On July 1, 2015, the Securities and Exchange Commission (the “SEC”) proposed rules directing the national securities exchanges and national securities associations to establish listing standards that require the issuer of any security to adopt and comply with a written policy (a “clawback policy”) to recover, in the event of a financial restatement due to material non-compliance with financial reporting standards under the securities laws, certain erroneously-awarded incentive-based compensation received by its executive officers. The proposed rules also will require each listed company to file its clawback policy as an exhibit to certain of its securities filings and to make public disclosures about its actions implementing its clawback policy if triggered. The proposing release is available here.
The rule proposal was approved by the SEC in a 3-2 vote, with SEC Chair Mary Joe White and Commissioners Kara Stein and Luis Aguilar voting in favor and Commissioners Daniel Gallagher and Michael Piwowar dissenting. Statements made by the Commissioners during the July 1st open meeting can be viewed here. The new rules were proposed to implement the provisions of Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“the “Dodd-Frank Act’), which added Section 10D to the Securities Exchange Act of 1934 (the “1934 Act”). The new rules are principally codified in new Rule 10D-1 promulgated under Section 10D of the 1934 Act and new Item 402(w) under Regulation S-K along with other conforming and related changes to the federal securities regulations. The proposal provides for a 60 day comment period.
Listing Standards Under Rule 10D-1
Proposed Rule 10D-1 would require national securities exchanges and associations to establish listing standards that require each listed company to adopt and comply with a clawback policy. A compliant clawback policy will require the company, in the event of an accounting restatement due to the company’s material non-compliance with any financial reporting requirement under the securities laws, to recover incentive-based compensation erroneously awarded to any of its current or former executive officers during the three fiscal years1 preceding the date on which the company is required to prepare such an accounting restatement. The company will recover any incentive-based compensation paid during those three years that exceeds the amount that would have been paid if the financial error had not initially occurred. Recovery would be required without regard to fault, whether or not any misconduct occurred and whether or not any particular executive officer had any responsibility for the erroneous financial statements. Failure to adopt or comply with a clawback policy would subject the company to delisting.
Applies to All Issuers with Very Limited Exceptions
The proposed rules would apply to the issuers of all listed securities, whether debt or common or preferred equity, with very limited exceptions.2 The proposed rules also do not exempt any categories of listed companies and thus would apply to foreign companies, controlled companies, limited partnerships and emerging growth and smaller reporting companies.
Definition of Executive Officers
The definition of an “executive officer” under proposed Rule 10D-1 is effectively the same as the definition of “officer” under Section 16 under the Exchange Act. The definition includes the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs 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 policy making functions of the listed company. Where the issuer is a limited partnership, officers or employees of the general partner that perform policy making functions for the limited partnership are also deemed executive officers of the limited partnership.
The proposed rule adopts a principles-based approach to determining the amount of erroneously awarded incentive-based compensation to be recovered and does not provide specific formulas for recovery. Issuers would be required to recover the amount of “incentive-based compensation” received by an executive officer that exceeds the amount the executive officer would have received had the incentive-based compensation been determined based on the accounting restatement. “Incentive-based compensation” is any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure. “Financial reporting measures” are measures determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measures that are derived from such measures, and stock price and total shareholder return. The rule proposal notes that where incentive-based compensation is based only in part on the achievement of financial reporting measure performance goals, the company would need to separate out the amount that was attributable to financial reporting measure goals from the part that was not and then reduce the part that was so attributable.
For purposes of the rule, incentive-based compensation will be deemed to have been received in the fiscal year that the financial metric that resulted in the award was attained, even if the payment, grant or vesting occurs after the end of that period. Moreover, the rule proposal notes that ministerial actions that need to be taken after such period, such as calculating the amount of the award or final approval by the board, do not affect the effective date of the award.
Incentive-based compensation subject to recovery under the rule includes compensation that is based on stock price or total shareholder return. For these measures, the rule provides that companies are entitled to use a reasonable estimate of the effect of the restatement on the measure to determine the amount to be recovered. The rule proposal notes that companies can use a number of possible methods to make these estimates with different levels of complexity and related costs. However, the rule does not provide much guidance to assist companies in navigating this difficult issue: estimating how the financial error affected the stock price (or metrics based on stock price). The proposed rule requires listed companies to maintain documentation of the determination of that reasonable estimate, provide such documents to the relevant exchange or association and disclose those estimates as outlined below. The recoverable amount is to be calculated on a pre-tax basis.
Applicable Recovery Period
Issuers would be subject to delisting for failure to comply with their clawback policy except to the extent that it would be impracticable to do so. The proposed rule provides that recovery would only be impracticable if (i) the direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered, or (ii) for foreign private issuers, recovery would violate home country law. Before concluding impracticability based on excessive third party expense, the issuer must first make (and document) reasonable attempts to recover the required amounts. Violation of home country law would only excuse recovery if such laws were enacted prior to the date of publication in the Federal Register of these proposed rules. Any determination of impracticability should be made by the independent directors responsible for compensation decisions.
Disclose Clawback Policy
Each issuer will be required to provide its clawback policy as an exhibit to its Exchange Act annual report.
New Item 402(w)
The proposed rules also provide for a new Item 402(w) under Regulation S-K requiring the following disclosures related to a company’s compliance with its clawback policy:
- the date on which the company was required to prepare an accounting restatement, the aggregate dollar amount of excess incentive-based compensation attributable to that statement and the amount of recovery outstanding at the end of the most recent completed fiscal year;
- if the financial reporting measure related to a stock price or total shareholder return metric, the estimates used to determine the excess incentive-based compensation attributable to the restatement;
- if the company determined to forego recovery of any amounts of excess incentives-based compensation, the names of each person from whom recovery is not being sought, the amount forgone for such person and the reason the company decided not to pursue recovery; and
- the amount due and name of each person, from whom recovery has been outstanding for 180 days or longer as of the end of the company’s last completed fiscal year.
The proposed disclosure would be included along with the issuer’s other executive compensation disclosure in annual reports and any proxy or information statements in which executive compensation disclosure is required. Issuers would also be required to block tag the disclosures in an interactive data format using eXtensible Business Reporting Language (XBRL). Conforming changes would also be made to the 1934 Act disclosure forms for foreign private issuers and registered management investment companies (to the extent not exempt from the rules).
Indemnification and Insurance
Listed companies will be prohibited from indemnifying executive officers for amounts subject to the clawback policies and from paying insurance premiums for executives to insure against such clawbacks.
The proposed rules would require each national securities exchange and association to propose rules or rule amendments no later than 90 days after publication of the final SEC rules in the Federal Register. The exchange and association rules would need to be approved and be effective no later than one year after publication of the final SEC rules in the Federal Register.
Each listed company would be required to adopt a clawback policy within 60 days following the effective date of the listing standards. The new disclosures would be required for all applicable filings following the effective date of the listing standards.
The proposed rule prescribes particular parameters for listed companies to adopt and enforce clawback policies. The SEC’s approach does not provide listed companies with much discretion or flexibility to tailor such policies or their implementation. We expect this issue, and others, will generate attention from commentators during the comment period. As a result, the parameters of the final rule may be different than what is in the current proposal. Many companies may wish to take a “wait and see” approach, deferring implementation of any clawback policy until the final rule is promulgated. Once the rule is finalized, the NYSE and NASDAQ will then need to propose and seek approval of formal rules prior to listed companies being subject to these requirements. Although we expect that NYSE and NASDAQ will be able to act relatively quickly following the SEC final approval of Rule 10D-1, there should still be sufficient time for companies to react and put in place their own clawback policies in accordance with the final SEC rule. In the meantime, other companies may wish to comment on the current proposal. We would be happy to discuss any questions you may have about the proposed rule or best practices in this area and would welcome the opportunity to assist any of our clients who may be interested in submitting comments to the SEC’s proposal.