. The proposed rules would implement the statutory requirement and address many interpretive issues left open by the Act, while leaving some issues still unresolved, as summarized below.

Which issuers are covered?

All listed issuers – including smaller reporting companies, emerging growth companies, foreign private issuers and controlled companies – would be covered. The only exceptions would be for issuers of security futures products and standardized options, registered investment companies that have not awarded incentive-based compensation to any executive officers of the company for the past three years, and unit investment trusts. Listed issuers of debt or preferred securities (even if they do not issue common equity securities) would be covered to the same extent as listed issuers of common equity securities.

What type of restatement would trigger application of the policy?

Under the proposed rules, a clawback policy would apply if the issuer was required to prepare an accounting restatement to correct an error that was material to previously issued financial statements. Certain retrospective changes to financial statements that are not considered error corrections under generally accepted accounting standards – such as retrospective application of a change in accounting principles – would not trigger application of the policy. The proposed rules do not attempt to define when an error would be considered “material” for this purpose, instead leaving it up to the issuer to determine in light of the facts and circumstances and in accordance with applicable regulatory guidance and legal precedents.

What is the date on which a restatement is required to be prepared?

For purposes of applying the three-year look-back period, the date on which a restatement is required to be prepared would be the earlier of (i) the date on which the issuer’s board of directors (or authorized delegate) concludes (or reasonably should have concluded) that the previously issued financial statements contained a material error, or (ii) the date on which a court, regulator or other legally authorized body directs the issuer to restate its financials. The date is not the date when the restatement is actually filed.

Which executives would be subject to the policy?

All current and former executive officers would be subject to the policy, with “executive officer” defined substantially the same as the definition that applies for purposes of reporting and short-swing liability under Section 16 of the Securities Exchange Act of 1934. “Executive officer” specifically would include the principal financial officer and principal accounting officer (or controller if there is no principal accounting officer). (Notably, the SEC is soliciting comment on whether “executive officer” should include additional officer positions that aren’t currently included in the Section 16 definition, such as the chief legal officer and chief information officer.) If a person served as an executive officer at any time during the performance period relevant to the incentive compensation, then all of his or her incentive compensation would be subject to clawback under the policy if received during the three-year look-back period. However, any incentive compensation with a performance period that ended before the person was an executive officer, or started after the person ceased to be an executive officer, would not be subject to the policy.

What types of incentive compensation would be subject to the policy?

Under the proposed rules, “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.” Financial reporting measures would include (i) any accounting-based measures presented in a company’s financials, (ii) any financial measures derived in whole or in part from such financial information (whether or not contained in any SEC filing or presented in the company’s financials), (iii) stock price, and (iv) total shareholder return (TSR). Compensation based on nonfinancial strategic or operating measures (such as the consummation of an M&A transaction or the opening of a specified number of stores) would be excluded, as would salary, service-based retention bonuses, and bonuses that are purely discretionary or that are based solely on subjective criteria (such as demonstrated leadership). There would be substantial complexities involved in applying the rules to performance measures such as stock price and TSR, which are further explained below.

Is a service-vested stock option or other equity award deemed to be “incentive based compensation” merely because its value is based on the company’s stock price?

No − service-based awards that vest merely on the passage of time are not “incentive based compensation”; only stock options and other equity awards, the granting or vesting of which is based all or in part upon the attainment of a financial reporting measure, would be included in the definition of “incentive based compensation.” Options and other equity awards that are granted and that vest based solely on the passage of time and the continued performance of services would not be considered “incentive based compensation” even though their value fluctuates with the value of the company’s stock price.

How is the three-year look-back period determined?

Under the proposed rules, the look-back period would be the three most recently completed fiscal years of the company immediately preceding the date on which the restatement is required to be prepared − not the 36-month period prior to such date. If a company changes its fiscal year during the look-back period, the look-back period would include any transition period of less than nine months occurring during or immediately following the three-year look-back period (so that up to four periods might be covered).

When is compensation “received”?

Compensation would be deemed “received” for purposes of the proposed rules in the fiscal period in which the financial reporting measure is attained, even if the compensation is not actually paid until a later date and even if the compensation is subject to further service-based vesting conditions after such period ends. The compensation must be received while the issuer is a listed company for the policy to apply. Incentive based compensation that is received after an issuer becomes listed would be subject to the policy, even if the compensation had been granted before the issuer becomes listed.

How does one determine the amount of compensation that must be recovered?

Under the proposed rules, the amount of incentive-based compensation that must be recovered (the “erroneously awarded compensation”) is the amount received by the current or former executive officer that exceeds the amount that would have been received had it been based on the accounting restatement. The recoverable amount would be determined on a pre-tax basis and the proposed rules do not address the consequences of recovery for the executive officer’s personal tax situation. If compensation has already been recovered pursuant to Section 304 of the Sarbanes-Oxley Act, the recovered compensation would be credited against the compensation to be recovered under the clawback policy.

How is the recoverable amount determined with respect to …

A. Incentive compensation based on a company’s stock price or TSR?

For incentive compensation that is subject to the attainment of a stock price or TSR goal, companies may use reasonable estimates to determine the effect of the erroneous data on the company’s stock price or TSR, must disclose their methodology for the estimate, and must maintain and provide documentation relating to their methodology to the exchange. The proposed rules suggest that an “event study” may be an appropriate methodology for determining the impact of a restatement on stock price or TSR, and acknowledge that an outside expert may need to be retained to perform the analysis, given the requirement that the estimate must be “reasonable” and the possibility that an executive officer may challenge the estimate.

B. Stock options and other equity awards?

For stock options or equity awards that are still outstanding, the recoverable amount is the number of options or shares that exceeds the number that should have been granted or vested. If options have been exercised and the shares are still held, the recoverable amount is the number of shares attributable to the excess options. If the shares under an option or other equity award have already been sold, the recoverable amount is the proceeds from the sale of shares attributable to the excess options or other award. For options that have been exercised, the recoverable amount is reduced by the exercise price paid. There may be additional complexities involved in determining the number of options or other equity awards subject to clawback, which the proposed rules do not directly address − for example, if the number of shares subject to an award was determined by dividing a dollar value by the closing stock price on the grant date, whether the estimated effect of the erroneous data on the stock price could or should also be taken into account.

C. Retirement plans?

Where erroneously awarded compensation has been deferred into a nonqualified plan, the proposed rules provide that the account balance or distributions attributable to the erroneously awarded compensation should be reduced, but do not provide any guidance on the potential consequences under Internal Revenue Code Section 409A. Where erroneously awarded compensation has been used to calculate an executive officer’s accrued benefit under a pension plan, the proposed rules provide that the accrued benefit should be reduced or distributions recovered, but do not address the potential application of ERISA prohibited transaction or anti-alienation rules or the similar IRS rules applicable to qualified retirement plans.

D. Bonus pools?

For a bonus pool, where the amount of the pool is based on the attainment of a financial reporting measure but individual awards are determined in the company’s discretion, the size of the bonus pool would be reduced based on the restated measure. If the reduced pool were less than the aggregate amount of the individual bonuses received, then the recoverable amount with respect to each individual bonus would be the pro rata portion of the total deficiency. An issuer would not have discretion to forgo recovery of discretionary bonuses received from a bonus pool except in the limited circumstances described below.

May a company exercise discretion in determining whether to recover compensation?

A company may decline to pursue recovery of erroneously awarded compensation only to the extent the pursuit would be impracticable because it would impose undue costs on the company or its shareholders or would violate home country law in existence at the time the proposed rules were published. For cost-related impracticability, only the direct costs payable to a third party (such as legal costs) and not indirect costs (such as reputational harm) could be taken into account. Before concluding that the costs of recovery would make recovery impracticable, a company would first have to make a reasonable attempt to recover the compensation, document its attempts to recover, provide such documents to the exchange on which it is listed and publicly disclose why it chose not to pursue recovery. For impracticability related to home country law, a company would have to obtain an opinion of home country counsel that the recovery was prohibited by home country law, and the option would need to be satisfactory to the listing exchange. “Home country law” is undefined and it is unclear whether it might apply, for example, with respect to U.S. state wage and hour laws, which might prohibit clawbacks in certain circumstances. Determinations regarding impracticability would need to be made by the compensation committee or (if no compensation committee) by the majority of independent directors on the board and would be subject to review by the listing exchange.

May a company exercise discretion in determining the means of recovery?

The proposed rules would allow issuers to exercise discretion in how to recover excess compensation (e.g., recovering compensation over time or reducing future pay), provided that they act in a manner that reasonably effectuates the purpose of the statute, including avoiding undue delay. While there would be no mandatory time limit for completing recovery, the exchanges would have the power to delist an issuer that was not in compliance with its clawback policy, including if the exchange determined that the issuer was not making good faith efforts to promptly recover the compensation.

What are the disclosure requirements relating to the clawback policy?

U.S. issuers would be subject to three new disclosure requirements with respect to their clawback policies:

  1. The issuer would be required to file its clawback policy as an exhibit to its annual report on Form 10-K.
  2. If a restatement requiring recovery under the policy was completed in the past fiscal year or if there was an outstanding balance of excess compensation due under the policy with respect to a prior restatement, the issuer would be required to disclose in its annual report and annual or special proxy statement: (i) the date when the restatement was required to be prepared, the amount of erroneously awarded compensation recoverable under the policy with respect to the restatement, any estimates used in calculating the erroneously awarded compensation and any unrecovered compensation as of the end of the fiscal year; (ii) the recipients and amounts of any erroneously awarded compensation that the issuer decided not to recover and the reasons why; and (iii) the recipients and amounts of any erroneously awarded compensation that had been outstanding for more than 180 days as of the end of the year.
  3. If an amount was recovered from an individual who is a named executive officer, the recovered amount would need to reduce the amount reported in the applicable column of the Summary Compensation Table for the fiscal year in which the recovered amount was initially reported, and be identified by footnote to the table.

Similar disclosure requirements would apply to foreign private issuers.

May a company indemnify an executive officer for recovery of erroneously awarded compensation?

The proposed rules would prohibit a company from indemnifying an executive officer for the loss of erroneously awarded compensation that the officer is required to pay back under the clawback policy, whether directly or indirectly (for example, by funding the officer’s purchase of third-party indemnification insurance), without regard to fault.

When would the new rules become effective?

There is a 60-day comment period for the proposed rules, after which they may be finalized by the SEC. The proposed rules would require the exchanges to propose listing standards within 90 days after the proposal is finalized by the SEC and to make the listing standards effective (with SEC approval) within one year after they have been proposed. Listed companies would have 60 days after final listing standards are effective to adopt clawback policies and would be subject to the disclosure requirements for any filings made on or after the effective date of the final listing standards. Clawback policies would be required to apply to any incentive compensation received by an executive officer with respect to a fiscal period ending on or after the effective date of the SEC proposal (not the listing standards), even if the contract or arrangement pursuant to which the incentive compensation was received was entered into before the effective date of the SEC proposal.

Are there any steps companies should be taking now?

Consider New Arrangements. Companies should consider adding provisions to any newly entered incentive compensation arrangement that would subject the compensation payable under the arrangement to any clawback policy that may be adopted by the company in the future.

Consider Existing Arrangements. With respect to existing arrangements, the proposed rules state that clawback policies would need to apply to any incentive compensation received with respect to a fiscal period ending on or after the effective date of the proposal, including compensation payable pursuant to pre-existing arrangements. In addition, the proposed rules further state that it would not be considered impracticable to recover compensation under existing contracts and arrangements merely because recovery might violate the terms of those arrangements, at least to the extent the arrangements could be amended to accommodate recovery. Issuers should therefore consider whether it is possible and, if possible, whether it is appropriate at this time to amend the terms of existing incentive compensation arrangements to subject compensation payable under the arrangements to any clawback policy that may be adopted by the issuer in the future.

Review Bylaw Provisions. If a company’s bylaws prohibit recovery of compensation that would be required to be recovered under the proposed rules, the company should consider whether it is appropriate at this point to amend its bylaws to allow such recoveries.

Review Indemnification Provisions. Similarly, if a company’s articles or bylaws, or if individual indemnification agreements with executive officers or a company’s D&O insurance policies provide for indemnification of executive officers for loss of erroneously awarded compensation, companies should consider whether it is appropriate at this point to amend these arrangements to eliminate these indemnification rights.

Review Compensation Committee Charters. Companies should consider whether it would be appropriate at this point to amend their compensation committee charters to address the new duties regarding clawback policy administration that would be imposed on compensation committees under the proposed rules.

Consider Clawback Policy Design Changes. Finally, companies that do not have clawback policies in place face the choice of whether to adopt a policy now that reflects the requirements of the proposed rules, or alternatively to wait until the SEC proposal and the exchange standards have been finalized. While the answer to this will depend on each company’s individual situation, consideration should be given to the fact that the rules are only proposed, are likely to receive substantial comment and may undergo substantial changes before being finalized. Similarly, companies with existing clawback policies will face the same choice regarding whether to amend the policies now or to wait and see, and their decisions should be informed by the same considerations.