The SEC has proposed rules that require the securities exchanges to adopt rules that in turn require listed companies to adopt, disclose and comply with a clawback policy for executive compensation based on erroneous financial statements. The new rules would apply to almost all companies listed on a securities exchange (such as NASDAQ and NYSE), including smaller reporting companies.
Many companies already have adopted interim clawback policies in an attempt to comply with the spirit of the law that requires the new rules, Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Until now, some key terms in the law have been undefined. The proposed rules are a good opportunity to think about whether existing policies sync with the proposed rules on the following key terms:
- Are the correct “executive officers” included under the policy?
- Is “incentive-based compensation” properly understood under the policy?
- What types of, and how much, incentive-based compensation must be clawed back?
- Are there any exceptions?
- What types of clawback terms should be included in employment agreements?
Required clawbacks under the proposed rules do not apply unless previously issued financial statements must be revised to correct one or more material errors. The clawbacks must apply to the amount that would not have been paid if the incentive-based compensation had been determined based on the correct accounting.
All incentive-based compensation paid to executive officers must be subject to clawbacks, meaning any compensation based on the attainment of a financial reporting measure. Examples include equity that is granted or vests based on satisfying a financial measure performance goal or bonuses paid out of a pool that results from achieving a financial measure performance goal.
Financial reporting measures include stock price, total shareholder return, and any measures derived from financial information, even if not included in a filing with the Commission. For example, “same store sales” are a financial reporting measure if affected by an accounting restatement for revenue recognition. Other potential financial reporting measures include EBITDA, cost per employees (if cost is the subject of an accounting restatement), profitability, working capital, and really any measure dependent on accounting.
No misconduct or mistake by an executive officer is required for a clawback to apply to the executive officer, and executive officers cannot be indemnified against clawbacks.
Comments on the proposed rules are due Sept. 14, 2015. The final SEC rule will be followed by a rulemaking process for the securities exchanges, so the date by which companies must comply is likely more than a year away.