SEC Adopts Final Executive Compensation Clawback Rules

Practical Law Legal Update w-037-3794 (Approx. 13 pages)

SEC Adopts Final Executive Compensation Clawback Rules

by Practical Law Corporate & Securities

Clawback Policy Requirement

New Exchange Act Rule 10D-1 directs the national securities exchanges to establish listing standards for listed companies requiring them to adopt and comply with clawback policies. Specifically, listed companies will be required to adopt and comply with a written clawback policy providing for the recovery of the amount of incentive-based compensation erroneously awarded to current and former executive officers if the company is required to prepare an accounting restatement due to the material noncompliance with any financial reporting requirement under the securities laws. The listing standards will also require listed companies to disclose the policy and certain related information (see Disclosure Obligations).

Any listed company that does not adopt and comply with a clawback policy meeting the requirements of the listing standard, or provide the required clawback policy disclosures, will be subject to delisting.

Covered Issuers

Rule 10D-1 and the requisite listing standards will apply to all listed companies, with only limited exceptions, such as certain listed registered investment companies (funds) to the extent they do not award incentive-based compensation to their employees. The SEC is also not granting securities exchanges the discretion to exempt any other categories of listed companies. This means the clawback policy and related disclosure requirements will apply to:

Foreign private issuers (FPIs).
Smaller reporting companies and emerging growth companies.
Controlled companies.

Accounting Restatements Triggering Recovery

Rule 10D-1 will not separately define accounting restatement or material noncompliance, and those terms will have the same meanings as already set out in existing accounting standards and guidance for purposes of the rule. Recovery under the clawback policy is triggered by the company's obligation to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, including any accounting restatement that:

Corrects an error in previously issued financial statements that is material to the previously issued financial statements ("Big R" restatements).
Corrects an error not material to previously issued financial statements, but would result in a material misstatement if:
- the error was left uncorrected in the current period; or
- the error correction was recognized in the current period ("little r" restatements).

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.

Compensation and Executives Subject to Clawback Policies

Incentive-based Compensation

For purposes of Rule 10D-1, incentive-based compensation is defined as "any compensation that is granted, earned or vested based wholly or in part on the attainment of a financial reporting measure."

Financial reporting measures is defined in Rule 10D-1 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.
Stock price and total shareholder return (TSR).

Financial reporting measures do not need to be presented in the financial statements or included in an SEC filing.

The SEC also reiterated non-exhaustive lists of examples of what "financial reporting measures" would include and what would and would not be considered "incentive-based compensation."

Examples of financial reporting measures include:

Revenues.
Net income.
Operating income.
Profitability of one or more reportable segments.
Financial ratios, such as accounts receivable turnover and inventory turnover rates.
EBITDA.
Funds from operations and adjusted funds from operations.
Liquidity measures, such as working capital and operating cash flow.
Return measures, such as return on invested capital and 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.
Cost per employee, where cost is subject to an accounting restatement.
Any financial reporting measures relative to a peer group, where the issuer's financial reporting measure is subject to an accounting restatement.
Tax basis income.

Specific examples of incentive-based compensation 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.
Other cash awards based on satisfaction of 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 includes:

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 at the discretion of the compensation committee or board that are not paid from a "bonus pool" that is determined by satisfying a financial reporting measure performance goal.
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 based 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.

Executive Officer

Rule 10D-1 will require recovery of incentive-based compensation received by a person:

After beginning service as an executive officer.
If that person served as an executive officer at any time during the recovery period (see below).

Rule 10D-1's definition of executive officer, which is consistent with the definition of officer in Exchange Act Rule 16a-1(f), includes 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.

The identification of executive officers for purposes of the clawback policy will include, at a minimum, anyone the company identifies as an executive officer under 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).

Time Period Covered by Clawback Policies

The company's adopted clawback policy must 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 recover compensation will not be dependent on if or when the company actually files its restated financial statements.

Received

Incentive-based compensation will be considered "received" in the fiscal period during which the specified financial reporting measure is attained, even if the payment or grant occurs after the end of that period. The date of receipt therefore depends 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 an equity award vests only on the achievement of a financial reporting measure, the award would be received in the fiscal period that it vests.

The incentive-based compensation must have been received while the company has a class of securities listed on a national securities exchange to be subject to the rule. That is, incentive-based compensation received by an executive officer before the company listed its securities on a national securities exchange 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 is the earlier of:

The date the company's board of directors or applicable board committee (or officers authorized to take action if board action is not required) concludes, or reasonably should have concluded, that the company is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws. If the company is required to file a Form 8-K report under Item 4.02(a), this date is expected to coincide with the occurrence of the event described in the Form 8-K (see Practice Note, Form 8-K: Non-reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review).
The date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.

For example, if a company with a calendar year-end fiscal year concludes in November 2024 that it needs to restate previously issued financial statements, the clawback policy would cover compensation received by executive officers in 2021, 2022, and 2023. The company's recovery obligation is not dependent on the date that it actually files the restated financial statements.

Recovering Erroneously Awarded Compensation

Calculating Compensation to be Clawed Back

The amount subject to recovery (the recoverable amount) by the company is the amount of incentive-based compensation received, based on the erroneous data, in excess of the amount that otherwise would have been paid had it been determined based on the accounting restatement. This amount must be calculated on a pre-tax basis.

To determine this amount, after an accounting restatement:

The company must first recalculate the applicable financial reporting measure and the amount of incentive-based compensation based on that measure.
The company must 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, if the amount of erroneously awarded compensation cannot be calculated directly from the information in the accounting restatement, the recoverable amount must 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 company must also maintain documentation of the determination of the reasonable estimation and provide it to the national securities exchange on which its securities are listed.

In cases where clawback under Section 304 of the Sarbanes-Oxley Act of 2002 or under a foreign recovery regime also applies, any amount reimbursed to the company under Section 304 or other recovery obligations would be credited to the extent that repayment of the same compensation by that officer would be required under the company's clawback policy.

Examples by Type of Incentive-Based Compensation

In terms of determining the recoverable amount, the SEC intends for the rule to apply in a principles-based manner with the determination based on the particular facts and circumstances applicable to the company and the executive officer's compensation arrangement. The SEC noted that companies are free to adopt more stringent clawback policies as long as the minimum requirements of the rules are met. However, the SEC provided a few examples of calculating erroneously awarded compensation as limited guidance to assist companies:

For cash awards, the recoverable amount is 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 cash awards paid from bonus pools, the recoverable amount is the pro rata portion of any deficiency that results from the aggregate bonus pool that is reduced based on 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 is the number of securities received in excess of the number that should have been received applying the restated financial reporting measure (or the value of that excess number). If the options or SARs have been exercised, but the underlying shares have not been sold, the recoverable amount is the number of shares underlying the excess options or SARs (or the value of those shares).

Obligation to Seek Recovery

Companies will be required to recover any excess incentive-based compensation in compliance with its clawback policy unless their compensation committee determines recovery would be impracticable because:

The direct costs paid to a third party to assist in enforcing recovery, such as reasonable legal expenses and consulting fees, would exceed the amount to be recovered.
Recovery would violate home country law, provided the law must have been adopted by that country before the date the SEC's adopting release is published in the Federal Register.
Recovery would cause an otherwise tax-qualified retirement plan, under which benefits are broadly available to employees of the company, to fail to meet qualification requirements (see Practice Note, Requirements for Qualified Retirement Plans: Basic Qualification Requirements and Standard Clause, Plan Language, Non-Assignability of Benefits).

To establish impracticability due to the expense of enforcement, companies must:

Make a reasonable attempt to recover the erroneously awarded compensation.
Document their attempt(s) to recover and provide that information to the securities exchange on which their securities are listed.

To establish impracticability due to violation of home country law, FPIs must:

Obtain an opinion of home country counsel (acceptable to the applicable securities exchange) that recovery would violate home country law.
Provide the opinion to the securities exchange on which their securities are listed.

Any determination that recovery would be impracticable under one of the three exceptions must be made by the company's compensation committee. In the absence of a compensation committee, the determination must be made by a majority of the board's independent directors.

While companies will not have discretion whether to seek recovery, as long as the excess incentive-based compensation is recovered reasonably promptly, companies will have discretion regarding the appropriate means of recovery (for example, forfeiture of an award or repayment by the executive).

Indemnification Prohibited

Companies will be prohibited from indemnifying any of their current or former executive officers against the loss of any erroneously awarded incentive-based compensation. While executive officers subject to the clawback policy may purchase insurance to cover their potential recovery obligations, Rule 10D-1's indemnification provision also prohibits companies from paying or reimbursing the executive officer for premiums for such an insurance policy.

Disclosure Obligations

As an element of the listing standards to be adopted by securities exchanges, companies will be required to disclose information regarding their clawback policies, as well as a copy of the policy, in accordance with the federal securities laws. As such, the SEC adopted a number of amendments adding disclosure obligations under Regulation S-K and Form 10-K applicable to US issuers, as well as to Forms 20-F and 40-F to implement similar disclosure requirements for FPIs.

Amendments to Regulation S-K

Item 402

New Item 402(w) of Regulation S-K will apply to any listed company if at any time during or after its last completed fiscal year:

It was required to prepare an accounting restatement that triggered recovery of erroneously 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, the listed company will be required to disclose:

The date on which the company was required to prepare an accounting restatement and the aggregate dollar amount of erroneously awarded incentive-based compensation attributable to the restatement, including an analysis of how the amount was calculated. If the amount has not been determined, the company must explain why and provide the amount and related disclosures in its next filing subject to Item 402.
The aggregate dollar amount of erroneously awarded incentive-based compensation that it had not yet recovered at the end of its last completed fiscal year.
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 and an explanation of the underlying methodology.
If recovery is determined to be impracticable under Rule 10D-1, for each current and former named executive officer and for all other current and former executive officers as a group, the amount of recovery forgone and a brief description of the reason the company decided in each case not to pursue recovery. This brief description should include the element of Rule 10D-1 that caused the impracticability and additional context relating to that element, such as:
- the types of direct expenses paid to a third party to assist in enforcing the recovery policy;
- identifying the foreign home country law that would be violated by the recovery; or
- how the recovery policy would affect an otherwise tax-qualified retirement plan.
For each current and former named executive officer, the amount of erroneously awarded compensation still owed that had been outstanding for 180 days or more since the date the company determined the recoverable amount.

If at any time during the last completed fiscal year a company prepared an accounting restatement but concluded that recovery of erroneously awarded compensation was not required under its clawback policy, the company must explain why application of its policy resulted in this conclusion.

Item 402(w) disclosures will be required in a listed company's annual report on Form 10-K and annual meeting proxy statement. The disclosure is required as a separate item rather than as an amendment to the Compensation Discussion & Analysis (CD&A) under Item 402(b) because:

The requirements apply to a broader group of executive officers (not just the named executive officers).
CD&A requirements do not apply to certain issuers.

However, if the listed company is required to provide a CD&A under Item 402(b), it can disclose this information in its CD&A rather than in a separate location.

In addition, any listed company that recovered compensation under its clawback policy will be required to update its Summary Compensation Table. New instructions to Item 402(c) and (n) direct companies to reduce the amount reported in the applicable column of the Summary Compensation Table for an applicable fiscal year by any amount recovered under the clawback policy and disclose this amount in a footnote. The company must make the same revisions to the "total" column in the Summary Compensation Table. The company must provide this update in any Exchange Act or Securities Act filing requiring a Summary Compensation Table for the affected fiscal year.

Any specific data points included in the compensation recovery disclosures, as well as block text tagging those disclosures, must be tagged in Inline XBLR (see Practice Note, XBRL Reporting Requirements: New XBRL Formatting: Inline XBRL).

Item 601

Amended Item 601(b) of Regulation S-K requires a listed company to file its clawback policy as an exhibit to its annual report on Form 10-K.

Item 404

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

Other Amendments

In addition to the Regulation S-K amendments, the SEC also adopted other related amendments:

New Cover Page Check Boxes. The SEC adopted amendments to the cover pages of Forms 10-K, 20-F, and 40-F to add check boxes for filers to indicate whether:
- the company's financial statements included in the filing reflect a correction of an error to previously issued financial statements, and
- any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the company's executive officers during the relevant recovery period.
The new check boxes are intended to provide more transparency around "little r" restatements.
FPIs and MJDS Filers. The SEC also amended Forms 20-F and 40-F to require FPIs and MJDS filers, respectively, to provide compensation recovery disclosure similar to the Item 402(w) information and permit the same exclusion to related party transaction disclosure as in Item 404 described above. These filers must also file their clawback policies as an exhibit to the respective forms.
Investment Companies. Schedule 14A and Form N-CSR have been amended to require certain investment companies subject to Rule 10D-1 to disclose compensation recovery information similar to the Item 402(w) information and file their clawback policies as an exhibit.

Implementation Timeframe

The final rules will become effective 60 days after publication in the Federal Register. As the securities exchanges will have to adopt the required listing standards, compliance with the clawback policy and disclosure rules for companies will be based on the implementation timeframe of their respective securities exchange. However, the SEC has adopted the following transition and timing deadlines:

Securities exchanges must propose listing standards governing clawback policies within 90 days after the adopting release is published in the Federal Register.
The proposed listing standards must be finalized and become effective within one year after the adopting release is published in the Federal Register.
Listed companies must adopt a compliant clawback policy within 60 days after the listing standard to which they are subject becomes effective.
Listed companies must begin providing the disclosures required by the listing standard and amended disclosure rules in annual reports and proxy statements filed after the clawback policy is adopted.

Each company will be required to recover all erroneously awarded incentive-based compensation received by current and former executive officers after the effective date of the applicable exchange's listing standard. Compliance will 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 Rule 10D-1.

For more information on and a sample form of a clawback policy, see Standard Document, Clawback Policy.

SEC Adopts Final Executive Compensation Clawback Rules | Practical Law