SEC Proposes Rules Requiring Companies to Adopt Executive Compensation Clawback Policies | Practical Law

SEC Proposes Rules Requiring Companies to Adopt Executive Compensation Clawback Policies | Practical Law

The SEC has proposed rules that would implement the executive compensation clawback requirements of Section 954 of the Dodd-Frank Act, which added new Section 10D to the Exchange Act.

SEC Proposes Rules Requiring Companies to Adopt Executive Compensation Clawback Policies

by Practical Law Corporate & Securities
Published on 06 Jul 2015 • USA (National/Federal)
The SEC has proposed rules that would implement the executive compensation clawback requirements of Section 954 of the Dodd-Frank Act, which added new Section 10D to the Exchange Act.
Update: On October 14, 2021, the SEC reopened the comment period on the proposed rule (see Legal Update, SEC Reopens Comment Period for Proposed Rule Requiring Companies to Adopt Clawback Policies).
On July 1, 2015, the SEC issued proposed rules that would direct the national securities exchanges to establish listing standards requiring companies to adopt policies for the recovery of erroneously awarded incentive-based compensation from their executive officers. The proposed rules are required by Section 954 of the Dodd-Frank Act, which was added to the Exchange Act as new Section 10D.
The SEC is accepting comments on the proposal through September 14, 2015.

Proposed Rule 10D-1

Proposed Rule 10D-1 under the Exchange Act would direct the national securities exchanges to establish listing standards requiring listed companies to adopt and comply with a clawback policy that meets the requirements of the rule.
A listed company that does not adopt and comply with a clawback policy meeting those requirements would be subject to delisting.

To Whom Would the Rule Apply?

Rule 10D-1 and any listing standards would apply to all listed companies except for certain registered investment companies to the extent they do not otherwise provide incentive-based compensation to their employees. The national securities exchanges would not be permitted to exempt any other category of companies from the clawback policy requirement. This means the proposed rules would apply to:

Clawback Policy Requirement

The clawback policy would provide that, if a company is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the federal securities laws, the company must recover incorrectly awarded incentive-based compensation from any individual who served as an executive officer of the company at any time during the performance period for that incentive-based compensation.
The incentive-based compensation must have been received while the company has a class of securities listed on a national securities exchange.

Accounting Restatement

An accounting restatement would be defined as the revision of previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements. The obligation to prepare the accounting restatement would trigger application of the clawback policy.
The following types of retrospective changes to financial statements would not represent correction of an error and would not trigger a clawback:
  • Application of a change in accounting principle.
  • Revision to reportable segment information due to a change in a company's internal organizational structure.
  • Reclassification due to discontinued operations.
  • Application of a change in reporting entity.
  • Adjustment to provisional amounts in connection with a prior business combination.
  • Revision for stock splits.
For purposes of Section 10D, any accounting restatement to correct an error that is material to previously issued financial statements would be deemed to result from material noncompliance with a financial reporting requirement under the federal securities laws.
The clawback policy would be triggered by the need for the accounting restatement, without regard to:
  • Whether any misconduct occurred.
  • An executive officer's responsibility for the erroneous financial statements.

Incentive-based Compensation

Incentive-based compensation would be defined as any compensation that is granted, earned or vested based wholly or in part on the attainment of a financial reporting measure. This would include:
  • Non-equity incentive plan awards that are earned solely or in part by satisfying a financial reporting measure performance goal.
  • Bonuses paid from a bonus pool, where the size of the pool is determined solely or in part by satisfying a financial reporting measure performance goal.
  • Restricted stock, restricted stock units, stock options, stock appreciation rights (SARs) and performance share units that are granted or vest solely or in part on satisfying a financial reporting measure performance goal.
  • Proceeds from the sale of shares acquired through an incentive plan that were granted or vested solely or in part on satisfying a financial reporting measure performance goal.
Compensation that would not be considered incentive-based compensation would include:
  • Salaries. However, a salary increase earned wholly or in part based on satisfying a financial reporting measure would be subject to clawback as a non-equity incentive plan award.
  • Bonuses paid solely on satisfying one or more subjective standards, such as demonstrating leadership, or completing a specified employment period.
  • Non-equity incentive plan awards earned solely on satisfying one or more strategic measures, such as consummating a transaction, or operational measures, such as opening a specified number of stores or increasing market share.
  • Stock options or other equity awards for which the grant is not contingent on achieving any financial reporting measure performance goal and vesting is contingent solely on completion of a specified employment period or satisfying a non-financial reporting measure. The fluctuation in value of these equity awards based on the company's stock price does not make them incentive-based compensation.
A financial reporting measure would be defined as:
  • Any measure that is determined and presented in accordance with the accounting principles used in preparing the financial statements, or any measure derived wholly or in part from this financial information.
  • Stock price and total shareholder return (TSR).
Examples of financial reporting measures (other than stock price and TSR) would include:
  • Revenues.
  • Net income.
  • Funds from operations.
  • Liquidity measures such as working capital or operating cash flow.
  • Return measures such as return on invested capital or return on assets.
  • Earnings measures such as earnings per share.
  • Sales per square foot or same store sales where "sales" is subject to an accounting restatement.
  • Revenue per user or average revenue per user where "revenue" is subject to an accounting restatement.
The financial reporting measure would not need to be presented in the financial statements or included in an SEC filing.

Executive Officer

The definition of executive officer is modeled on the definition of officer in Rule 16a-1(f) under the Exchange Act and would include the company's:
  • President.
  • Principal financial officer.
  • Principal accounting officer or controller.
  • Any vice president in charge of a principal business unit, division or function, such as sales administration or finance.
  • Any other officer who performs a policy-making function.
  • Any other person (such as an executive officer of a subsidiary or parent entity) who performs similar policy-making functions for the company.
Anyone that the company identifies as an executive officer for purposes of Item 401(b) of Regulation S-K (that is, they are listed as an executive officer in the company's Form 10-K report or proxy statement) would be presumed to be an executive officer for purposes of the clawback policy.

Time Period Covered by Clawback

The clawback policy would apply to any incentive-based compensation received during the three completed fiscal years immediately preceding the date on which the company is required to prepare an accounting restatement and, if applicable, any transition period resulting from a change in fiscal year within or immediately following the three completed fiscal years.
The company's obligation to claw back compensation would not be dependent on if or when the company actually filed its restated financial statements.

Received

Incentive-based compensation would be considered "received" in the fiscal period during which the specified financial reporting performance measure is satisfied or achieved, even if payment or grant would occur after the end of that period. The date of receipt would therefore depend on the terms of the award. For example, an award that is granted based on the achievement of a financial reporting measure would be received in the fiscal period that the measure was satisfied. By contrast, if the award vests on the achievement of a financial reporting measure, the award would be received in the fiscal period that it vests.
Incentive-based compensation received by an executive officer before the company listed its securities on a national securities exchange (see above) would not be subject to the clawback policy.

Date of Obligation for Accounting Restatement

The date on which the company is required to prepare an accounting restatement would be the earlier of the following:
For example, if a company with a fiscal year ending December 31 concludes in November 2018 that it needs to restate previously issued financial statements, it would be required to clawback compensation received by executive officers in 2015, 2016 and 2017. The company's obligation is not dependent on the date that it files the restated financial statements.

Amount of Incentive Compensation to be Clawed Back

The amount subject to recovery (the recoverable amount) by the company is the amount of incentive-based compensation in excess of the amount that otherwise would have been paid had it been determined based on the accounting restatement. This amount would be calculated on a pre-tax basis.
To determine this amount, after an accounting restatement:
  • The company would first recalculate the applicable financial reporting measure and the amount of incentive-based compensation based on that measure.
  • The company would next determine whether the executive officers received a greater amount of incentive-based compensation than would have been received applying the recalculated financial reporting measure, based on:
    • the originally calculated financial reporting measure; and
    • taking into consideration any discretion that the compensation committee applied to reduce the amount originally received.
For incentive-based compensation that is based on stock price or TSR, the proposed rules acknowledge that the amount of erroneously awarded compensation cannot be calculated directly from the information in the accounting restatement. In these instances, the recoverable amount would be based on a reasonable estimate of the effect of the accounting restatement on the stock price or TSR on which the compensation was received. The proposing release identifies several possible methods for calculating this reasonable estimate in Section III.B.2. The company must document its determination of a method of reasonable estimation and may be required to provide this information to the national securities exchange on which its securities are listed.

Examples Based on Type of Incentive Compensation

For cash awards received on satisfaction of a financial reporting measure, the recoverable amount would be the difference between the amount of the cash award that was received (whether payable in a lump sum or over time) and the amount that should have been received applying the restated financial reporting measure.
For equity awards:
  • If the shares, options or SARs are still held at the time of recovery, the recoverable amount would be the number received in excess of the number that should have been received applying the restated financial reporting measure.
  • If the options or SARS have been exercised, but the underlying shares have not been sold, the recoverable amount would be the number of shares underlying the excess options or SARs applying the restated financial measure.
  • If the shares have been sold, the recoverable amount would be the sale proceeds received by the executive officer for the excess number of shares.
  • If the shares have been gifted, the recoverable amount would be the gifted shares' fair market value at the date of the gift.
  • In any case in which shares have been obtained on payment of an exercise price, the recoverable amount would be reduced to reflect the applicable exercise price paid.
In cases where the clawback under Section 304 of the Sarbanes-Oxley Act of 2002 would also apply, any amount reimbursed to the company under Section 304 would be credited to the extent that repayment of the same compensation by that officer would be required under the company's clawback policy.

Recovery

The company would be required to recover any excess incentive-based compensation in compliance with its clawback policy unless it would be impracticable to do so because either:
  • The direct costs of enforcing recovery (expenses paid to a third party to assist in enforcing the policy, such as reasonable legal expenses) would exceed the recoverable amount.
  • Recovery would violate home country law.
To establish impracticability due to expense of enforcement, the company would be required to:
  • Make a reasonable attempt to recover the incorrectly awarded compensation.
  • Have its compensation committee determine that recovery would be impracticable.
  • Document its attempt(s) to recover and provide that information to the national securities exchange on which its securities are listed.
To establish impracticability due to violation of home country law, the company would be required to:
  • Obtain an opinion of home country counsel (not unacceptable to the applicable national securities exchange) that recovery would violate home country law, as long as the law had been adopted by that country before July 14, 2015.
  • Have its compensation committee determine that recovery would be impracticable.
  • Provide the opinion to the national securities exchange on which its securities are listed.
Companies may exercise discretion regarding the appropriate means of recovery (for example, forfeiture of an award or repayment by the executive) as long as the excess incentive-based compensation is recovered reasonably promptly.

Indemnification

The company would be prohibited from indemnifying any of its current or former executive officers against the loss of any incorrectly awarded incentive compensation, including by paying or reimbursing the officer for premiums for an insurance policy covering any such potential losses.

Disclosure

The company would be required to disclose all information relating to its clawback policy, as well as a copy of its policy, in accordance with the federal securities laws. The disclosure requirements under the federal securities laws are further described below.

Amendments to Regulation S-K

Item 402

Proposed Item 402(w) would apply to any listed company if at any time during its last completed fiscal year either:
  • It completed an accounting restatement that triggered recovery of incorrectly awarded incentive-based compensation under its clawback policy.
  • There was an outstanding balance on the recoverable amount from the application of its clawback policy to an earlier accounting restatement.
In either case, under proposed Item 402(w), a listed company would be required to disclose:
  • For each accounting restatement:
    • the date on which the company was required to prepare the restatement;
    • the aggregate dollar amount of excess incentive-based compensation attributable to the restatement;
    • the aggregate dollar amount of excess incentive-based compensation that it had not yet recovered at the end of its last completed fiscal year; and
    • if the company used stock price or TSR as a financial reporting measure, the estimates used in determining the recoverable amount attributable to the restatement.
    If the company had not yet determined the total amount attributable to the restatement, it would have to disclose this information and explain why this determination had not yet been made.
  • The name of each person subject to recovery of incorrectly awarded compensation under the clawback policy, if any, from whom the company decided not to pursue recovery, the recoverable amount from that person and the reason why the company decided not to pursue recovery.
  • The name of each person from whom, at the end of the last completed fiscal year, incorrectly awarded compensation had been outstanding for 180 days or more since the date the company determined the recoverable amount, and the amount still owed from that person to the company.
As part of Item 402 of Regulation S-K, this information would be required in a listed company's annual report on Form 10-K and annual meeting proxy statement. If the listed company provides a Compensation Discussion & Analysis (CD&A) under Item 402(b), it could disclose this information in its CD&A rather than in a separate location.
The company would also be required to provide this Item 402(w) information in XBRL format as an exhibit to its Form 10-K or proxy statement, as applicable. For more information on XBRL formatting, see Practice Note, XBRL Reporting Requirements.
Foreign private issuers that do not file Form 10-K reports or annual meeting proxy statements would be required to provide this Item 402(w) information in their annual reports on Form 20-F or 40-F.
In addition, any listed company that recovered compensation under its clawback policy would be required to update its Summary Compensation Table. Under proposed amendments to Item 402(c) and (n), the company would reduce the amount reported in the applicable column of the Summary Compensation Table for an applicable fiscal year by any amount actually recovered under the clawback policy and disclose this amount in a footnote. The company would make the same revisions to the "total" column in the Summary Compensation Table. The company would provide this update in any Exchange Act or Securities Act filing requiring a Summary Compensation Table for the affected fiscal year.
For example, a company reports that in 2016 its chief executive officer earned $1 million in non-equity incentive plan award compensation, and later determines that an accounting restatement of its 2016 financial statements was warranted and that the CEO had been awarded $300,000 in excess incentive compensation. If the company recovers the $300,000 excess incentive compensation in 2018, it would need to amend its Summary Compensation Table. The 2018 Summary Compensation Table would revise the CEO's 2016 reported non-equity incentive plan award to $700,000 (and revise the 2016 total compensation amount accordingly) and include a footnote disclosing that $300,000 in excess incentive compensation had been recovered under the company's clawback policy. These revisions would be made in any Form 10-K report, proxy statement or registration statement that includes 2016 compensation information.

Item 404

Item 404 would be amended to allow a listed company to exclude a discussion of its compensation recovery efforts in its related party transaction disclosure, as applicable, if it provides the Item 402(w) information.

Item 601

Item 601 would be amended to require a listed company to file the following with the SEC:
  • The clawback policy, which would be included as an exhibit to its annual report on Form 10-K.
  • The XBRL file of compensation recovery disclosure, which would be included as an exhibit to its annual report on Form 10-K. Schedule 14A would also be amended to include this exhibit as applicable.
Foreign private issuers that do not file Form 10-K reports or annual meeting proxy statements would be required to provide these documents as exhibits to their Forms 20-F and 40-F.

Other Amendments

Item 22 of Schedule 14A would be amended to require registered investment companies subject to Rule 10D-1 to disclose compensation recovery information similar to the Item 402(w) information. Schedule 14A would also be amended to require the XBRL exhibit described above.
Forms 20-F and 40-F would be amended to require compensation recovery disclosure similar to the Item 402(w) information as described above and permit the same exclusion to related party transaction disclosure as in Item 404 as described above.
Form N-CSR would be amended to require compensation recovery disclosure similar to the Item 402(w) information and inclusion of the clawback policy and the XBRL file described above as exhibits.

Proposed Transition Period

Under the SEC's proposal:
  • The exchanges would be required to file their proposed listing standards no later than 90 days after the publication of final Rule 10D-1 in the Federal Register.
  • The listing standards would be required to become effective no later than one year after that Federal Register publication date.
Companies would be required to adopt clawback policies no later than 60 days after the date on which the relevant exchange's listing standards become effective.
Each company would be required to recover all excess incentive-based compensation received by current and former executive officers on or after the effective date of Rule 10D-1 that results from achieving a financial reporting measure based on financial information for any fiscal period ending on or after the effective date of Rule 10D-1. Compliance would be required whether the incentive-based compensation is received under a pre-existing contract or arrangement or one that is entered into after the effective date of the exchange's listing standards.
Companies would be required to comply with the new disclosure requirements in any Exchange Act annual report and in any proxy or information statement filed on or after the effective date of the exchange's listing standards.