Start preparing: SEC issues proposed guidance on executive compensation clawbacks

Almost five years since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Act), the U.S. Securities and Exchange Commission (SEC) finally provided guidance on one of the Act’s most controversial provisions: the executive compensation clawback. By way of background, Section 954 of the Act generally provides that in the event that a public company is required to prepare an accounting restatement, the company must recover from its executive officers any “excess” incentive compensation received during the three-year period preceding the restatement, without regard to fault. The Act specifically instructs the SEC to adopt rules implementing Section 954. On July 1, 2015, the SEC issued proposed guidance under Section 954 of the Act, compelling companies to rethink the design and implementation of their executive compensation clawback programs.

The proposed rules would:

• Mandate that a company “must” recover erroneously awarded compensation due to a financial restatement. A company would not have discretion whether to pursue recovery, except in limited circumstances.
• Require that a company’s clawback policy apply to all executive officers, broadly defined to cover:
  • The president
  • The principal financial officer
  • The principal accounting officer
  • Any vice-president in charge of a principal business unit
  • Any other person who performs policy-making functions for the company
• Apply the three-year look-back period for the recovery policy to the three completed fiscal years preceding the date of the restatement.
• Require all incentive-based compensation that is granted to, earned by, or vested in an executive officer based on the attainment of any “financial reporting measure” to be subject to recovery.
• Prohibit a company from indemnifying an executive officer for the impact of a clawback.
• Amend a company’s securities disclosure obligation to include specific disclosures regarding the impact of a financial restatement, the executive officers and compensation affected by the restatement, and the actions (or inactions) taken by the company in response to the restatement.
• Require the clawback policy to cover compensation paid with respect to performance periods ending on or after the effective date of the final SEC rules.

The proposed rules apply to all publicly listed companies, with limited exceptions. Despite acknowledgement by the SEC that compliance with the “clawback” program may be “disproportionately burdensome” on some issuers, such as emerging growth companies and foreign private issuers, the SEC specifically applied the clawback rules to almost all listed companies. The proposed rules apply to companies with any securities listed, including issuers of debt or preferred securities that do not have listed equity. Thus, any company with any listed security must understand and be prepared to comply with the proposed rules.

Due to the broad scope, complexity, and organization necessary to comply with the compensation clawback rules, companies should not delay in preparing to adopt or revise their compensation clawback policies in accordance with the final SEC and exchange guidance (which will come following the 60 day comment period). In anticipation of the effective final rules, companies should begin evaluating current clawback policies against the proposed rules, educating select employees on the potential application and administration of clawback policies using the proposed rules as a guide, and inform management of the likely actions the company would take in the event of a restatement requiring the clawback of executive compensation. 

As of the date of this alert, the proposed rules are less than 48 hours old. Accordingly, this alert is intended to highlight our initial reaction to the proposed rules, and encourage companies to start preparing for the final clawback rules. We will continue to provide updates on Dodd-Frank and the executive compensation clawback rules through future publications and our blog.

Highlights

Recovery Mandate: Companies would be required to adopt “clawback” policies providing that in the event of an accounting restatement, the company will recover from current and former executive officers any incentive-based compensation that would not have been provided based on the restatement, irrespective of any fault or culpability. In addition, companies would be required to file their clawback policy, disclose their actions to recover any excess incentive-based compensation and disclose any outstanding balance of excess incentive-based compensation from an earlier restatement. Under the proposed guidance, a publicly listed company would be subject to delisting if it does not:

• Adopt a compensation recovery policy
• Disclose the policy
• Comply with the policy’s recovery provisions.

Executive Officers: The proposed rules apply the compensation clawback to a broad class of executives, expanding the reach beyond the chief executive officer, chief financial officer and even the “named executive officers.” Under the proposed guidance, all of the following individuals would be covered by the policy:

• The president
• The principal financial officer
• The principal accounting officer
• Any vice-president in charge of a principal business unit
• Any other person who performs policy-making functions for the company.

Moreover, the proposed rules would require recovery of excess incentive-based compensation received by an individual who served as an executive officer at any time during the performance period for that incentive-based compensation. This would include incentive-based compensation derived from an award authorized before the individual becomes an executive officer, and inducement awards granted to a new hire, as long as the individual served as an executive officer of the listed issuer at any time during the award’s performance period. Accordingly, in order to comply with their clawback policy and avoid delisting, companies would be required to carefully track all individuals who meet the broad “executive officer” definition at any time during a given performance period.

Triggering Event: Under the Act, compensation clawbacks are required “in the event that the issuer is required to prepare an accounting restatement due to material noncompliance of the issuer with any financial reporting requirement under the securities laws.” In other words, a “material” restatement of a company’s financial statements will trigger the clawback policy. Despite comments requesting clarification as to the applicable event triggering the required compensation clawback, the SEC proposed to adopt a broader, more ambiguous standard for when a compensation clawback will be required.

Under the proposed rules, an error that is material to previously issued financial statements will be deemed “material noncompliance.” In short, the proposed rules would determine “materiality” under a facts and circumstances analysis that may effectively encourage companies to conclude that most restatements will be material for purposes of their clawback policies (so as to not risk delisting if their determination of "materiality" is wrong). While the proposed rules do not clarify the applicable triggering event, they do list a limited number of events that will not trigger application of the recovery policy, such as a change in an accounting principle.

Three-Year Look-Back: Since the Act provides for a three year look-back from the date of the restatement, for purposes of determining the applicable time period covered by the clawback policy, it will be important to identify the effective date of the restatement. In this regard, the proposed rules would provide that a restatement will be deemed to occur on the earlier of:

• The date the company’s board of directors, a committee of the board of directors, or the officer or officers of the issuer authorized to take such action if board action is not required, concludes, or reasonably should have concluded, that the company’s previously issued financial statements contain a material error.
• The date a court, regulator or other legally authorized body directs the issuer to restate its previously issued financial statements to correct a material error.

Accordingly, a company’s obligation to recover excess incentive-based compensation is not dependent on if or when the restated financial statements are filed, but rather when the company should have known of the error.

The proposed rules define the three-year look-back period for the recovery policy as the three completed fiscal years immediately preceding the date the company is required to prepare an accounting restatement. In other words, the three-year look back is based on full fiscal years, rather than the preceding 36-month period. Using this mechanic, for example, if a company using a calendar fiscal year determines in November 2018 that a restatement of previously issued financial statements is required and files the restated financial statements in January 2019, the recovery policy would apply to compensation received in 2015, 2016 and 2017.

Incentive-Based Compensation Subject to Recovery: Under the proposed rules, incentive-based compensation that is granted to, earned by or vested in an executive officer based on the attainment of any “financial reporting measure” would be subject to recovery. Financial reporting measures are defined as those metrics based on the accounting principles used in preparing the company’s financial statements, any measures derived from such financial information, and any measures based on stock price or total shareholder return. Thus, compensation subject to the recovery policy required by the proposed listing standards would include:

• Non-equity incentive plan awards that are earned based wholly or in part on satisfying a financial reporting measure performance goal.
• Bonuses paid from a “bonus pool,” the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal.
• Equity-based incentive awards that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal.
• Proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based wholly or in part on satisfying a financial reporting measure performance goal.

Companies, however, should understand that their clawback policies do not need to encompass all forms of incentive compensation. For example, salary, discretionary bonuses, and awards based solely on time-based vesting criteria are not covered. In addition, an incentive plan award that is granted, earned or vested based solely upon the occurrence of certain non-financial events, such as opening a specified number of stores, obtaining regulatory approval of a product, or the consummation of certain corporate transactions, would not be “incentive-based compensation” because these measures of performance are not deemed financial reporting measures.

Impact of Timing of Awards: The mechanics of incentive compensation programs add a further wrinkle to the scope of a company’s clawback policy. As proposed, incentive-based compensation would be deemed received for purposes of triggering the clawback policy in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if the payment or grant occurs after the end of that period. Stated another way, if the grant of an award is based on satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when that measure was satisfied.

Administrative procedures necessary to effect issuance or payment, such as calculating the amount earned or obtaining the board of directors’ approval of payment, would not affect the determination of the date received. For example, for an equity award deemed received upon grant, receipt would occur in the fiscal year that the relevant financial reporting measure performance goal was satisfied, rather than a subsequent date on which the award was actually issued.

Under the proposed rules, incentive-based compensation would be subject to the company’s recovery policy to the extent that it is received while the company has a class of listed securities. An award of incentive-based compensation granted to an executive officer before the company lists a class of securities would be subject to the recovery policy, so long as the incentive-based compensation was received by the executive officer while the company had a class of listed securities. Accordingly, companies would be required to separately track the date of “receipt” for purposes of their clawback policy in addition to the grant date for accounting and disclosure purposes because such dates would often be different.

Amount of Clawback: In the event of a restatement, the proposed rules provide a method for calculating the amount that should be recovered. After an accounting restatement, the company would first recalculate the applicable financial reporting measure and the amount of corresponding incentive-based compensation, calculated on a pre-tax basis. In addition, companies must factor in any discretion that the compensation committee had applied to reduce the amount originally received.

In order to determine the amount of the clawback, cash awards that are received upon satisfaction of a financial reporting measure should be relatively straightforward. The recoverable amount would be the difference between the amount of the cash award that was received and the amount that should have been received applying the restated financial reporting measure. For cash awards paid from bonus pools, the size of the aggregate bonus pool from which individual bonuses are paid would be reduced based on applying the restated financial reporting measure. If the reduced bonus pool is less than the aggregate amount of individual bonuses received from it, the excess amount of an individual bonus would be the pro rata portion of the deficiency. If the aggregate reduced bonus pool would have been sufficient to cover the individual bonuses received from it, then no recovery would be required.

For equity awards, if the awards 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. If the awards have been settled, but the underlying shares have not been sold, the recoverable amount would be the number of shares underlying the excess awards. If the shares have been sold, the recoverable amount would be the sale proceeds received by the executive officer with respect to the excess number of shares.

If, however, an executive officer reimburses a company pursuant to the clawback provisions of Sarbanes-Oxley, such amounts would be credited to the extent that a company’s policy requires repayment of the same compensation by that executive officer.

While the impact of how certain financial measures effect incentive-based compensation may be clear, the impact of a restatement on a company’s stock price is less evident. Fortunately, the proposed rules acknowledge that some companies may need to engage in complex analyses in order to determine the stock price impact of a material restatement. In recognition of this complexity, the proposed rules permit companies to use “reasonable estimates” when determining the impact of a restatement on both stock price and total shareholder return. Companies, however, must disclose the estimates and basis for their determination.

Disclosures: Each listed company would be required to file its compensation recovery policy as an exhibit to its Exchange Act annual report. In addition, if during its last completed fiscal year the company either prepared a restatement that required recovery of excess incentive-based compensation, or there was an outstanding balance of excess incentive-based compensation relating to a prior restatement, a company would be required to disclose:

• The date on which the company was required to prepare an accounting restatement;
• The aggregate dollar amount of excess incentive-based compensation attributable to the restatement;
• The estimates used to determine the excess incentive-based compensation attributable to such accounting restatement, if the financial reporting measure related to a stock price or total shareholder return metric;
• The aggregate dollar amount of excess incentive-based compensation that remained outstanding as of the end of the last completed fiscal year;
• The name of each person, if any, from whom during the last completed fiscal year the company decided not to pursue recovery, the amount forgone from each such person, and a brief description of the company’s reasons for not pursuing recovery; and
• The name of, and amount due from, each person from whom, at the end of its last completed fiscal year, excess incentive-based compensation had been outstanding for 180 days or longer since the date the company determined the amount the person owed.

The proposed disclosure would be included along with the company’s other executive compensation disclosure in annual reports and any proxy or information statements in which executive compensation disclosure is required.

In addition, the proposed rules would modify the summary compensation table disclosure requirements. A new instruction to the summary compensation table would require that any amounts recovered pursuant to a company’s erroneously awarded compensation recovery policy reduce the amount reported in the applicable column for the fiscal year in which the amount recovered initially was reported. In addition, companies must include a footnote disclosure describing the revision.

Recovery: Under the proposed rules, compliance is mandatory; a company must recover erroneously awarded compensation in compliance with its recovery policy. The proposed rules do provide two narrow exceptions. A company will not be required to clawback compensation to the extent that pursuit of recovery would be impracticable because it would impose undue costs on the company or would violate the laws of an applicable foreign jurisdiction.

Before concluding that recovery would be impracticable based on enforcement costs, however, the company would first need to make a reasonable attempt to recover that incentive-based compensation, document its attempts to recover, and provide that documentation to the applicable exchange. As noted, the company also would be required to disclose why it determined not to pursue recovery. Similarly, before concluding that it would be impracticable to recover because doing so would violate foreign law, the company first must obtain an acceptable opinion of local counsel that recovery would result in such a violation. In either case, to prevent potential conflicts of interest, any determination that recovery would be impracticable would need to be made by the company’s committee of independent directors that is responsible for executive compensation decisions or, in the absence of a compensation committee, a majority of the independent directors serving on the board.

The proposed rules do not specify the manner in which a company must effectuate recovery of erroneously awarded compensation. Rather, companies are permitted to exercise discretion in how to accomplish recovery so long as action is taken in a reasonably prompt time frame.

Notably, the proposed rules specifically prohibit a company from indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation. Moreover, while an executive officer is permitted to purchase a third-party insurance policy to fund potential clawback obligations, the indemnification prohibition would prohibit a company from paying or reimbursing the executive for premiums for such an insurance policy.

Compliance Time Line: The proposed rules require the exchanges to file their proposed listing rules no later than 90 days following the publication of the adopted version of the final SEC rules. The proposal also requires the exchange listing rules to become effective no later than one year following the publication date.

Each listed company would be required to adopt its recovery policy no later than 60 days following the date on which the exchange’s listing rule becomes effective. Each listed 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 the final SEC rules that results from attaining a financial reporting measure based on financial information for any fiscal period ending on or after the effective date of the final SEC rules. Listed companies would be required to comply with the new disclosures in proxy or information statements and Exchange Act annual reports filed on or after the effective date of the listing exchange’s rule.

Conclusion

While the compensation clawback rules remain proposed guidance, the clawback rules will apply to periods ending after the effective date of the final SEC rules. As a result, companies must be prepared to quickly finalize their clawback policies and ensure that the appropriate protocols are in place in order to properly administer the policy. Companies should work with their counsel to make sure that their compensation policies are drafted in accordance with the final rules, and to understand how and when the clawback mechanic will work in practice.

McDonald Hopkins can assist with implementation, disclosures, training, and messaging regarding executive compensation clawback policies, and compliance with the Dodd-Frank Act.

For more information, please contact the attorney listed below, or any member of our Executive Compensation and Governance team.