On July 1, 2015, the Securities and Exchange Commission proposed rules regarding clawback policies and disclosure, requiring the recovery of incentive-based compensation of officers in cases of material non-compliance with accounting reporting requirements. These proposed rules are required by Section 10D of the Securities Exchange Act of 1934, as added by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rules would be implemented through new listing standards to be adopted by national securities exchanges. The proposed rules were approved by a 3-2 vote of the Commission and drew sharp criticism from Commissioners Gallagher and Piwowar. Commissioner Gallagher referred to the proposed rules as the Commission’s “newest Goya, tortured and nightmarish.” The proposed rules can be found here.

The proposed rules impose significant additional detailed requirements to the framework established by Dodd Frank and Section 10D. Of particular concern to issuers is the sweeping scope of the proposed rules. They (i) impose a “no fault” clawback requirement on a broad group of the issuer’s officers, (ii) cover incentive-based compensation that is tied not only to financial reporting measures, but also to stock price and total shareholder return, and (iii) provide limited discretion for an issuer’s compensation committee to determine not to pursue a clawback. Further, as proposed, emerging growth companies, smaller reporting companies and foreign private issuers are not exempt from the rules.

The proposed rules would add a new Exchange Act Rule 10D-1 and amend Regulation S-K, Form 20-F and Form 40-F to address the new clawback requirements for listed companies.

As proposed, the clawback regime for listed companies would include the following features:

  • Listed companies must adopt and publish clawback policies as required by their applicable securities exchange.
  • Recovery would be required from any current or former executive officer who received incentive-based compensation during the three fiscal years preceding the date on which the issuer is required to prepare an accounting restatement to correct a material error. The recovery would be required regardless of whether any misconduct occurred or whether an executive officer had responsibility for the error in the financial statements.
  • Incentive-based compensation would be deemed “received” for purposes of triggering the recovery 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.
  • The executive officer definition in the proposed rules tracks the definition of an “officer” under Section 16 of the Exchange Act, which is much broader than the named executive officer definition for whom compensation disclosure is required in a company’s proxy statement. The proposed definition includes an issuer's president, principal financial officer, principal accounting officer, any vice-president of the issuer in charge of a principal business unit, division or function, any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer. Officers of the issuer's parent or subsidiaries may fall within the proposed definition, if they perform such policy-making functions for the issuer.
  • “Incentive-based compensation” is defined as compensation granted, earned or vested, based wholly or in part on the attainment of any financial reporting measure. “Financial reporting measures” are those based on the accounting principles used in preparing the issuer’s financial statements, any measures derived wholly or in part from such financial information, and stock price and total shareholder return.
  • The recovery amount equals the amount of incentive-based compensation received by an executive officer that exceeds the amount the executive officer would have received had the incentive-based compensation been determined based on the restated financial statements.
  • If the incentive-based compensation is based on stock price or total shareholder return, companies are permitted to use a “reasonable estimate” of the effect of the accounting restatement to determine the recovery amount.
  • Companies are required to pursue recovery of all incentive-based compensation, except under two limited circumstances. Recovery is not required if the committee of independent directors that is responsible for executive compensation decisions (or, if there is no such committee, a majority of the board’s independent directors) determines that (i) it would be impracticable to seek recovery because the direct expense of seeking recovery would exceed the recoverable amounts, or (ii) for foreign issuers, it would violate the issuer’s home country law. The proposed rules impose the following additional conditions if an issuer desires to use these exceptions:
      • Expense exceeds recovery amount exception: The issuer must make a reasonable attempt to recover applicable incentive-based compensation, document attempts to recover the applicable incentive-based compensation, and provide the documentation to its securities exchange.
      • Foreign law exception: The foreign issuer must obtain an opinion of foreign local counsel that recovery violates the issuer’s home country law. This opinion will only be accepted with respect to home country laws adopted prior to the date of publication of proposed Rule 10D-1 in the Federal Register.
  • The proposed rules would also add requirements to Item 402 of Regulation S-K as well as require the listed issuer’s clawback policy to be added as an exhibit to the issuer’s annual report (Form 10-K, 20-F or 40-F). In addition, if, at any time during its last completed fiscal year, either (i) a restatement that required recovery of excess incentive-based compensation pursuant to the issuer’s compensation recovery policy was completed or (ii) there was an outstanding balance of excess incentive-based compensation from the application of that policy to a prior restatement, the following disclosure items must be included:
      • For each restatement, the date on which the issuer was required to prepare an accounting restatement, the aggregate dollar amount of excess incentive-based compensation attributable to such accounting restatement and the aggregate dollar amount of excess incentive-based compensation that remains outstanding at the end of its last completed fiscal year.
      • The estimates used to determine the excess incentive-based compensation attributable to such accounting restatement, if the incentive payment related to a stock price or total shareholder return metric.
      • The name of each person subject to recovery of excess incentive-based compensation attributable to an accounting restatement, from whom the issuer decided during the last completed fiscal year not to pursue recovery, the recovery amount forgone for each such person, and a brief description of the reason the issuer decided in each case not to pursue recovery.
      • The name of, and amount due from, each person from whom, at the end of the issuer’s last completed fiscal year, excess incentive-based compensation had been outstanding for 180 days or longer since the date the issuer determined the amount the person owed.
      • Issuers would also be required to block tag the disclosure using XBRL.
  • Issuers are not permitted to indemnify officers against any amounts recovered under its clawback policies or to pay premiums on an insurance policy covering an officer’s potential clawback obligations. This is similar to the SEC’s position that liability for short-swing profits under Section 16(b) of the Exchange Act may not be indemnified or insured.

We expect significant comments to be submitted regarding the proposed rules, and do not expect the rules to be in place for next year’s annual report/proxy season. Nevertheless, issuers should take this opportunity to review their current clawback policies and incentive-based compensation plans to determine how the proposed rules could impact the issuer’s compensation policies.

We invite you to reach out to us for any assistance you may require as you review your policies and plans and consider how to prepare for the upcoming clawback requirements.