SEC Proposes Compensation Clawback Rules

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By Holly J. Gregory Esq., John P. Kelsh Esq., Thomas J. Kim Esq., Corey Perry Esq., and Claire H. Holland Esq.

Sidley Austin LLP

On July 1, 2015, the Securities and Exchange Commission (SEC), by a 3-2 vote, proposed long-awaited rules1 mandated by Section 954 of the Dodd-Frank Act that would direct the national securities exchanges and associations to establish listing standards that would require any company to adopt, disclose and comply with a compensation clawback policy as a condition to listing securities on a national securities exchange or association. With the proposal of the clawback rules, the SEC has now proposed or adopted rules to implement all of the Dodd-Frank Act provisions relating to executive compensation.

The clawback policy would be required to provide that, in the event that the company is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, the company would recover from any of its current or former executive officers (not just named executive officers) who received incentive-based compensation during the preceding three-year period based on the erroneous data, any such compensation in excess of what would have been paid under the accounting restatement.  In addition to requiring that a company file its clawback policy as an exhibit to its annual report on Form 10-K or 20-F, as applicable, the proposed rules would require proxy statement disclosure of certain actions taken pursuant to the clawback policy.

Highlights of the Proposed Rules
Applicability All companies listed on a national securities exchange or association, including emerging growth companies, smaller reporting companies, foreign private issuers, controlled companies and companies with listed debt only
Executive Officers Covered Any current or former executive officer, including the president, principal financial officer, principal accounting officer (or, if none, the controller), any vice-president in charge of a principal business unit, division or function, and any other person who performs policy-making functions for the company
Recovery Trigger Accounting restatement required due to material noncompliance with any financial reporting requirement under the securities laws
Recovery Period Three-year period preceding the date on which the company is required to prepare the accounting restatement, meaning the earlier to occur of (i) the date the company's board, board committee or authorized officer concludes, or reasonably should have concluded, that previously issued financial statements contain a material error or (ii) the date a court or regulator directs the company to restate its financial statements to correct a material error
"No-Fault" Recovery Mandate Policy would apply even if an executive officer (or any other person) did not engage in misconduct and if the executive officer had no responsibility for the financial statement errors that required restatement
Compensation Subject to Recovery Any compensation that is granted, earned or vested based wholly or in part upon attainment of any financial reporting measure, including stock price and total shareholder return (TSR)
Recoverable Amount Incentive-based compensation received based on erroneous data in excess of what would have been paid without the restatement
Discretion Not to Pursue Recovery Recovery required except in two limited circumstances if the compensation committee (or majority of independent directors) determines that it would be impracticable: (i) if the direct costs of enforcing recovery would exceed the recoverable amount or (ii) if recovery would violate the home country laws applicable to a foreign private issuer
Failure to Comply A company would be subject to delisting if it does not adopt, disclose and enforce its clawback policy
No Indemnification or Insurance to Mitigate Losses A company would be prohibited from indemnifying executive officers against, or paying the premiums for an insurance policy to cover, losses incurred under the clawback policy
Required Disclosures
  • File a clawback policy as a Form 10-K or 20-F exhibit, as applicable
  • In the event of a restatement, disclose in a proxy or information statement certain actions taken under the clawback policy with respect to all individuals subject to the clawback, including any decision not to pursue recovery under the policy
  • Clawback disclosure would have to be provided in block-text tagged format and filed as an XBRL exhibit to the proxy or information statement
  • Amounts recovered pursuant to a clawback policy must be deducted from the applicable column and total column of the summary compensation table and identified in a footnote to the table

Current Clawback Policies

Many large public companies already maintain and publicly disclose compensation clawback policies. According to Equilar's 2013 Clawback Policy Report, the number of Fortune 100 companies that disclose clawback policies has increased dramatically from 18% in 2006 to 89% in 2013. Some companies adopted these policies after the Sarbanes-Oxley Act was enacted in 2002. Section 304 of the Sarbanes-Oxley Act gave the SEC the power to recoup from the CEO or CFO, for the company's benefit, compensation and profits realized from stock sales in the event of a financial restatement that resulted from misconduct (although not necessarily that of the CEO or CFO).

The prevalence of clawback policies continued to increase after the financial crisis and the adoption of the Dodd-Frank Act, particularly the clawback provision of Section 954. More recently, proxy advisory firms have publicly expressed their support for clawback policies and take them into account when making voting recommendations relating to executive compensation. In addition, ISS will consider whether a company has disclosed a clawback provision when assigning a Governance QuickScore to the company.

Currently, clawback policies vary widely by company and industry in terms of their scope and rigor. These policies commonly:

  • Require recovery of compensation from only a limited group of executive officers;
  • Require misconduct leading to the material accounting error to trigger recovery; and
  • Give the company broad discretion as to whether or not to seek recovery under the policy.

The proposed rules are more prescriptive and, if adopted as proposed, would require nearly all public listed companies to revise their existing clawback policies or adopt new policies responsive to the rules.

The proposed rules would supplement existing provisions relating to the clawback of erroneously awarded executive compensation, including Section 304 of the Sarbanes-Oxley Act. They would also supplement the disclosure under Item 402(b)(2)(viii) of Regulation S-K, which requires companies to disclose in the CD&A, if material, policies and decisions regarding adjustment or recovery of named executive officers' awards or payments if the relevant performance measures upon which they are based are restated or adjusted in a way that would reduce the size of an award or payment.

Proposed Compensation Clawback Rules

Section 954 of the Dodd-Frank Act added Section 10D to the Exchange Act requiring the SEC to adopt rules directing the national securities exchanges and associations to prohibit the listing of any security of a company that is not in compliance with Section 10D's requirements regarding the recovery of erroneously awarded incentive-based compensation and the disclosure of a company's clawback policy. The proposed rules would implement Section 10D by, among other things, adding a new Rule 10D-1 under the Exchange Act and amending Items 402, 404 and 601 of Regulation S-K.

Applicability

Proposed Rule 10D-1 would apply to all listed companies, including emerging growth companies, smaller reporting companies, foreign private issuers, controlled companies and issuers of listed debt whose stock is not also listed. The proposed rules would not apply to the listing of any security issued by a listed registered management investment company if the company has not awarded incentive-based compensation to any of its executive officers during the last three fiscal years.

Executive Officers Covered

Section 10D(b)(2) of the Dodd-Frank Act contemplates that the exchanges will adopt listing standards requiring companies to adopt and comply with policies that provide for recovery of excess incentive-based compensation from "any current or former executive officer of the issuer who received incentive-based compensation" during a specified period. The term "executive officer" is not defined in Section 10D.

Proposed Rule 10D-1 would include a definition of "executive officer" that is analogous to the definition of "officer" in Rule 16a-1(f) under the Exchange Act.  Specifically, the clawback rules would apply to a company's president, principal financial officer, principal accounting officer (or, if none, the controller), any vice-president in charge of a principal business unit, division or function (such as sales, administration or finance) and any other person who performs policy-making functions for the company. Unlike the definition of "executive officer" in Rule 3b-7 under the Exchange Act, the proposed definition would explicitly include a company's chief accounting officer.

The proposed rules would require recovery of excess incentive-based compensation received by any current or former executive officer of the company who served as an executive officer at any time during the performance period for the recovered incentive-based compensation.

Recovery Trigger

Section 10D(b)(2) contemplates that the exchanges will adopt listing standards requiring companies to adopt and comply with policies to recover excess incentive-based compensation "in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws."

The proposed rules define an "accounting restatement" as the result of a process of revising previously issued financial statements to correct one or more errors that are material to those financial statements. The SEC indicated that an error that is material to previously issued financial statements would constitute "material noncompliance" with financial reporting requirements under the securities laws, as contemplated by Section 10D. Accordingly, proposed Rule 10D-1 would provide that the obligation to prepare a restatement to correct an error that is material to previously issued financial statements would trigger application of the clawback policy.

The SEC did not explain what type or characteristic of an error would deem it material, but it did suggest that a series of immaterial error corrections, when viewed in the aggregate, could constitute a material error for purposes of the proposed rules. The SEC identified certain changes to financial statements that would not trigger application of the clawback policy because they do not represent error corrections under applicable accounting standards.  Such changes include retrospective applications of a change in accounting principle or a change in reporting entity and retrospective revisions for stock splits

Recovery Period

Section 10D(b)(2) contemplates that the exchanges will adopt listing standards requiring companies to adopt and comply with policies to recover excess incentive-based compensation received "during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement."

The proposed rules clarify that the three-year look-back period would be based on the three most recently completed fiscal years rather than the preceding 36-month period, recognizing that issuers typically make compensation decisions and awards on a fiscal year basis. The SEC provided the following example in the proposing release: If a calendar year issuer concludes in November 2018 that a restatement of previously issued financial statements is required and files the restated financial statements in January 2019, the clawback policy would apply to compensation received in 2015, 2016 and 2017.

Under the proposed rules, the date on which a company "is required to prepare an accounting restatement" is the earlier to occur of:

  • The date the company's board of directors, a board committee or authorized officer (if board action is not required) concludes, or reasonably should have concluded, that the company's previously issued financial statements contain a material error; or
  • 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.

A company's obligation to claw back excess incentive-based compensation is not dependent on if or when a company files restated financial statements or a Form 8-K disclosing non-reliance on previously issued financial statements. Nevertheless, the SEC indicated that the date in the first bullet above generally is expected to correspond with the occurrence of a triggering event under Item 4.02(a) of Form 8-K.

"No-Fault" Recovery Mandate

The proposed rules would require recovery of excess incentive-based compensation from an executive officer even if such officer (or any other person) did not engage in misconduct or have any role in preparing the company's financial statements that required restatement. The SEC explicitly stated in the proposing release that, consistent with the no-fault nature of Section 10D, it does not believe the extent to which an individual executive officer may be responsible for the financial statement errors requiring the restatement should be considered in seeking recovery.

Compensation Subject to Recovery

Section 10D(b)(2) contemplates that the exchanges will adopt listing standards requiring companies to adopt and comply with policies that apply to "incentive-based compensation (including stock options awarded as compensation)" that is received during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement, "based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement."

Incentive-based compensation would be subject to the clawback policy only if it is received while the company has a class of securities listed on a national securities exchange or association. Incentive-based compensation would be deemed "received" in the fiscal period during which the applicable financial reporting measure (as specified in the terms of the award) is attained, even if the payment or grant occurs after the end of that fiscal period.

As proposed, "incentive-based compensation" would be defined as "any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure." Financial reporting measures are those determined and presented in accordance with the accounting principles used in the company's financial statements, any measures derived wholly or in part from such financial information and stock price and TSR.  The measures need not be included in an SEC filing or presented within the company's financial statements (i.e., included in a company's MD&A).

The SEC provided several examples of financial reporting measures in the proposing release including, but not limited to, the following accounting-based measures: revenues; net income; operating income; profitability of a reporting segment; financial ratios; net assets or net asset value per share; EBITDA; funds from operations; liquidity measures; return measures; earnings measures; sales per square foot or same store sales; revenue per user; cost per employee; any of such financial reporting measures relative to a peer group; and tax basis income.

The SEC also provided guidance as to certain types of incentive-based compensation that would not be subject to recovery under a clawback policy, as summarized in the table below.

Compensation Subject to Recovery Compensation Not Subject to Recovery
A salary increase earned wholly or in part based on the attainment of a financial reporting measure Base salary
Non-equity incentive plan awards that are earned based wholly or in part on satisfying a financial reporting measure performance goal Non-equity incentive plan awards that are tied solely to strategic metrics (e.g., closing a merger) or operational metrics (e.g., increase in market share) that are not financial reporting measures
Bonuses paid from a "bonus pool," the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal Bonuses paid solely at the discretion of the compensation committee or board that are not paid from a "bonus pool," the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal
Restricted stock, RSUs, performance share units, stock options and SARs that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal Bonuses paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) and/or completion of a specified employment period
Proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based wholly or in part on satisfying a financial reporting measure performance goal Equity awards for which the grant is not contingent upon achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more non-financial reporting measures

If an award is subject to multiple conditions, the clawback policy would be triggered when the applicable financial reporting measure performance goal is attained, even if the executive officer only has a contingent right to payment at that time because subsequent performance conditions unrelated to a financial reporting measure remain unsatisfied.

Recoverable Amount

Section 10D(b)(2) contemplates that the exchanges will adopt listing standards requiring companies to recover the amount of incentive-based compensation received "in excess of what would have been paid to the executive officer under the accounting restatement." The proposed rules define the recoverable amount as "the amount of incentive-based compensation received by the executive officer or former executive officer that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement."

The SEC provided guidance as to how to calculate the recoverable amount for certain types of incentive-based compensation, as summarized in the table below.

Type of Compensation Recoverable Amount
Cash awards received upon satisfaction of a financial reporting measure Difference between the amount of the cash award (whether payable as a lump sum or over time) that was received and the amount that should have been received applying the restated financial reporting measure
Cash awards paid from "bonus pools"

The size of the aggregate bonus pool from which individual bonuses are paid would be reduced based on applying the restated financial reporting measure

  • If the restatement resulted in a "pool" that was smaller than originally established, but still larger than the amount of bonuses actually paid, then no clawback would be required
  • If the reduced bonus pool is less than the aggregate amount of individual bonuses received from it, the excess amount of an individual bonus would be the pro rata portion of any deficiency
  • The board would not be permitted to pursue differential recovery among executive officers, including in "pool plans"  
Shares, options or SARs still held at the time of recovery The number of shares, options or SARs received in excess of the number that should have been received applying the restated financial reporting measure
Options or SARs have been exercised but underlying shares have not been sold The number of shares underlying the excess options or SARs applying the restated financial reporting measure
Options or SARs have been exercised and underlying shares have been sold

The sale proceeds received by the executive officer with respect to the excess number of shares 

  • If an exercise price was paid to obtain the shares, the recoverable amount would be reduced to reflect the applicable exercise price paid If excess shares have been gifted, the recoverable amount would be the gifted shares' fair market value at the date of the gift

Under the proposed rules, a company would calculate the amount of erroneously awarded compensation without regard to any taxes paid by the executive officer. The SEC indicated in the proposing release that, in circumstances in which both proposed Rule 10D-1 and Section 304 of the Sarbanes-Oxley Act could provide for recovery of the same incentive-based compensation, if an executive officer reimburses a company pursuant to Section 304, the amount recoverable under the company's Rule 10D-1 clawback policy should be deducted by the amount of the reimbursement.

For incentive-based compensation based on stock price or TSR, where it is not possible to calculate the recoverable amount directly from the information in an accounting restatement, the proposed rules would permit companies to use reasonable estimates when determining the impact of a material restatement on stock price and TSR. In such case, the company would be required to (i) disclose the estimates in its proxy statement, (ii) maintain documentation of the determination of the estimates, and (iii) provide such documentation to the relevant exchange.

Discretion Not to Pursue Recovery

The proposed rules would give boards of directors the discretion to forgo recovery of excess incentive-based compensation as impracticable in either of two limited circumstances:

  • If the aggregate direct costs of enforcing recovery under the clawback policy would exceed the recoverable amount; or
  • If recovery would violate a foreign private issuer's home country's laws, but only if such laws were adopted prior to the date of publication of proposed Rule 10D-1 in the Federal Register.

A company would have to meet several conditions in order to qualify for either of these exceptions. First, any determination that recovery would be impracticable would need to be made by the company's compensation committee or, if none, a majority of the independent directors on the board, and would be subject to review by the relevant exchange.

Before concluding that it would be impracticable to pursue recovery based on enforcement costs, the company would first need to make a reasonable attempt to recover the excess incentive-based compensation and incur the related costs. For purposes of the proposed rules, only direct financial expenditures to third parties, such as reasonable legal expenses, would be considered. Indirect costs, such as opportunity costs or reputational costs, would not be taken into account. The company would be required to document its recovery efforts and provide that documentation to the relevant exchange.

Before concluding that it would be impracticable to pursue recovery based on a violation of home country law, the company would first need to obtain a legal opinion from home country counsel, not unacceptable to the relevant exchange, that recovery would result in a violation, and provide the opinion to the exchange.

Finally, a company that determines to forgo recovery under either exception would be required to provide proxy statement disclosure regarding that determination under new Item 402(w) of Regulation S-K.

Failure to Comply

Under the proposed rules, a company would be subject to delisting if it does not adopt, disclose and enforce its clawback policy. As proposed, a securities exchange or association may not list the securities of a company that it has delisted or that has been delisted from another exchange or association for failing to comply with its clawback policy until it comes into compliance with the policy.

The proposed rules permit companies to exercise discretion in the manner in which they seek and enforce recovery.  The securities exchanges would be tasked with monitoring compliance with the clawback policy, including assessing, among other things, whether the company has made a good faith effort to promptly pursue recovery.

No Indemnification or Insurance to Mitigate Losses

The proposed rules would expressly prohibit a company from indemnifying its executive officers against the loss of erroneously awarded compensation. Furthermore, under the proposed rules, a company would not be permitted to pay or reimburse its executive officers for insurance premiums to cover losses incurred under the company's clawback policy. The SEC stated its belief that such arrangements would fundamentally undermine the purpose and no-fault nature of Section 10D.

Proposed Clawback Disclosure Requirements

The proposed rules would amend Item 601(b) of Regulation S-K to require a company to file its written clawback policy as an exhibit to its annual report on Form 10-K or, in the case of a foreign private issuer, its Form 20-F.

Under a proposed new paragraph (w) of Item 402 of Regulation S-K, if, at any time during the company's last completed fiscal year (i) either a restatement was completed that required recovery of excess incentive-based compensation under the company's clawback policy, or (ii) there was an outstanding balance of excess incentive-based compensation from the application of the clawback policy to a prior restatement, a company would be required to disclose the following information:

For each restatement:

  • The date on which the company was required to prepare the accounting restatement;
  • The aggregate dollar amount of excess incentive-based compensation for all executive officers (not just named executive officers) attributable to the restatement;
  • The estimates used to determine such amount, if the financial reporting measure related to stock price or TSR; and
  • The aggregate dollar amount of excess incentive-based compensation that remains outstanding as of the end of the last completed fiscal year;
  • The name of each person subject to recovery from whom the company determined not to pursue recovery during the last completed fiscal year, the amount forgone and a brief description of the reason the company determined not to pursue recovery; and
  • The name of each person from whom, as of the end of the company's last completed fiscal year, excess incentive-based compensation had been outstanding for 180 or more days since the date the company determined the amount owed by the person, and the amount due from each such person.

Proposed Instruction 4 to Item 402(w) would provide that, if the aggregate dollar amount of excess incentive-based compensation has not yet been determined, the company would be required to disclose this fact and explain the reasons.

The proposed disclosure would be included with the company's other Item 402 disclosure in annual reports on Form 10-K and any proxy and information statements that require executive compensation disclosure pursuant to Item 402 of Regulation S-K. A company could choose to include the clawback disclosure required by proposed Item 402(w) along with the discussion of clawback policies and decisions in its CD&A pursuant to Item 402(b)(2)(viii).

Under the proposed rules, companies would be required to provide the clawback disclosure in block-text tagged format using XBRL to increase the information's comparability and usefulness to investors. The tagged data would have to be filed as an XBRL exhibit to the proxy or information statement in which the same disclosure is included. This approach is consistent with the SEC's pay versus performance disclosure rules proposed in April 2015, which marked the first time that the SEC required data tagging of proxy statement disclosure.

The proposed rules would add an instruction to Items 402(c) and (n) of Regulation S-K that would require that any amounts recovered from an executive officer pursuant to a company's clawback policy (i) reduce the amount reported in the applicable column and the total column of the summary compensation table for the fiscal year in which the amount recovered initially was reported as compensation, and (ii) be identified by footnote.

Finally, the proposed rules would add an instruction to Item 404 of Regulation S-K that would provide that the recovery of erroneously awarded compensation from an executive officer under the company's clawback policy need not be disclosed as a related person transaction under Item 404(a) if it is disclosed pursuant to proposed Item 402(w).

Process and Timeline

The SEC will seek comment on the proposed rules for 60 days following their publication in the Federal Register. The proposing release identifies several topics on which the SEC is specifically requesting comments from the public, including (i) whether certain categories of issuers should be exempted from the proposed rules, (ii) the scope of the definitions used in the proposed rules, including "executive officer" and "incentive-based compensation," and (iii) the circumstances under which a board of directors may determine not to pursue recovery under a company's clawback policy.

The SEC proposed that each securities exchange file with the SEC proposed listing standards that comply with the SEC's clawback rules within 90 days of the publication of the final version of Rule 10D-1 in the Federal Register, and that the listing standards be approved by the SEC and become effective no later than one year after that publication date.

Once an exchange's listing standards take effect, a company listed on that exchange would have 60 days to adopt a compliant clawback policy. The proposed rules would require each company to comply with the clawback policy to recover all erroneously awarded compensation received by executive officers on or after the effective date of Rule 10D-1 as a result of the attainment of a financial reporting measure based on or derived from financial information for any fiscal period ending on or after the effective date of Rule 10D-1. Each company would be required to comply with the clawback disclosure requirements in applicable SEC filings made on or after the effective date of the relevant listing standards.

Practical Implications

We do not know whether the proposed rules will be adopted and, if so, when the corresponding listing standards will be proposed and become effective. It is also uncertain what the terms of the listing standards will be and whether there will be meaningful differences in the standards adopted by the major securities exchanges.  In the meantime, companies would be well-advised to consult with counsel regarding compliance with the proposed rules and take the following actions:

  • Discuss the proposed rules and their implications with their compensation committees.
  • Review current clawback policies for consistency with the proposed rules and analyze what revisions would be necessary.
  • Identify the group of executive officers whose compensation would be subject to recovery under the company's clawback policy and communicate with them as to the status of the SEC's rule-making and the potential impact of such rules on such executive officers and their compensation (past and future).
  • Review existing compensation plans and employment agreements with executive officers and consider whether amendments to such arrangements would be required in order for the clawback policy to apply.
  • Consider whether to make adjustments to compensation mix and/or performance metrics and discuss such matters with compensation consultants and shareholders, as appropriate.
  • Review disclosure controls and procedures to identify whether any adjustments may be advisable.
  • Consider submitting or contributing to a comment letter on the proposed rules to the SEC.
  • Follow rule-making by the SEC and national securities exchanges in this area closely.

Sidley Austin provides this information as a service to clients and other friends for educational purposes only.  It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Furthermore, this update was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any U.S. federal, state or local tax penalties that may be imposed on such person.

For more information, in the Tax Management Portfolios, see Maldonado and Daley, 362 T.M., Securities Law Aspects of Employee Benefit Plans.

© 2015 Sidley Austin LLP.


  1 The SEC's proposing release is available here.