The Securities and Exchange Commission (“SEC”) on October 26, 2022, adopted final rules1 directing national securities exchanges and associations,2 to establish listing standards that require public companies to develop and implement a policy for the recovery (i.e., “clawback”) of incentive-based compensation that is erroneously awarded to executive officers (“Final Rules”).3 The Final Rules adopt the rules substantially as originally proposed by the SEC,4 but with certain modifications to broaden the scope of covered restatements and clarify the rules. Significant changes from the Proposed Rules are noted below.

Key Takeaways

  • The Final Rules require U.S. public companies to develop, implement and disclose a written clawback policy providing for the recovery of incentive-based compensation (including stock options awarded as compensation) where that compensation is based on erroneously reported financial information.
  • The Final Rules apply broadly to all current and former executive officers regardless of whether the executive officer was involved in the error or misconduct which caused the erroneous financial reporting.

  • The Final Rules require clawback policies to be triggered in the event a covered company is required to prepare an accounting restatement that corrects an error in previously issued financial statements that is material to the previously issued financial statements, or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period (i.e., both “Big R” and “little r” restatements). The Final Rules significantly expand the applicability of clawback policies, which under the Proposed Rules would have only applied to Big R restatements.

  • Under the Final Rules, clawback policies must apply to the three completed fiscal years (“lookback period”) preceding the date on which a company is required to prepare an accounting restatement.

Clawback Trigger

Under the Final Rules, the clawback requirement is triggered upon the earlier of (i) the date a company concludes (or reasonably should have concluded) that an accounting restatement is required, or (ii) the date a regulator, court or other legally authorized entity directs the company to restate previously issued financial statements. This includes “Big R” restatements, which are restatements that correct errors resulting from a material misstatement in prior financial statements. In a significant departure from the Proposed Rules, the Final Rules provide that the clawback requirement is also triggered by “little r” restatements, which are restatements where errors were immaterial in prior period financial statements but would result in a material misstatement in the current period if recognized or left uncorrected. Clawbacks are not required where errors are immaterial to both previous and current periods.

Covered Companies

With limited exception, the Final Rules require exchanges and associations to apply the clawback requirements to all listed companies.5 Consequently, any listed company that does not implement and adhere to a clawback listing standard would risk delisting. The SEC has explicitly stated that foreign private issuers, smaller reporting companies, business development companies, controlled companies and emerging growth companies are not exempt from the Final Rules. This approach is substantially similar to the one in the Proposed Rules, with the SEC rejecting arguments from several commenters that these companies should not be subject to the clawback requirement.

Covered Executives

Consistent with the Proposed Rules, under the Final Rules, a company’s clawback policy must pertain to all of its current and former executive officers who erroneously received incentive-based compensation during the applicable lookback period.6 The definition of “executive officer” is modeled on the definition of “officer” in Exchange Act Rule 16a-1(f) and is broadly defined to include a company’s president, principal financial officer, principal accounting officer, any vice president in charge of a principal business unit, division or function and any officer who performs a policy-making function, including at the company’s parent or subsidiary.

Incentive-Based Compensation Subject to Clawback

The Final Rules approach “incentive-based compensation” in a principles-based manner and will include any compensation that is granted, earned or vested wholly or in part upon the attainment of any financial reporting measure. The SEC specifically noted that the “in part” language is included in the definition to clarify that incentive-based compensation need not be based solely upon attainment of a financial reporting measure. An example of compensation based “in part” upon the attainment of a financial reporting measure would include an award in which 60% of the target amount is earned if a certain revenue level is achieved, and 40% of the target amount is earned if a certain number of new stores are opened. Some additional examples of “incentive-based compensation” include: (i) non-equity incentive plan awards based in whole or in part on satisfying a financial reporting measure performance goal, and (ii) restricted stock, restricted stock units, and options that are granted or become vested wholly or in part on satisfying a financial reporting measure performance goal. The Final Rules define “financial reporting measures” as measures that are determined and presented in accordance with the accounting principles used in preparing the company’s financial statements, and any measures derived wholly or in part from such measures. Financial reporting measures include, but are not limited to, revenue, net income, operating income, profitability of one or more reportable segments and earnings before interest, taxes, depreciation and amortization. Financial reporting measures also include stock price and total shareholder return.

Incentive-based compensation is subject to clawback under the Final Rules to the extent the compensation received by an executive officer exceeds the amount the executive should have received based on the accounting restatement computed without regard to taxes paid (“erroneously awarded compensation”). The SEC recognized that it may be difficult to establish the relationship between an accounting restatement and stock price. Consequently, for erroneously awarded compensation that is based on stock price or total shareholder return that is not subject to mathematical recalculation, the erroneously awarded compensation may be determined based on a reasonable estimate of the effect of the accounting restatement. Under such circumstances, companies will have flexibility to determine the method that is most appropriate for determining the amount of erroneously awarded compensation based on the facts and circumstances.

Under the Final Rules, companies must recover erroneously awarded compensation in compliance with their clawback policies except to the extent that recovery would be impracticable. Discretion to determine impracticability is narrow, including only situations where (i) the cost of recovery exceeds the amount that would be recovered, (ii) recovery would likely result in the failure of a tax-qualified retirement plan, or (iii) recovery would violate home country law and additional conditions are met. Any determination that recovery would be impracticable must be made by the company’s committee of independent directors that is responsible for executive compensation decisions.

No Indemnification or Insurance

Under the Final Rules, companies are prohibited from indemnifying current or former executives against losses caused by the recovery of erroneously awarded compensation. Further, companies cannot pay or reimburse premiums on an insurance policy to protect executives from such recovery. These requirements may have significant practical impact on executives that are subject to having their compensation clawed back.

Disclosure Requirements

The Final Rules will require that companies disclose their clawback policies as an element of the listing standards and also include their policies and certain related materials in certain SEC filings. The SEC disclosure will require tagging of the additional information in Inline XBRL and the inclusion of check box disclosure on the cover of SEC Forms 10-K, 20-F and 40-F.

The Final Rules will add a new Item 402(w) to Regulation S-K which will be triggered if a company is required to prepare an accounting restatement that requires the recovery of erroneously awarded compensation or there is an outstanding balance of unrecovered erroneously awarded compensation for the prior year. Under these circumstances, companies must disclose (i) the date of the required accounting restatement, (ii) the recoverable amount of incentive-based compensation revealed by the accounting restatement, (iii) how the recoverable amount was calculated (or if it has not yet been calculated, why not), (iv) the remaining amount to be recovered from an executive officer 180 days or more after the initial recoverable amount was determined by the issuer, and (v) any information relating to the non-recovery of otherwise recoverable incentive-based compensation due to impracticability.

Compliance Deadlines

Under the Final Rules: (i) each exchange or association will be required to file its proposed listing standard no later than 90 days following publication of the Final Rules in the Federal Register, (ii) the listing standard must be effective no later than one year following the publication date of the Final Rules, and (iii) each company subject to the listing standard must adopt a clawback policy no later than 60 days following the date the applicable listing standard becomes effective.

Any company subject to the Final Rules should fully review the new requirements and commence taking the necessary steps to ensure compliance. Companies should keep watch for the new listing standard from their exchange implementing the Final Rules and consider whether any modifications are needed to their existing clawback policies. In addition, companies should develop strategies for communicating with executives in the event existing contracts or agreements require amendments to comply with the Final Rules.