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The SEC’s New Compensation “Clawback” Rules: What Directors and Officers Should Know

March 29, 2023

/Management Liability/D&O

Dodd-Frank clawback rules—threatened for years—are getting closer. In this week’s post, my colleague provides a briefing on what directors and officers need to know now as well as what steps they should take to get ready. –Priya Huskins

The US Securities and Exchange Commission (SEC) adopted new rules in October 2022 that implement the compensation recovery (“clawback”) provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). While most can get behind the primary purpose of the new rules—to prevent executive officers from keeping compensation received based on misstated financials—some have taken issue with the SEC’s prescriptive approach.

Businessperson opening envelope with paycheck

A Brief History of the SEC’s Clawback Rules

The Dodd-Frank Act, among other things, mandated that the SEC adopt rules directing the securities exchanges (e.g., the New York Stock Exchange and NASDAQ) to require listed companies to “develop and implement a policy” providing for (i) how they approach incentive-based compensation based on reported financial information; and (ii) the recovery of such incentive-based compensation from any current or former executive officer, to the extent that such compensation was based on reported financial information that has to be restated.

Almost five years passed before the SEC issued proposed clawback rules, which were met with criticism. Because the proposed rules focus on clawback incentive compensation, some speculated that the proposed rules could actually result in driving up base salaries and making it so executives become less aligned with shareholders. The proposed rules effectively lay dormant until June of last year, when the SEC reopened the proposed rules for comment. The SEC ultimately adopted the final rules a few months later.

Key Provisions of the SEC’s Final Compensation Clawback Rules

 What follows is high-level summary of key provisions of the final SEC compensation clawback rules (the new rules) that directors and officers of public companies should know. For a comprehensive discussion of the new rules, see this article from Sullivan & Cromwell.

Affected Companies

While there are some limited exceptions, nearly all listed companies will need to comply with the new rules.

Compensation Recovery Policy

Affected companies will need to adopt and comply with a written policy providing that, in the event it is required to prepare a “Big R” restatement or a “little r” restatement (explained below), the company will recover compensation from its current and former executive officers. It may recover the amount of erroneously awarded incentive-based compensation received during the three completed fiscal years immediately preceding the date the restatement is required.

Triggering Events: “Big R” Restatements and “Little r” Restatements

A “Big R” restatement occurs when a company must prepare an accounting restatement to correct errors in previously filed financial statements that are material to those financial statements. This also requires the filing of a Form 8-K to restate those financial statements. Compare this to a “little r” restatement where the error is immaterial to the previously issued financial statements, but relevant to the current period financial statements. In those cases, the company must still correct the error, but the company may do so in the period the error was identified, thus avoiding the larger production of a “Big R” restatement.

While both restatements are methods of correcting errors, in practice, including “little r” restatements unnecessarily complicate the new rules. Specifically, since “little r” restatements are generally reserved for the correction of immaterial errors, the clawback requirement may be triggered when the error did not lead to erroneous compensation, or it may require a clawback of a de minimis amount.

Why did the SEC include “little r” restatements in the rule? The SEC has been concerned about what it views as opportunistic behavior by some companies when choosing between a “Big R” and “little r” restatement. Broadening the scope of restatements subject to a clawback analysis may be a roundabout way for the SEC to address its concerns.

Covered Executive Officers

The scope of individuals potentially subject to the new rules is broad. “Executive officers” include the company’s:

  • Current or former 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 (such as sales, administration, or finance)
  • Any other officer who performs a policy-making function
  • Any other person who performs similar policy-making functions for the issuer, regardless of involvement with the events leading to the restatement.

“Executive officers” may also include officers of the company’s parent(s) or subsidiaries if they perform similar policy-making functions for the company. 

No Fault

Compensation clawback will be on a “no-fault” basis. That is, there will be no regard to any misconduct or responsibility on the part of the executive officer for the misstated financial statements.

Compensation Subject to Clawback

Incentive-based compensation includes any compensation that is granted, earned, or vested, based wholly or in part upon the attainment of any financial reporting measure. Potentially subject to clawback would be the company’s current or former executive officers’ incentive-based compensation (including stock options awarded as compensation) received during the three completed fiscal years preceding the date a restatement is required, based on erroneous data, in excess of what the executive officer would have been entitled to absent the reporting error. The SEC’s final rules include the following illustrative example:

“…assume a situation in which, based on the financial reporting measure as originally reported, the amount of the award was $3,000. However, the issuer exercised negative discretion to pay out only $2,000. Following the restatement, the amount of the award based on the corrected financial reporting measure is $1,800. Taking into account the issuer’s exercise of negative discretion, the amount of recoverable erroneously awarded compensation would be $200 (i.e., $2,000 – $1,800).”

Examples of compensation generally not subject to clawback are:

  • Salaries
  • Discretionary bonuses
  • Bonuses paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) or completion of a specified employment period
  • Non-equity incentive plan awards earned upon satisfying strategic measures (e.g., completing a merger or divestiture) or operational measures (e.g., increase in market share)
  • Equity awards where the grant is not contingent on achieving a financial reporting measure and vesting is contingent solely on completing a specified employment period and/or attaining nonfinancial reporting measures.

Limited Discretion to Not Claw Back Compensation

Companies will be required to recover erroneously awarded incentive compensation, unless (i) doing so would be impracticable—such as the direct cost of recovery exceeding the amount of recovery, and the company has made a reasonable attempt to claw back; (ii) the recovery would violate home country laws that existed at the time the rules are effective, and the company provides a legal opinion to that effect to the securities exchange; or (iii) the clawback would likely cause an otherwise tax-qualified retirement plan (e.g., 401(k) plan) to fail to meet the requirements of the Internal Revenue Code.

Further, companies will be required to recover erroneously awarded incentive compensation “reasonably promptly.” The SEC didn’t adopt a definition of “reasonably promptly” but expects companies and “their directors and officers, in the exercise of their fiduciary duty to safeguard the assets of the issuer (including the time value of any potentially recoverable compensation), will pursue the most appropriate balance of cost and speed in determining the appropriate means to seek recovery.” Boards will have discretion as to the means of recovery (e.g., setting up a deferred payment plan for executive officers to repay owed erroneous compensation).

Insurance and Indemnification Prohibited

Companies are prohibited from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.

In the SEC’s discussion of the final rules, it contemplates that although “an executive officer may be able to purchase a third-party insurance policy to fund potential recovery obligations, the indemnification provision prohibits an issuer from paying or reimbursing the executive officer for premiums for such an insurance policy.” (Note: At this time, carriers are not lining up to sell insurance policies of the type the SEC creatively contemplated.)

Also prohibited would be any such indemnification or reimbursement through modification to current compensation arrangements or other means that would equate to indemnification (e.g., granting the executive officer a new cash award, which the company could then look to for purposes of recovering outstanding amounts subject to a clawback).

No Grandfathering

Incentive-based compensation awarded to executive officers prior to the effective date of the listing rules of their securities exchange is subject to potential clawback if it’s received after the effective date.

Disclosure Obligations

Companies will be required to disclose their clawback policies as an exhibit in their annual report on Form 10-K, or Form 20-F for foreign private issuers. Companies will also need to disclose, among other things, how they have applied the policy, including, as applicable:

  • The date it was required to prepare a restatement and the aggregate dollar amount of erroneously awarded compensation attributable to that restatement
  • The aggregate amount that remains outstanding and any outstanding amounts due from any current or former named executive officer for 180 days or more
  • Details regarding any reliance on the impracticability exceptions.

Failure to Comply

Affected companies that fail to comply with the new rules as adopted in the listing rules of their securities exchange will be subject to delisting.

Key Compliance Dates

The rules and amendments became effective on January 27, 2023, which started the clock for the securities exchanges to file proposed listing standards with the SEC. The New York Stock Exchange and NASDAQ filed their proposed listing standards with the SEC on February 23, 2023, and February 22, 2023, respectively. November 28, 2023, is the latest date the listing standards must become effective. Companies will have to adopt a compliant clawback policy within 60 days of that date. While it is conceivable that applicable listing standards become effective in January 2024, companies would be wise to anticipate an earlier deadline and prepare accordingly.

Considerations for Directors and Officers

Directors and officers should consider the following when it comes to clawbacks:

  • Ensure Key Stakeholders Appreciate the Potential Implications of the New Rules. Many are aware of the recovery provision of the Sarbanes Oxley Act of 2002 (SOX) applicable to CEOs and CFOs. That provision is triggered when a restatement is the result of “misconduct.” The new rules have a broader application and do not require “misconduct.” This, along with the requirement that companies pursue clawback efforts “reasonably promptly,” is expected to translate to companies having to quickly perform restatement analyses and determine any amounts that may need to be recovered from executive officers. Preparing for such an event will require a concerted effort by the board, management, Finance/Accounting, Legal, and Human Resources/Compensation, among others. 
  • Review Executive Officer Determinations. As noted above, “executive officers” for purposes of the new rules is broadly defined and, in some cases, even includes executive officers of subsidiaries. As a result, executive officer determinations by companies under the new rules will carry more weight. Companies should revisit their process for determining executive officer status through the lens of the new rules.

  • Review Your Existing Clawback Policy. Companies should review their existing clawback policies to identify what changes may be required to comply with the new rules. This review will need to be performed again once the respective stock exchanges have implemented final listing standards. It may be advisable for companies to wait for the latter before amending their existing clawback policies.

    For companies that do not have a clawback policy, consider adopting a clawback policy that makes an effort to meet the standards of the new rules. Rationale is a function of good corporate governance, which was an area of focus in a recent Department of Justice (DOJ) memo on corporate criminal enforcement that emphasizes the role clawback policies can play when it comes to deterring misbehavior.

  • Review Organizational Documents, Employment Agreements, and Insurance. Clawback and/or indemnification language may already live within your organizational documents (i.e., articles of incorporation and bylaws), executive employment agreements (e.g., indemnification agreements), and insurance programs. Perform an analysis of these documents to develop a process to comply with new rules—and ultimately the final securities exchange listing standards. As a reminder, the new rules prohibit companies from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.

  • Review Compensation Programs. Perform an analysis of existing incentive-based compensation programs with an eye on the new rules. For new incentive-based awards, consider whether to include a provision specifically referencing the new rules and indicating that the awards are subject to the new rules as ultimately adopted by the company. Adding “as may be amended from time to time,” is a qualifier that you may want to include. Also worthy of discussion are any changes to the executive officer compensation mix.

  • Review Related Disclosures. Public company disclosures related to clawback policies will need to be bolstered or newly drafted as a function of the new rules. As companies work to finalize a compliant clawback policy, consider what the narrative discussion regarding the policy will look like, as well as to the policy being a publicly filed document.

Parting Thoughts

Clawing back of executive compensation is generally a rare occurrence outside of those examples that make headlines. Cooley covered one such example in an article in early 2022. That case involved a company issuing a “Big R” restatement and had some interesting facts, which makes it a worthy read. The new rules change the game in that “little r” restatements would trigger a clawback analysis and likely the clawback of executive compensation.

These new rules will undoubtedly add more complexity to the structuring of executive officer compensation, analysis of financial reporting errors, and the board’s and/or compensation committee’s oversight role. Planning with the above considerations in mind should help avoid headaches down the road.

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All views expressed in this article are the author’s own and do not necessarily represent the position of Woodruff-Sawyer & Co. The information in this article is for general informational purposes only; it is not intended to and does not constitute legal advice.

Lenin Lopez, Esq.

Senior Vice President, Corporate Securities Attorney

Lenin helps clients understand their directors & officers liability and how to take action to mitigate their risk.

415.402.6545

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Lenin Lopez, Esq.

Senior Vice President, Corporate Securities Attorney

Lenin helps clients understand their directors & officers liability and how to take action to mitigate their risk.

415.402.6545

LinkedIn