On July 1, the SEC issued long-awaited proposed rules pursuant to the 2010 Dodd-Frank Act. As we've discussed in prior posts here and hereSection 954 of Dodd-Frank required the SEC to direct national security exchanges not to list any company that does not adopt a policy requiring recovery of incentive-based pay received by executive officers in excess of what would have been received under an accounting restatement. Although the new rules are only proposals and they could change after public comment, it's not too early for executives to begin to plan for the financial issues they will face in the event their company issues a financial restatement, as 746 companies did in 2014.

Clawbacks of executive compensation after a financial restatement are not new, of course. After the 2002 Sarbanes-Oxley Act authorized the SEC to claw back one year’s worth of incentive compensation from a CEO or CFO whenever there has been a financial restatement resulting from "misconduct," companies began voluntarily adopting clawback policies applicable to financial restatements.  And after the Emergency Economic Stabilization Act of 2008 required clawback policies for companies receiving financial assistance under TARP that applied to "any bonus, retention award, or incentive compensation... based on statements of earnings, revenues, gains or other criteria that are later found to be materially inaccurate,"  additional companies adopted or expanded their clawback regimes. Today, most Fortune 100 companies have a clawback policy applicable to restatements (although they differ widely as to the triggering events, the types of compensation subject to clawback, whether the executive must have caused or contributed to the false or incorrect financial reporting, and the board's discretion to forgo a clawback, among other variables). But many large companies and most mid-cap and small companies have not adopted clawback policies, and virtually no company has implemented a clawback policy as severe as the Dodd-Frank legislation’s mandate. Most have been waiting for the SEC's proposed rules.

The SEC's proposed rules will, assuming they are not changed before they become effective, require every company listed on a United States exchange to have a clawback policy that meets certain stringent standards. While the proposed rules are lengthy and would require an extensive discussion beyond this alert, we note several important features below.

First, clawbacks will be required in the event that the company is required to prepare an accounting restatement due to the company’s non-compliance with any financial reporting requirement, without regard to fault. Whereas SOX authorized the SEC to claw back excess incentive compensation where the restatement resulted from "misconduct," the Dodd-Frank Act, as interpreted by the SEC, provides that issuers must recover excessive incentive pay regardless of the executive’s fault, or even their knowledge of and/or complicity in making the error leading to the restatement.

Second, under Dodd-Frank, recovery of excess incentive-based compensation is required from "any current or former executive officer" who received it. The SEC's proposed definition of "executive officer" includes not only the issuer's "president, principal financial officer, [and] principal accounting officer,"  but  "any vice-president of the issuer in charge of a principal business unit, division or function" as well as "'any other officer who performs a policy making function or any person who performs similar policy-making functions for the issuer." This definition could sweep numerous unsuspecting officers into a clawback policy's ambit, including those who may have no financial reporting or accounting responsibilities whatsoever.

Third, Dodd-Frank required that issuers adopt clawback policies requiring recovery of "excess incentive based compensation" received "during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement." The SEC's proposed rule defines "incentive-based compensation" not only to include all compensation based wholly or partially on any accounting metric used in financial statements, but compensation based on stock price or total shareholder return. The recoverable amount is defined by the SEC to be "the amount of incentive-based compensation received ... that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement." The proposed rule further clarifies that the required recovery would include "the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement." In this manner, the proposed rule will require every issuer who restates to claw back substantial sums, except in the most unusual situations. And, as the SEC's proposed rule makes clear, the recoverable amount would be calculated on a pre-tax basis!

Fourth, the SEC's proposed rules would allow the issuer the discretion not to seek erroneously awarded incentive-based compensation only if pursuit of recovery “would impose undue costs on the issuer or its shareholders.” In the SEC's view, the only criteria that should be considered is whether the direct costs of enforcing recovery would exceed recoverable amounts. The SEC’s proposed rules would require issuers to attempt to clawback the amount they deem subject to recovery from every executive before declaring the clawback "impractical," and to thereafter report their failed efforts to the listing exchange. Thus, executives can expect their company to seek to claw back the determined amount of excess compensation in connection with every accounting restatement, no matter how small.

Fifth, and finally, the SEC's proposed rule would prohibit a listed issuer both from indemnifying any executive officer against the loss of erroneously awarded compensation and from paying or reimbursing the executive for premiums for an insurance policy to fund potential recovery obligations. Importantly, the SEC's proposed rule does not prohibit executives from purchasing their own insurance policies, assuming such policies are offered in the marketplace, or prohibit issuers from indemnifying an executive officer's legal fees incurred in contesting a clawback. But only time will tell whether these "rights" survive the public comment process.

Few companies listed on the U.S. exchanges have ever attempted to claw back an executive's compensation. That day is about to change. Although these proposed rules are not yet final and affected companies will have substantial time to implement them once they become final, it is time for executives to take note. In future alerts, we will focus on steps executives may want to take to protect themselves from the clawback rules and how "innocent" executives may be able to challenge attempts to claw back already earned compensation after a financial restatement.