On July 1, 2015, a divided Securities and Exchange Commission (the “SEC”) proposed rules to implement the clawback provisions of Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.1 The proposal, if adopted, would require public companies to implement policies to broadly recover incentive-based compensation paid to current or former executive officers based on materially misstated financial statements. For this purpose, incentive-based compensation is defined as compensation that is granted, earned, or vested based wholly or in part on attainment of a financial reporting measure, including stock price and total shareholder return.2
The proposed rules would effectively expand the current Sarbanes-Oxley requirement3 by, among other things, (i) requiring reimbursement from any executive officer of a listed issuer, not merely the chief executive officer and chief financial officer, (ii) requiring reimbursement of incentive-based compensation for any restatement resulting from material noncompliance with reporting requirements, regardless of whether there was misconduct by the company, (iii) requiring reimbursement of incentive-based compensation received by executive officers during the three years prior to the discovery of a need to file an accounting restatement, which is a different time period than required by Sarbanes-Oxley, and (iv) requiring listed companies to disclose and comply with specific policies for the recovery of executive compensation published in their annual reports.
- Companies Required to Adopt Mandatory Compensation Clawback Policies and Disclosures
The proposed rules would require national securities exchanges and associations to adopt listing standards requiring the filing of and compliance with a policy for receiving incentive-based compensation reimbursement from executive officers in the event of an accounting restatement. The listing standards also would require the disclosure of certain details of past and outstanding compensation reimbursements under an issuer’s filed policy. These rules would apply to most issuers, including foreign private issuers, emerging growth companies, controlled companies, smaller reporting companies, and companies with only listed debt securities outstanding.4 Failure to comply with the disclosure and implementation requirements would result in delisting until the company comes into compliance.
- Recovery Conditions and Determination
Companies subject to the proposed rules would be required to seek reimbursement from individuals who served as an executive officer at any time during the performance period for the incentive-based compensation in the event of accounting restatements due to material noncompliance with reporting requirements.5 However, companies would not be required to seek reimbursement when costs of recovering the compensation would exceed the recovered amount or when home country foreign law adopted prior to publication of the proposed rule prohibits recovery, in either case as determined by independent members of the board of directors.
Restatements due to material noncompliance would trigger a three-year lookback for reimbursements from the date the restatement is first required. For purposes of the proposed rules, the date when the restatement is considered required would be the earlier of (i) the date that the board of directors, board committee, or officers authorized to take such action conclude that the issuer’s prior financial statements contain a material error, and (ii) the date that a court, regulator or other legal authority directs the issuer to restate a financial statement due to a material error.
Within the three-year lookback period, any incentive-based compensation received by executive officers6 that would have been less based on the restated financial statements, as opposed to the initial erroneous data, would be subject to recovery. This would include incentive-based compensation based directly on accounting metrics, such as revenues and net income, as well as compensation tied to performance measures that are affected by accounting information, such as stock price and total shareholder return.7 Compensation would be considered received by the executive in the first fiscal period when the conditions for the award have been satisfied, such as when a particular financial performance target is first achieved, even if the actual payment occurs on a later date.
The reimbursement amount due to the issuer would be based on the excess of the initial incentive-based compensation received by a given executive over the compensation that would have been received by that executive based on the restated financial information, computed without regard to taxes paid. In the case of cash awards paid from bonus pools, the company would be required to seek the reimbursement on a pro rata basis from each executive based on the incentive-based compensation received by that particular executive and not “pool” or divide the reimbursement costs in any other manner. When incentive-based compensation is based on stock prices or other measures that cannot be directly recalculated in retrospect, the issuer would need to use, and publicly disclose, a reasonable estimate of the corrected compensation amount.
- Prohibition on Indemnity or Insurance Coverage by the Company
Any amount that is recovered under the proposed rules may not be repaid to the affected executive pursuant to an indemnity obligation. Similarly, companies would be prohibited from paying the premiums for any insurance policy for executives that would cover the reimbursements required by the proposed rules.8
- Timing of the Proposed Rules
Before any action is required from issuers, the proposed rules need to be finalized, and there will be a 60- day comment period beginning once the proposal is published in the Federal Register. Then, under the current proposal if adopted, the exchanges would be required to file their proposed listing standards within 90 days, which standards must become effective within one year. Once the new listing standards are effective, companies would have 60 days to adopt a policy in compliance with such listing standards. However, companies would be required to comply with the new policy for any incentive-based compensation distributed after the effective date of the final rules, as opposed to the date the company implements its new policy.