The Securities and Exchange Commission commissioners voted 3-2 on Wednesday, July 1, 2015, in favor of proposing a rule that would require issuers listed on a national securities exchange to adopt strict policies regarding the recovery of incentive compensation paid to executive officers on the basis of erroneous financial reporting.1   The proposed rule, which would implement Section 954 of 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act, would also require issuers to make extensive disclosures about their policies and practices concerning such clawbacks.


Section 304 of the Sarbanes-Oxley Act of 2002, enacted in the aftermath of accounting scandals at Enron and WorldCom, empowered the SEC to recover incentive-based compensation awarded to CEOs and CFOs on the basis of financial statements that are restated because of misconduct.  Dodd-Frank, passed in the wake of the financial crisis, went further by amending the Securities Exchange Act of 1934 to require the SEC to promulgate rules directing national securities exchanges and associations to adopt listing standards governing incentive pay clawbacks.3

Under Dodd-Frank, exchange listing standards must require issuers to recover compensation from current and former executive officers who received incentive-based pay during the three-year period leading up to a required restatement of financials due to “material noncompliance” with any financial reporting requirement under the securities laws. The listing standards must also require issuers to make certain disclosures about their clawback policies and practices.

In the nearly-five years that have passed since Dodd-Frank became law, there has been ample speculation about precisely how the SEC might implement Section 954. Issuers and investors alike have raised concerns about which individuals should be included in the definition of “executive officers”, what forms of compensation should be classified as incentive-based compensation, what constitutes “material noncompliance”, application of any financial reporting requirement under the securities laws, and what degree of individual culpability (if any) for a  misstatement  of  a  financial  metric  should  be  demonstrated  before  subjecting  an  executive  officer  to clawbacks. The newly-proposed Rule 10D-1 finally sheds light on the SEC’s position on these issues.

What obligations would the proposed rule impose on issuers?

Under the proposed rule (and conforming exchange listing standards), each issuer would need to adopt and comply with a written policy providing that, in the event that it is required to restate its financials due to material noncompliance  with  a  financial  reporting  requirement,  it  will  recover  erroneously  awarded  incentive-based compensation from its executive officers.

Recovery policies would have to apply to compensation received during the three fiscal years preceding the date that the issuer became required to prepare an accounting restatement. Under the proposal, compensation is deemed  “received”  in  the  fiscal  period  during  which  the  financial  reporting  metric  upon  which  it  is  based  is attained,  regardless  of  when  the  executive  officer  is  actually  paid.  An  accounting  restatement  is  deemed “required” as of the earlier of the date upon which the issuer’s board concludes or reasonably should conclude that it is required or the date upon which a governing body orders the issuer to prepare a restatement.

Clawback obligations under the proposed rule would not be dependent on any issuer or executive misconduct or the executive’s involvement in the mistake or wrongdoing that gave rise to the need for an accounting restatement. In stark contrast to the issuer misconduct requirement of SOX Section 304, the SEC’s proposal is essentially a strict liability regime.

Issuers  would  have  extremely  limited  discretion  to  choose  not  to  pursue  a  clawback  claim.  The  only circumstances in which the mandate to rescind erroneously-awarded compensation is excused are when the direct, third-party expenses of enforcing the claim would exceed the amount to be recovered or when the issuer is a foreign company and recovery would violate the pre-existing laws of its home country. In any event, the issuer must make a reasonable attempt at recovery before determining that either of those exceptions applies. Furthermore,  issuers  would  not  be  permitted  to  indemnify  or  insure  executive  officers  against  the  risk  of clawbacks.

Who is an executive officer?

Section 10D of the Exchange Act states that the SEC’s clawback rules must apply to “any current or former executive officer” of an issuer. However, the statute did not define the term “executive officer.” The proposed rule includes a broad definition that is patterned after the meaning of “officer” under Section 16 of the Act.

“Executive officers” under the proposed rule include the issuer’s president, principal financial officer, principal accounting officer (or controller), any vice president in charge of a principal business unit, division, or function, any  officer  who  performs  a  significant  policy-making  function,  and  any  other  person  who  performs  a  similar policy-making  function.  If  adopted,  this  expansive  definition  would  greatly  increase  the  number  of  corporate executives  who  are  subjected  to  potential  compensation  clawbacks  in  comparison  to  Section  304  of  SOX (applicable only to CEOs and CFOs).

The clawback rules apply to any individual who was an executive officer of the issuer at any point during the performance period for the incentive-based compensation metric in question.

What is incentive-based compensation?

The proposed regulations state that incentive-based compensation is any compensation that is granted, earned, or vested based wholly or partially upon the attainment of a financial reporting measure. Financial reporting measures  are  defined  as  measures  that  are  determined  and  presented  in  accordance  with  the  accounting principles used in preparing the issuer’s financial statements and measures derived wholly or partially from such measures, as well as metrics of stock price and total shareholder return (which includes share price appreciation and dividends).

Incentive compensation is not limited to compensation based on metrics that are expressly stated in the issuer’s financial  statements  or  securities  filings.  However,  executive  incentive  compensation  based  on  non-financial business goals (such as opening a new facility) does not fall within the proposed rule. Accordingly, the scope of incentive-based  compensation  proposed  to  be  subject  to  the  rule  is  narrower  than  the  scope  of  incentive compensation (pursuant to incentive plans) subject to executive compensation disclosure requirements under Item 401(a)(6) of Regulation S-K.

How much compensation is clawed back?

The amount of compensation subject to recovery under the proposed rule is the amount of incentive-based compensation paid in excess of the amount that would have been paid if it had been calculated using the restated financial information, without regard to any taxes paid.

Determining the clawback amount may be particularly difficult when compensation is based on stock price or total shareholder return, as restated financials will not provide corrected values for those metrics. The proposed rule addresses this problem by permitting issuers to base clawback amounts on a “reasonable estimate” of the effect of accounting restatements on stock price or total shareholder return. Issuers must provide the exchanges on which their securities are listed with documentation supporting such estimates and disclose the basis for the estimates to investors.

What disclosures are required?

The proposed rule would require each affected issuer to file a written incentive compensation recovery policy as an exhibit to its Form 10-K (or applicable annual reporting form). Additionally, if an issuer made an accounting restatement that triggered clawback obligations in the prior fiscal year, it would be required to make disclosures about its recovery efforts both in its Form 10-K (or applicable annual reporting form) and in any proxy statement in which it is otherwise required to disclose information about executive compensation. Any decision to forego a recovery action would have to be explained in the issuer’s filings as well.

Although  the  primary  clawback  disclosure  would  be  separate  from  the  issuer’s  Compensation  Discussion  & Analysis disclosure (which covers a narrower group of officers), amounts recovered under the clawback policy would  reduce  compensation  reported  in  the  Summary  Compensation  Table  for  the  applicable  fiscal  year.  In keeping with the trend of recent proposals, the required clawback disclosure would be tagged in XBRL format.

Which companies will be exempt?

Few classes of listed issuers would be exempt under the proposed rule. Exempt companies include clearing agencies for security futures products or standardized options and registered management investment companies that do not pay incentive compensation to executive officers. More notable are those issuers not proposed for exemption: emerging growth companies, smaller reporting companies, foreign private issuers, controlled companies, and issuers of only listed debt or preferred securities. The proposed rule would not give exchanges discretion to exempt categories of issuers not expressly exempted under the proposed rule.

What enforcement issues may arise?

The SEC specifically requests comments on whether there are “sufficient enforcement mechanisms to ensure compliance with the listing standard.” Compensation arrangements in foreign jurisdictions where clawbacks are prohibited under local law are exempt under the proposed rule. The proposed rule does not, however, address the  potential  for  conflicts  with  state  wage  and  hour  laws.  Such  laws  may  limit  the  effectiveness  of  some clawback policies. Another enforcement issue concerns potential conflicts between clawback policies and pre- existing  employment  contracts  that  do  not  provide  for  clawbacks,  including  contracts  under  which  a  "good reason" termination could be triggered in the event of a reduction in compensation due to a clawback.   Issuers who do not comply with the requirements for adoption of a policy, disclosure, and recovery may be subject to delisting.

When would companies have to comply?

The SEC will accept public comments on proposed Rule 10D-1 for sixty days following its publication in the Federal  Register.  If  adopted,  national  securities  exchanges  and  associations  will  have  ninety  days  after publication of the final rule to propose listing standards that implement it, and such listing standards will need to be approved by the SEC and become effective within one year of publication of the final rule. Affected issuers would have sixty days after the applicable exchange rules become effective to implement compliant policies.

Only compensation awarded based on financial information for periods ending on or after the date upon which the proposed rule is effective would be subject to clawbacks.


Going forward, we may see heightened pressure (if such a thing is possible) to avoid restatements, to classify a restatement as not required, or to argue that the restatement was not due to material noncompliance with any financial reporting requirement under the securities laws. Issuers with existing clawback policies should begin to consider whether their policies will need to be updated to comply with the new rule. Issuers that restate their financials  after  the  new  rule  goes  into  effect,  but  before  a  clawback  policy  must  be  adopted,  may  find themselves in the position of adopting a policy with the facts of a pending clawback in-hand.