The Securities and Exchange Commission recently issued proposed rules that would implement Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires recovery of excess incentive-based compensation paid due to a material error in an issuer’s financial statements. The rules would also require the policy to be filed as an exhibit to the issuer’s annual report and would require disclosure of any actions taken pursuant to the policy.

Introduction

The Securities and Exchange Commission recently issued proposed rules that would implement Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires recovery of excess incentive-based compensation paid due to a material error in an issuer’s financial statements. The rules would also require the policy to be filed as an exhibit to the issuer’s annual report and would require disclosure of any actions taken pursuant to the policy.

The proposed rules, which apply to both domestic companies and foreign private issuers, will remain open for comment for 60 days following their publication in the Federal Register. If adopted by the SEC, the rules would require the New York Stock Exchange, Nasdaq and other US exchanges to prepare listing rules based on the SEC requirements. The exchanges could elect to adopt rules that are more extensive than the SEC requirements, and companies could choose to adopt policies that are more extensive than the exchange requirements.

Compensation recovery rules

If adopted as proposed, the rules would require companies to adopt and implement policies to recover incentive-based compensation received by current or former executive officers during the three fiscal years prior to the date the company is required to prepare an accounting restatement of the company’s financial statements due to an error that is material to the previously issued financial statements. Companies generally would be required to recover the amount of incentive-based compensation received by an executive officer that exceeds the amount that would have been received had the incentive-based compensation been determined based on the restated financial statements.

Whether or not an error is material would be analyzed in the context of the particular facts and circumstances. Changes to financial statements that would not represent error corrections include (i) retrospective application of a change in accounting principle, (ii) retrospective revision to reportable segment information due to a change in the structure of an issuer’s internal organization, (iii) retrospective reclassification due to a discontinued operation, (iv) retrospective application of a change in reporting entity, (v) retrospective adjustment to provisional amounts in connection with a prior business combination, and (vi) retrospective revision for stock splits.

Companies would be required to recover erroneously awarded compensation in compliance with their recovery policies except to the extent that the company’s committee of independent directors responsible for executive compensation decisions (or, if none, a majority of independent directors serving on the board) determines that:

  • the direct costs of enforcing recovery would exceed the recoverable amounts (following a reasonable attempt to recover such compensation, which is documented and provided to the applicable exchange); or
  • for foreign private issuers, recovery would violate home country law adopted prior to the date that the proposed rules are published in the Federal Register (based upon an opinion of home country counsel not unacceptable to the applicable exchange).

Indemnification of executive officers against the loss of erroneously awarded compensation would be prohibited, as would payment by the company of premiums for insurance covering such losses.

Incentive-based compensation

Under the proposed rules, incentive-based compensation would be defined to include “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) measures that are based on the accounting principles used in preparing the company’s financial statements, (ii) measures derived wholly or in part from such financial information, and (iii) stock price and total shareholder return. Importantly, service-based awards whose vesting is linked solely to continued employment or service with the employer would not need to be subject to clawback under the proposed rules.

Examples of financial reporting measures whose attainment would be considered part of incentive-based compensation include (i) revenue, net income, or operating income, (ii) profitability of one or more reportable segments, (iii) financial ratios (such as accounts receivable turnover or inventory turnover rates), (iv) net assets or net asset value per share, (v) EBITDA, (vi) funds from operations and adjusted funds from operations, (vii) liquidity measures such as working capital or operating cash flow, (viii) return measures such as return on invested capital or return on assets, (ix) earnings per share, (x) sales per square foot or same store sales, where sales is subject to an accounting restatement, (xi) revenue per user, or average revenue per user, where revenue is subject to an accounting restatement, (xii) cost per employee, where cost is subject to an accounting restatement, (xiii) any of such measures relative to a peer group, and (xiv) tax basis income.

Certain forms of incentive-based compensation would not be included in the SEC’s proposed clawback policy. An incentive plan award that is granted, earned or vested based solely on the occurrence of non-financial events, such as opening a specified number of stores, obtaining regulatory approval of a product, consummating a merger or divestiture, or completing a restructuring plan or financing transaction, would not be “incentive-based compensation” because these measures of performance are not financial reporting measures.

Examples of compensation that would not be incentive-based compensation would include (i) salaries, (ii) bonuses paid solely at the discretion of the compensation committee or board that are not paid from a bonus pool whose size is determined based wholly or in part on satisfying a financial reporting measure performance goal, (iii) bonuses paid solely upon satisfying one or more subjective standards (such as leadership) and/or completion of a specified employment period, (iv) non-equity incentive plan awards earned solely upon satisfying one or more strategic measures (consummating a merger or divestiture) or operational measures (increases in market share or completion of a project), and (v) equity awards for which the grant is not contingent on achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more non-financial reporting measures.

The policy would apply to excess incentive-based compensation received during the three completed fiscal years (not the most recent 36 months) immediately preceding “the date on which the issuer is required to prepare an accounting restatement.” The proposed rules clarify that the “date on which the issuer is required to prepare an accounting restatement” would be the earlier of (i) the date the company’s board, board committee or officers authorized to act, if board action is not required, concludes, or reasonably should have concluded, that its previously issued financial statements contain a material error, and (ii) the date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error. The SEC’s proposing release also notes that, while not dispositive, a company would have to consider carefully any notice received from its independent auditor that previously issued financial statements contain a material error.

Incentive-based compensation would be deemed “received” in the fiscal period during which the financial reporting measure specified in the award is attained, even if payment or grant occurs after the end of that fiscal period. For example, if the grant of an award is based on satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when that measure is satisfied. If an equity award vests upon satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when it vests. If adopted as proposed, the rules would apply to incentive-based compensation received by executive officers and former executive officers as a result of attainment of financial reporting measures based on or derived from financial information for any fiscal period ending on or after the effective date of the new SEC rules and that is granted, earned or vested on or after the effective date of the new SEC rules.

Executive officers subject to the recovery rules

Under the proposed rules, recovery would apply to both current and former executive officers, regardless of whether any misconduct occurred or whether a particular executive officer had responsibility for the erroneous financial statements. An individual would be subject to recovery of any excess incentive-based compensation earned during the three fiscal years immediately preceding the date the company is required to prepare a restatement if he or she served as an executive officer of the company at any time during the applicable three-year look-back period for the compensation in question.

The definition of executive officer under the proposed rules, similar to the definition of officer under Section 16 of the Securities Exchange Act, would include the company’s president, principal financial officer, principal accounting officer (or if none, the controller), any vice president in charge of a principal business unit, division or function, any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the company. Executive officers of the company’s parents or subsidiaries would be deemed executive officers of the company if they perform such policy making functions for the company.

Companies subject to the recovery rules

The proposed rules would generally apply to all listed companies, including foreign private issuers, emerging growth companies, business development companies, smaller reporting companies and controlled companies, with only limited exceptions. 

While the rules would apply to foreign private issuers, the proposal would allow exchanges to permit foreign private issuers to forgo recovery as impracticable if the recovery of erroneously awarded compensation would violate the home country’s laws. The SEC’s proposing release also solicited comment whether foreign private issuers should be allowed to comply with home country law rather than the SEC’s proposed clawback rules where home country law already includes an applicable clawback policy.

In addition, the proposed rules would generally apply without regard to the type of securities issued (e.g., issuers of listed debt or listed preferred securities that do not have listed common stock would still be covered).

Proposed disclosure required for recoveries

As proposed, listed issuers, including foreign private issuers, would be required to file their excess incentive-based compensation recovery policy as an exhibit to their annual report (on Form 10-K, 20-F or 40-F).

In addition, if, at any time during its last completed fiscal year, either the company prepared a restatement that required recovery of excess incentive-based compensation, or there was an outstanding balance of excess incentive-based compensation from the application of its policy to a prior restatement, any listed issuer, including foreign private issuers, would be required to disclose:

  • the date the company was required to prepare an accounting restatement, the aggregate dollar amount of excess incentive-based compensation attributable to the restatement and the aggregate dollar amount of excess incentive-based compensation that remained outstanding at the end of the last completed fiscal year; 
  • reasonable estimates used to determine the excess incentive-based compensation, if the financial reporting measure related to stock price or total shareholder return goals; 
  • the name of each person subject to recovery from whom the company decided during the last completed fiscal year not to pursue recovery, the amount forgone for each such person, and a brief description of the reason the company decided in each case not to pursue recovery; and
  • the name of, and amount due from, each person from whom, at the end of the company’s last completed fiscal year, excess incentive-based compensation had been outstanding for 180 days or longer.

Under the proposed rules, the disclosures would be included in the listed issuer’s annual reports and proxy or information statements in which executive compensation disclosure is required. In addition, the disclosures would need to be prepared in interactive data format using XBRL block-text tagging (however, foreign private issuers that prepare their financial statements in accordance with IFRS as issued by the IASB would continue to be exempt from submitting interactive data files until the SEC specifies a taxonomy for use by such foreign private issuers).

The disclosure requirement is proposed as a separate disclosure item rather than an amendment to the CD&A rules, but listed issuers who prepare a CD&A could choose to include the new disclosure in their CD&A discussion. The proposed rules would also require an adjustment to the disclosure in the summary compensation table. Compensation recovered pursuant to a listed issuer’s erroneously awarded compensation recovery policy would reduce the amount reported in the applicable column for the fiscal year in which the amount recovered initially was reported, and would be identified by footnote.

Required disclosures would need to be included in applicable SEC filings required on or after the date on which the exchange rules become effective. 

Timing and procedural requirements

  • If adopted as proposed, the rules would require national securities exchanges and associations to file listing rules requiring companies to recover excess incentive-based compensation. Such rules would need to be filed no later than 90 days after publication of the final SEC rules in the Federal Register. The exchange rules would be required to be effective no later than one year from such publication date.
  • Listed companies would be required to adopt policies providing for the recovery of excess incentive-based compensation no later than 60 days after the date that the listing exchange’s rules become effective.
  • Compensation recovery policies would need to be applied to excess incentive-based compensation received by current and former executive officers as a result of attainment of financial reporting measures based on or derived from financial information for any fiscal period ending on or after the effective date of the new SEC rules and that is granted, earned or vested on or after the effective date of the new SEC rules. Issuer compliance would be required whether such incentive-based compensation is received pursuant to a pre-existing contract or arrangement, or one that is entered into after the effective date of the exchange’s listing standard.
  • Listed companies would be required to provide disclosure in applicable SEC filings required on or after the date on which the exchange rules become effective regarding the application of their compensation recovery policies.

Next steps

Listed companies that will become subject to these new rules once finalized should begin to develop a clawback policy, or review existing clawback policies to determine what changes, if any, may be required under the new rules.

Listed companies and executive officers should also begin to evaluate more generally possible modifications to existing incentive compensation plan design features in order to facilitate compliance with the new rules. As the SEC noted in its proposing release, “incentive-based compensation as defined in the proposed rule and rule amendments would not include base salary; compensation tied to operational metrics that are not financial reporting measures; or compensation awarded solely at the issuer’s discretion. These forms of compensation would not be subject to recovery under a policy that meets the proposed rule requirements. These exclusions may create the incentive to shift compensation from forms that are subject to recovery to forms that are not subject to such recovery.”