Thursday, November 3, 2022
Dodd-Frank Wraps Up: The SEC Adopts Executive Compensation Clawback Rules
On October 26, 2022, the Securities and Exchange Commission (the “SEC”), in a 3-to-2 vote, adopted its long-awaited final rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) requiring listed public companies to establish executive compensation recovery, or “clawback,” policies.
The final rules implement Section 10D of the Securities Exchange Act of 1934 (“Exchange Act”), which was added when Congress enacted the Dodd-Frank Act in 2010. The SEC had originally proposed clawback rules in 2015, but the proposed rules remained dormant until the SEC reopened them for further public comment in 2021 and again in June 2022. The final rules add new Exchange Act Rule 10D-1 (“Rule 10D-1”), which largely tracks the long-pending proposed rules but also incorporates terms previewed in the SEC’s 2021 release reopening the comment period.
Rule 10D-1 will obligate national securities exchanges to adopt listing standards that will apply the disclosure and compensation recovery policy requirements to all listed issuers (including emerging growth companies, smaller reporting companies and foreign private issuers), with only limited exceptions. Each listed issuer will be required to adopt a compensation recovery policy, to comply with that policy, and to provide certain disclosures regarding the policy and, if relevant, its application. An issuer will be subject to delisting if it does not adopt and comply with a compensation recovery policy that meets the requirements of the listing standards.
Compensation Recovery Requirements
When the Clawback Policy is Triggered
Under Rule 10D-1, an issuer’s clawback policy must provide that, in the event the issuer is required to prepare an accounting restatement, including both a “Big R” restatement (i.e., a restatement that corrects an error that is material to previously issued financial statements) and a “little r” restatement (i.e., a restatement to correct an error that is not material to prior period financial statements, but that would result in a material misstatement if the error were left uncorrected in the current report or the error correction was recognized in the current period), the issuer would be required to recover from any current or former executive officers the incentive-based compensation that was erroneously awarded to such persons during the three fiscal years preceding the date such restatement was required (the “Look-Back Period”). Application of the clawback policy would not be triggered by an out-of-period adjustment (i.e., a situation where the error is immaterial to the previously issued financial statements and the correction of the error is also immaterial to the current period).
For the purposes of Rule 10D-1, the date that a restatement is required is the earlier to occur of (a) the date that the issuer’s board (or a committee of the board or authorized officers) concludes, or reasonably should have concluded, that the issuer is required to prepare a restatement or (b) the date that a court, regulator or other authorized body directs the issuer to prepare a restatement. According to the release accompanying the final rule, the SEC took this approach and avoided a bright-line test because it believes that this approach provides reasonable certainty for issuers, shareholders, and exchanges while minimizing incentives for issuers to delay their restatement conclusions. Nevertheless, the SEC stated in its notice when it reopened the comment period in 2021, “[f]or errors that are material to the previously issued financial statements, we generally expect the date in (a) to coincide with the date disclosed in the Item 4.02(a) Form 8-K filed.”
Executives Subject to the Clawback Policy
Rule 10D-1 covers any current or former executive officer of the issuer who received incentive-based compensation during the Look-Back Period. The definition of “executive officer” for purposes of Rule 10D-1 tracks the definition of “officer” found in Rule 16a-1(f) under the Exchange Act and includes the issuer’s president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division or function, and any other person who performs policy-making functions for the issuer. In addition, executive officers of the issuer’s parents or subsidiaries will be deemed executive officers of the issuer if they perform policy-making functions for the issuer.
Incentive Compensation Covered
The compensation that must be recovered is the amount of incentive-based compensation received by the executive in excess of what would have been received if the incentive-based compensation was determined based on the restated financial statements (computed without regard to any taxes paid). This includes any compensation granted, earned or vested based, in whole or in part, upon the attainment of a financial reporting measure, which includes non-GAAP financial measures, stock price and total shareholder return (“TSR”). Incentive-based compensation does not include compensation that is based solely on continued employment for a specified period of time (e.g., time-vesting awards, including time-vesting stock options), unless such awards were granted or vested based in whole or in part on a financial reporting measure. It also does not include base salary, compensation awarded solely at the board’s discretion, or compensation awarded upon the achievement of subjective, strategic or operational measures that are not financial reporting measures (such as the achievement of ESG goals). Compensation is deemed received under Rule 10D-1 in the fiscal period during which the applicable financial reporting measure is attained, even if the payment or grant occurs after the end of that period.
When compensation is based on TSR or stock price and the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement, the amount must be based on a reasonable estimate of the effect of the accounting restatement on the applicable measure. Further, the issuer must maintain documentation of the determination of the estimate and provide it to the applicable securities exchange.
Enforcement of the Clawback Policy
Recovery of erroneously awarded compensation is required under Rule 10D-1 regardless of any misconduct by an executive officer (or lack thereof) in connection with the error that triggers the restatement. Limited impracticability exceptions are available only in circumstances where (a) direct expenses paid to third parties to assist in enforcing the policy would exceed the amount to be recovered and the issuer has made a reasonable attempt to recover the erroneously award compensation, (b) recovery would violate home country law that existed at the time of adoption of the rule and the issuer provides an opinion of counsel to that effect to the securities exchange, or (c) recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code. Furthermore, issuers are prohibited from indemnifying their current or former executive officers against the loss of erroneously awarded compensation.
Reporting and Disclosure Requirements
A listed issuer will be required to file its clawback policy as an exhibit to its annual report on Form 10-K (or Form 20-F for a foreign private issuer), as well as to indicate on the cover page of its annual report whether (a) the financial statements included in the filing reflect a correction of an error to previously issued financial statements and (b) whether any such corrections are restatements that required a recovery analysis.
A listed issuer will also be required to disclose certain information about compliance with its policy in connection with any restatement, including:
- the date on which the issuer was required to prepare each accounting restatement;
- the aggregate amount of erroneously awarded compensation related to an accounting restatement, including a description of how the amount was calculated (including estimates, with the methodology disclosed, for compensation based on stock price or TSR);
- the aggregate amount of erroneously awarded compensation that is still outstanding as of the end of the prior fiscal year;
- the amount that remains uncovered from each current or former named executive officer for 180 days or more since the date the issuer determined the amount of such person’s erroneously awarded compensation; and
- if recovery would be impracticable, the amount of recovery foregone and a description of the reason the issuer decided not to pursue recovery.
In addition, a new instruction to the Summary Compensation Table will require that any amounts recovered pursuant to an issuer’s clawback policy reduce the amount reported in the applicable column, as well as the “Total” column of the table, for the fiscal year in which the amount recovered initially was reported, with the clawback identified by footnote.
Finally, issuers will be required to use Inline XBRL to tag their compensation recovery disclosure.
The final rules will become effective 60 days following publication of the SEC’s adopting release in the Federal Register. National securities exchanges will be required to file proposed listing standards no later than 90 days following such publication, and the listing standards will be required to be effective no later than one year following such publication. Thereafter, affected issuers must adopt a clawback policy within 60 days following the effective date of the new stock exchange listing standards. The mandated clawback policies must apply to any incentive-based compensation that is received by current or former executive officers on or after the effective date of the applicable listing standard. Compliance with the disclosure requirements is required in the first annual report or proxy or information statement required to be filed after the effective date of the new listing standards.
For additional information about any of the above developments, or to discuss any questions that you may have, please contact a member of Maynard’s Public Company Advisory Group.