As described in more detail below, the NYSE and Nasdaq listing standards and SEC Rule 10D-1 under the Securities Exchange Act of 1934, as amended (Exchange Act) will apply to nearly all companies with listed securities, including smaller reporting companies, emerging growth companies and foreign private issuers. This alert highlights the general requirements of the stock exchange listing standards and the actions that listed companies should be taking now to prepare for the adoption and implementation of a clawback policy that complies with applicable stock exchange listing standards by December 1, 2023. More detailed discussion of Rule 10D-1 and the stock exchange listing standards is available in two Goodwin alerts, SEC Adopts Final Rules Requiring Disclosure and Recovery of Erroneously Awarded Incentive-Based Compensation and Mandatory Executive Compensation Clawback Policies: The Time Is . . . Soon.
What Companies Should be Doing Now
- With the final compliance date now known, listed companies should finalize a plan for adoption of a clawback policy that satisfies the applicable stock exchange listing standards by December 1, 2023. Dealing with existing incentive compensation plans and awards, as well as existing employment-related arrangements affected by the clawback policy, may require significant attention.
- Review the company’s existing timeline, or establish a timeline now, to appropriately manage the process of adopting a clawback policy that will comply with the stock exchange rules by December 1, 2023, including internal and external review and board communications and final board approval
- If the company has an existing clawback policy, determine whether to adopt a stand-alone clawback policy that complies with the stock exchange rules and a stand-alone clawback policy that is broader than the stock exchange rules, or to integrate the two policies
- Review the company’s existing incentive compensation plans, policies, programs and practices and existing employment and compensation-related agreements and arrangements to determine (i) what actions may be appropriate to ensure that the company can properly enforce the clawback policy required by stock exchange listing standards and (ii) whether it would be advantageous to revise or restructure incentive compensation programs that use financial performance measures (including stock price and total shareholder return) for future periods
- Review the company’s existing indemnification arrangements, including those contained in the company’s organizational documents, stand-alone agreements or in employment- or compensation-related agreements, to determine whether any changes are required to comply with the prohibitions on indemnification under the stock exchange rules
- Review the company’s internal control over financial reporting and disclosure controls and procedures to assure that (i) triggering events under the clawback policy can be identified in a timely manner, (ii) internal and external resources can be promptly engaged to analyze the situation and its financial and compliance impacts, including making determinations about which current or former executive officers may be affected, the amount of any required clawback, and how the company will recover any amounts subject to clawback, and (iii) relevant internal and external parties can be promptly informed that a triggering event has occurred and that they will receive all information necessary to comply with SEC and stock exchange disclosure requirements, including the disclosures required in the company’s public filings
- Domestic listed companies may wish to review their determinations of which employees are designated as “officers” under Section 16 of the Exchange Act to avoid unnecessarily subjecting officers to the new clawback policy. Foreign private issuers, which are not subject to Section 16, should determine, likely for the first time, which officers will be “executive officers” for purposes of the new clawback policy
Consider Training Sessions and Tabletop Exercises
Companies should consider how they will plan for potential application of the clawback policy. This process may be technically complex, and Rule 10D-1 and the stock exchange listing rules provide limited time periods for companies to make the various necessary determinations and disclosures. The consequences of missed deadlines and noncompliance with the company’s clawback policy and stock exchange and SEC rules can result in a variety of serious consequences, such as loss of Form S-3 eligibility and potential delisting.
Companies may also want to consider whether it would be beneficial to conduct training sessions to familiarize company personnel, and potentially the company’s independent auditor, external legal counsel and compensation consultant, with the requirements of the company’s clawback policy and stock exchange and SEC rules as well as the various existing compensation arrangements that may be impacted by the clawback policy. The following may be helpful for companies:
- Develop a written playbook that (i) describes the conditions or events that would trigger the company’s clawback policy, (ii) identifies the relevant parts of the clawback policy, SEC rules, compensation arrangements and any other applicable materials, (iii) describes in sequential order the actions necessary if the company’s clawback policy is triggered, and (iv) identifies and assigns responsibility to appropriate internal or external persons or functions. The playbook should be updated as necessary to reflect any changes, such as a new compensation plan or changes in the company’s organizational structure or roles, that would affect the playbook
- Consider internal training sessions and/or tabletop exercises that will familiarize company personnel, and possibly the company’s independent auditor, external legal counsel and compensation consultant, with the clawback playbook and the company’s clawback policy, and the company’s relevant compensation arrangements. Tabletop exercises may be particularly useful because they may identify improvements in the company’s internal control over financial reporting and its disclosure controls and procedures
Summary of Stock Exchange Clawback Policy and SEC Disclosure Requirements
The summary below highlights the most significant elements of the stock exchange listing standards on incentive compensation clawbacks and SEC disclosure requirements. The alerts cited earlier include more detailed discussions.
Companies Subject to the Stock Exchange Listing Standards and SEC Rules. The clawback listing standards and disclosure rules apply to nearly all listed companies, including smaller reporting companies, emerging growth companies, foreign private issuers and controlled companies, with very limited exceptions. The listing standards also apply to private companies that have listed debt or preferred securities and, with limited exceptions, to investment companies with exchange-listed securities. There are no deferred compliance provisions for smaller reporting companies or emerging growth companies.
Executive Officers Covered. The stock exchange listing standards and final SEC rules apply to “executive officers,” which is defined as a company’s president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice-president in charge of a principal business unit or function (e.g., sales, administration or finance), any other officer of the company who performs a policy-making function, and any other person who performs similar policy-making functions for the company. For domestic issuers, this definition is consistent with the definition of “officer” in Rule 16a-1(f) of the Exchange Act, often referred to as “Section 16 officers.” There is no requirement that an executive officer had a direct role in financial reporting. The listing standards do not require recovery of incentive-based compensation received by a person before the individual became an executive officer.
Indemnification and Reimbursement Prohibited. Companies may not indemnify any executive officer or former executive officer against loss of erroneously-awarded compensation under the company’s clawback policy. The SEC stated In the adopting release that it views this requirement as also prohibiting companies from paying for or reimbursing a current or former executive officer for the cost of any third-party insurance policy intended to fund potential recovery obligations or modifying current compensation arrangements or taking other actions that would amount to de facto indemnification, such as by providing an executive officer a new cash award which the issuer would then “cancel” to effect recovery of outstanding recoverable amounts.
Fiscal Years Covered; When Compensation is “Received.” The stock exchange listing standards require listed companies’ clawback policies to apply to compensation received on or after October 2, 2023. Compensation will be deemed “received” for purposes of the recovery policy in the fiscal period during which the applicable financial reporting measure is attained, even if the payment or grant occurs after the end of that period. For instance, an equity award that is earned based on the company’s total shareholder return for the three-year period ending December 31, 2024, would be deemed received in 2024 even though the shares are not issued until early 2025, and even if the shares are subject to additional time-based vesting. As a result, the shares would be subject to potential clawback if the company was required to prepare an accounting restatement in 2025, 2026 or 2027.
Compensation Covered by Clawback Policies. The stock exchange listing standards provide that clawback policies must require the recovery of erroneously awarded “incentive-based compensation,” which means any compensation that is granted, earned or vested based wholly or in part on the attainment of any “financial reporting measure.” “Financial reporting measure” is defined as a measure that is determined and presented in accordance with the accounting principles used in preparing the company’s financial statements, and measures derived from such measures, including stock price and total shareholder return. Financial reporting measures may include non-GAAP financial measures.
The adopting release includes a non-exhaustive list of examples that include, among many others, measures such as accounts receivable turnover and other ratios, sales per square foot or same store sales (if sales is subject to an accounting restatement), revenue per user (if revenue is subject to an accounting restatement), cost per employee (if cost is subject to an accounting restatement), and any financial reporting measures relative to a peer group (if the company’s financial reporting measure is subject to an accounting restatement). The definition of financial reporting measure does not require that a measure be presented in the company’s financial statements or included in an SEC filing.
Amounts Subject To Recovery. Clawback policies must require recovery of the amount of incentive-based compensation received that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the restated financial statements, without adjustment for any taxes paid on the compensation. To the extent that the amount of erroneously awarded compensation is based on the company’s stock price or total shareholder return where the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement, the amount of erroneously awarded compensation must be calculated based on a reasonable estimate of the effect of the restatement on the stock price or total shareholder return upon which the compensation was received.
Exceptions To The Recovery Requirement. The stock exchange listing standards require companies to recover erroneously awarded compensation in compliance with their recovery policy, except in the following limited circumstances:
- The direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered
- For companies incorporated outside the U.S., recovery would violate a home country law adopted prior to November 28, 2022, and the company provides an acceptable opinion of home country counsel to the stock exchange
- Recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code
In addition, the compensation committee of the company’s board of directors (or a majority of independent directors, in the absence of a compensation committee) must make the determination that recovery would be impracticable.
Disclosure Requirements. The stock exchange listing standards require listed companies to file all disclosures related to a company’s clawback policy as required by SEC rules.
Listed companies are required to file their clawback policy as an exhibit to a company’s Form 10-K or Form 20-F annual report.
There are new check boxes on the cover page of Form 10-K and Form 20-F to indicate (i) whether the company’s financial statements included in the annual report reflect correction of an error to previously issued financial statements and (ii) whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation pursuant to Rule 10D-1(b).
If, during the prior fiscal year, there was a restatement that triggered a company’s clawback policy or there are unrecovered amounts of incentive compensation that are subject to the company’s clawback policy, Item 402(w) of Regulation S-K requires the company to provide disclosures about its financial restatement(s), its clawback policy and how it has applied the policy. The disclosure required by Item 402(w), will be required in the company’s annual report and in its proxy or information statements that call for Item 402 disclosure, and will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 unless the company specifically incorporates it by reference. Form 20-F provides essentially identical disclosure requirements for foreign private issuers. Companies must tag disclosures that relate to clawback policies in compliance with the SEC’s Inline XBRL requirements.
SOX Clawback Requirements. The clawback requirements of the Sarbanes-Oxley Act of 2002 (SOX), which require a company’s chief executive officer and chief financial officer to reimburse the company for any incentive or equity-based compensation and any profits from selling securities received during the year after the company issued inaccurate financial statements if the company is required to prepare an accounting restatement as a result of “misconduct,” continue to apply. To the extent that the clawback policy required by the stock exchange listing standards and the SOX clawback provisions apply to the same compensation, any amounts recovered by the company under the SOX clawback provision will be credited to the recovery required by the clawback policy required by the stock exchange listing standards.