SEC Issues Long-Awaited Rule on Clawback of Executive Compensation

Overview

On October 26, 2022, the Securities and Exchange Commission (the “SEC”) adopted Rule 10D-1, a rule requiring companies to recover erroneously awarded incentive-based compensation based on mistakes in the companies’ financial reporting — the so-called clawback rule (the “Rule”). In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) added Section 10D under the Security Exchange Act of 1934, as amended (the “Exchange Act”), which instructed the SEC to require stock exchanges to order each public company to implement a clawback policy focused on incentive compensation paid to current and former executive officers, and, in response, the SEC proposed the original version of the Rule in 2015.

Under the Rule, the national securities exchanges must adopt listing standards compelling nearly all listed companies to develop and implement clawback policies. These clawback policies should require a company to recoup its executives’ erroneously awarded incentive-based compensation in the event of a “Big R” or “little r” accounting restatement.

The Rule applies to all reporting companies, including emerging growth companies, foreign private issuers, smaller reporting companies and controlled companies, with very limited exceptions. Notably, all covered companies are subject to the same standards, including the disclosure requirements, compliance period, and XBRL tagging implementation period that are described in more detail below. The Rule will be effective 60 days following publication in the Federal Register. Within 90 days following publication, the national securities exchanges must file proposed listing standards that will be effective within one year following publication. Companies must adopt compliant clawback policies no later than 60 days following the date that the applicable listing standards become effective, and compliance with the new public disclosure requirements will be required in the first annual report, proxy statement, or information statement required to be filed following the effective date of the final listing standards.

For additional information, please see the final rule published by the SEC. 

Rule 10D-1 – Compensation Recovery Rules

The Rule requires companies to claw back incentive compensation erroneously received by current and former executives during the three-year period preceding the required restatement date. Under the Rule, the term “received” generally means that the applicable financial reporting measure connected to incentive compensation has been satisfied and such incentive compensation has been earned, even if such incentive compensation has not yet actually been paid. For example, an annual bonus award is deemed received in the fiscal year that the executive earns the award based on achievement of the underlying performance measure(s), even if the award is not actually paid until March of the following fiscal year. Because the Rule applies to incentive compensation received by executive officers on or after the effective date of the listing standards, incentive compensation granted prior to the effective date would still be subject to the Rule if it is not received prior to the effective date.

The recoverable amount (on a pre-tax basis) is the difference between the incentive-based compensation received by the executives and the amount that would have been received based on the required restatement.

The Rule applies not only to “Big R” restatements, but also to “little r” restatements.

Unlike the proposed 2015 version of the clawback rule, which was limited to “Big R” restatements, the Rule applies to both “Big R” and “little r” restatements. “Big R” restatements restate historical financial statements to correct errors that were material to those previously issued financial statements, and “little r” restatements restate prior period information in the current period comparative financial statements. Issuers utilize “little r” restatements for errors that are not material to previously issued financial statements, but would result in a material misstatement if the errors were left uncorrected in the current report or if the error correction were recognized in the current period.

The proposed rule required the clawback of compensation only if the company identified major accounting errors that required restating the prior years’ financial results. However, the Rule requires the clawback of compensation even if the company identifies smaller errors affecting only the latest year’s results. SEC economists estimate that “little r” restatements are approximately three times more common than “Big R” restatements. Because the Rule includes “little r” restatements, it might require a company to either: (i) conduct a clawback analysis, even if the applicable error did not lead to erroneously paid compensation to its executive officers; or (ii) claw back a de minimis amount of compensation from its executives.

Under the Rule, the date on which a company is required to prepare a restatement is the earlier of: (i) the date that the board of directors, a committee of the board of directors, or an authorized officer concludes, or reasonably should have concluded, that the company is required to prepare such accounting restatement due to material noncompliance with any financial reporting requirement; or (ii) the date that a court, regulatory, or other legally authorized body directs the company to prepare a restatement. In determining when the applicable body should have reasonably concluded to prepare the required restatement, the SEC notes that a company would have to consider any notice it may receive from its auditor that previously issued financial statements contain a material error.

“Executive officers” includes both former and current employees who performed policy-making functions.

The Rule broadly defines executive officers in a manner that is consistent with the definition of “officer” for purposes of Section 16 of the Exchange Act and, as such, generally includes all Section 16 officers (or anyone who qualified as a Section 16 officer during the relevant three-year period). Under the Rule, “executive officers” includes any current or former employee who has performed a policy-making function for the issuing company within the preceding three years (even if employed by the company’s parent or subsidiaries), without regard to whether the employee was involved with the events leading to the restatement or is deemed to be at fault.

“Incentive-based compensation” encompasses both accounting-based and market-driven metrics.

Under the Rule, “incentive-based compensation” covers any compensation that is granted, earned or vested wholly or in part on a financial reporting measure, which includes not only accounting-based metrics, but also market-driven metrics. Consequently, companies are required to claw back up to three years of incentive-based compensation, including stock options, based on market-driven metrics, such as stock price and total shareholder return (“TSR”), which both reflect factors beyond the company’s reported financial information. Because the recoverable amount of incentive-based compensation based on either TSR or stock price cannot directly be calculated solely based on the information in an accounting restatement, the Rule requires that a company (i) base the recoverable amount on a reasonable estimate of the accounting restatement’s effect on the applicable measure; and (ii) provide documentation to the applicable national securities exchange regarding the methodology employed to determine such reasonable estimate. As stated above, the amount to be clawed back is equal to the difference between the amount of incentive-based compensation received by current or former executives and the amount that would have been received after giving effect to the restatement.

The Rule includes an impracticability accommodation, which provides limited exceptions to the Rule’s scope.

A company is exempted from complying with the Rule if the company meets the Rule’s impracticability standard. Under this standard, a company is not required to recover erroneously awarded compensation if: (i) the direct expense the company would have to pay to a third party for help exceeds the amount the company would recover from its executive officers; (ii) recovery would violate a home country law that was adopted prior to October 26, 2022; or (iii) recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the Internal Revenue Code’s requirements.

To qualify for the first prong of the impracticability standard listed above, the company must not only make a “reasonable attempt” to claw back the compensation, but also document the efforts it undertakes. Notably, the cost-benefit analysis does not include internal costs, such as resources required to work with, manage, or monitor the third party’s efforts, or costs associated with defending counterclaims.

Companies are subject to additional disclosure requirements under the Rule.

The Rule implements additional public disclosure requirements that apply even if a company has not been required to apply its clawback policy to recoup incentive compensation. All covered companies must now file their clawback policies as a tagged exhibit to their annual reports.

Under the Rule, if a company has applied its clawback policy, the company must disclose: (i) the date on which the company was required to prepare an accounting restatement; (ii) the amount of erroneously awarded compensation based on its accounting restatement; (iii) an analysis of the calculation that determined the erroneously awarded compensation; (iv) the estimates used to determine the amount of erroneously awarded compensation linked to either stock price or TSR, and an explanation of the methodology used for such estimates; (v) amounts still owed; and (vi) if amounts erroneously awarded have not yet been recovered, this fact and the reason(s) for it.

Additionally, Forms 10-K, 20-F, and 40-F will include new check boxes for a company to indicate whether: (i) the included financial statements reflect the correction of an error to previously issued financial statements; and (ii) any such error corrections are restatements that required a clawback analysis of incentive-based compensation received by any executive officers during the three-year recovery period pursuant to the Rule. Clawed back compensation will also trigger additional disclosures within a company’s Summary Compensation Table for the relevant period(s).

In the event that a company has used an impracticability exception described in the preceding section in order not to recover compensation that is covered by the Rule, the company must also provide a brief disclosure of the reason that the company determined not to pursue recovery and any details that would give the company’s shareholders context around that decision.

Next Steps

Reporting companies are subject to delisting if they that do not adopt and comply with both the Rule’s compensation recovery policies and the listing exchanges’ final listing standards adopted in response to the Rule. Consequently, companies without an existing clawback policy should begin discussing a policy that is compliant with the Rule, and companies with existing clawback policies should begin evaluating such policies as compared to the Rule. Because many companies implemented clawback policies based on the proposed 2015 rule, which, as discussed above, is much more limited in scope than the Rule, an existing clawback policy does not guarantee compliance. Further, since the Rule applies to all incentive-based compensation received by current or former executive officers on or after the effective date of the applicable listing standard (even if such incentive-based compensation was granted prior to such effective date), companies should evaluate pre-existing documentation governing incentive-based compensation to ensure that the clawback of such incentive-based compensation in accordance with the Rule is permitted.