SEC Clawback Proposal to Trigger Big Shifts in Current Pay Practices

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By Yin Wilczek

July 7 — The Securities and Exchange Commission's clawback proposal is problematic and may lead to significant changes in executive compensation practices if adopted, legal experts told Bloomberg BNA.

“It will lead to a lot of disruption,” predicted George Georgiev, an assistant adjunct professor at the University of California, Los Angeles School of Law who is studying the impact of clawback provisions in various countries.

Georgiev also described as noteworthy the SEC's surprise move of including foreign private issuers (FPIs) in the companies covered by the proposal. Unless subsequently clarified, that approach may lead to disparate treatment between FPIs and U.S. companies, he told BBNA in a July 6 interview.

Divided Commission 

On July 1, a divided SEC proposed a rule in which national securities exchanges would establish listing standards requiring issuers to adopt clawback policies. The requirements were mandated by § 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the proposal, U.S. companies and FPIs would have to develop and enforce policies to recover improperly awarded incentive-based compensation from current and former executives where there is an accounting restatement to correct a material error.

Recovery would be mandatory even where the executives are not at fault.

Attorneys told BBNA that while § 954 itself is prescriptive, the proposal reaches beyond what the statute requires.

“While this Dodd-Frank provision was specific in some respects, once again a majority of the commission has opted to propose more expansive—rather than tailored—rules implementing a Dodd-Frank mandate,” noted Elizabeth Ising, a Washington-based partner at Gibson, Dunn & Crutcher LLP.

“The SEC’s decision to take this expansive approach will unnecessarily increase compliance costs and lead to other unintended consequences,” Ising warned in a July 7 e-mail.

Attorneys also told BBNA that the proposed requirements differ from clawback policies adopted by many companies under the 2002 Sarbanes-Oxley Act.

If finalized, the proposal “would represent a significant change from existing policies,” Michael Hermsen, a partner at Mayer Brown LLP in Chicago, said in a July 6 e-mail.

Significant Differences 

A January PricewaterhouseCoopers report found that in a sample group of 100 large public companies, about 90 percent had clawback policies in 2014. Of those policies that condition recovery upon a restatement, 73 percent required some showing that the executive in question caused or contributed to the incorrect financial reporting.

Among other differences, the SEC's proposal would:

• extend the category of employees covered by most existing policies;

• eliminate the substantial discretion accorded to many corporate boards in deciding whether to implement clawbacks, who should be subject to clawbacks and what can be recovered;

• mandate a look-back period—three years—that is longer than most existing policies; and

• mandate a clawback trigger different from the SOX provision.


While SOX clawback is triggered in an accounting restatement due to material noncompliance as a result of misconduct, the SEC proposal would require reimbursement whenever there is a restatement impacting the amount earned, subject to certain exceptions.

Questions, Challenges 

One significant question arising from the proposal is how companies would implement and enforce the requirements, Hermsen said.

“How are companies going to enforce the provision—particularly with respect to persons who earned incentive compensation but are no longer employed by the company?” he asked. “It is still early, but we are having discussions about this point in particular.”

Matthew Dallett, a Boston-based partner at Locke Lord LLP, told BBNA that the proposal, if finalized, will require a “significant tightening” of most corporate policies. “In general, such policies have been adopted in response to institutional investor checklists, not the pending Dodd-Frank rules, and are—in my view—fairly toothless,” he said in a July 7 e-mail.

Dallett also noted that the SEC proposal, if adopted, would present a number of challenges. He said that these include:

• planning around the uncertainty that will be caused by existing employment agreements and compensation plans that do not clearly reserve the company’s rights to claw back compensation as required by the rule;

• planning around the uncertainty that will be caused by inconsistent state (e.g., wage) laws;

• planning ahead to avoid adverse tax treatment for the executive (particularly one not at fault) under Internal Revenue Code §409A;

• addressing D&O insurance policy coverage for potential recovery litigation, e.g., ensuring that the insured v. insured exclusion won’t impede the company’s recovery;

• determining the amount to claw back where compensation was based on stock price increase or total shareholder return; and

• most importantly, socializing the executives to the new environment.


Proposal's Potential Impacts 

Georgiev suggested that potential impacts from the SEC's proposed rule include longer and costlier audits, costlier restatements, increased litigation and delay of information to investors. If adopted, the proposal also could trigger a broader shift by companies to restructure their pay programs so as to avoid the hassle and costs of clawbacks, he said.

With regards to litigation, Georgiev noted that because the clawbacks must be calculated, companies may have to rely on experts and “backward-looking investigations” to determine how much to recover, which in turn leads to uncertainty. “Any time you have to rely on expert judgment or you have additional variables, that increases the potential for litigation and complications,” he said.

Among other examples, Georgiev suggested that contractual lawsuits may arise if employment agreements do not clearly spell out how clawbacks would work. In addition, employees who are not at fault may seek to recover from the executives who were at fault in the restatement.

Moreover, the plaintiffs' bar likely will come up with “creative theories” in derivative and other actions claiming that clawbacks either were not properly implemented or calculated, Georgiev said.

Gaming the Requirements 

Georgiev added that one of the biggest drawbacks of the SEC's proposal is how easily it can be gamed.

According to the SEC's release, the proposal would cover “incentive-based compensation that is granted, earned or vested based wholly or in part on the attainment of any financial reporting measure.”

Georgiev noted that issuers can avoid the proposal's coverage in two ways:

• by moving away from incentive-based compensation to other kinds of pay, such as salary; or

• by tying incentive-based compensation to non-financial metrics, such as operational measures.


“The takeaway for me is that it will lead to strategic behavior on the part of companies” to circumvent the requirements, Georgiev said. If that happens, it will undermine the proposed rule's efficacy as well as other parts of Dodd-Frank, he added. “Ultimately, I'm not sure how effective” the clawback requirements will be, especially when seen against Dodd-Frank's goals to link pay to corporate performance and to make executives more accountable.


Meanwhile, the SEC proposal would cover FPIs as long as it doesn't violate the issuer's local laws.

Georgiev observed that there are about 960 foreign entities listed on U.S. exchanges that include some of the most well-known multinationals. The SEC's decision in the proposal to cover FPIs was unexpected, especially given their exemption from prior executive compensation rulemakings, including say-on-pay, employee hedging and pay-for-performance, he said.

One problem with including FPIs is that they report under international financial reporting standards while U.S. issuers use U.S. generally accepted accounting principles, Georgiev noted. The standards differ as to when companies must restate their financials.

Under IFRS, companies often can correct mistakes in their current financial statement without having to issue a restatement, Georgiev said. “That makes it tricky because you can have a situation where if a U.S. company and a foreign company have the same kind of mistake in their financial statements,” only the U.S. company has to restate its financials and thus be subject to the clawback requirements, he said. So potentially, the proposal would “introduce unequal treatment” for U.S. issuers and FPIs.

Ultimately, that could make a U.S. listing less attractive for foreign companies, Georgiev said. “If foreign companies are on the margins of trying to decide whether to retain their U.S. listing, this may be a factor against maintaining” that listing, he said, adding that those trying to decide whether to list in the U.S. may now find other jurisdictions more desirable.

What Should Companies Do Now?

In the meantime, the proposal will be subject to a 60-day comment period once published in the Federal Register. Given the other timelines in the proposal and assuming that the commission doesn't drag its heels on the rulemaking, it could be 2017 before the requirements take effect.

Nonetheless, some law firms suggested in client memoranda that companies should start taking stock of their existing and new compensation arrangements to consider whether amendments are in order.

In a July 2 memo, McGuireWoods LLP also suggested that companies review their:

• bylaw provisions;

• indemnification provisions;

• compensation committee charters; and

• consider clawback policy design changes.


To contact the reporter on this story: Yin Wilczek in Washington at

To contact the editor responsible for this story: Ryan Tuck at

The PwC report is available at

McGuireWoods's client memo is available at