Under Dodd-Frank, every public company will soon be required to adopt a “clawback” policy for the recovery of certain incentive-based compensation from its executive officers in the event the company is required to restate its financials as a result of material noncompliance with reporting requirements. Failure to develop and implement (and to disclose) such a policy will subject an issuer to delisting by U.S. securities exchanges and associations.
That much is known. But the brief clawback provision in the Dodd-Frank Act paints with broad (and largely undefined) strokes, leaving the details to be filled in by SEC regulation. There is no statutory deadline for the SEC rule-making process on clawbacks, and although expected in the near future, no rules have yet been proposed. Indeed, on December 31, 2011, the SEC announced that it expects to propose rules by June 30, 2012, on the recovery of erroneously awarded incentive compensation and expects to adopt those rules by December 31, 2012. Until then, companies will have to wait for official guidance on a number of issues, including the following:
Clawback Trigger. Dodd-Frank provides that a policy’s clawback requirements will be triggered if the issuer “is required” to prepare an accounting restatement due to any material noncompliance with financial reporting requirements under securities laws. As written, the statute imposes a strict liability standard on issuers – whereas the Sarbanes-Oxley clawback is tied to restatements necessitated by company misconduct, no malfeasance needs to have occurred for the Dodd-Frank requirements to apply.
No Director Discretion. Under Dodd-Frank, a clawback policy will also provide that the issuer “will recover” the excess amount of incentive-based compensation. Does this word choice mean that company directors will be forced to pursue clawbacks even if the effort would cost more than the potential recovery? If directors have no discretion in the matter and if the trigger is based on strict liability, then a corporation could be forced to pursue clawback from an innocent officer who, because of typical officer indemnification provisions, would be entitled to reimbursement (and even advancement) of costs for defense against the clawback. In other words, the company could end up paying for both the prosecution and defense of its recovery efforts.
Targeted Officers. The individuals whose compensation is subject to possible clawback under Dodd-Frank include “any current or former executive officer.” The definition of “executive officer” remains open, but it certainly appears that the net will be cast over a wider pool of potential targets than just CEOs and CFOs, who alone had been subject to Sarbanes-Oxley clawbacks. As to former officers, another question arises as to how a company would pursue recovery from someone who, upon departure, had signed a mutual release of claims with the company.
Targeted Compensation. The center point of Dodd-Frank’s clawback is aiding recovery of “incentive-based compensation” paid during a three-year look-back period “preceding the date on which the issuer is required to prepare an accounting restatement” that would not have been paid under correct financial statements. Although it’s obvious that Dodd-Frank’s lookback period is longer than the 12 months provided for Sarbanes-Oxley clawbacks, the SEC’s eventual rules will need to clarify what dates will bookend the new look-back period. In other words, what is the date “on which the issuer is required to prepare an accounting restatement”?
It also remains to be seen what is meant by “incentive-based compensation,” other than stock options, which are expressly included as a type of recoverable payment. As to stock options, more questions arise: What is the proper valuation date? And for those options that have been exercised, how would a company determine the clawback amount, since it’s unclear how different financial statements may have impacted stock price? As to other types of bonuses and incentive compensation, if awards are not strictly tied to financial benchmarks, how do companies pinpoint the excess amount that would not have been paid under restated financials?
Initial answers to these and more questions should soon be coming down the pike. In the meantime, it may be a good idea for companies to begin discussing potential changes to the compensation structure for the indemnification and release of claims against its officers in response to final clawback regulations.