On October 26, 2022, the U.S. Securities and Exchange Commission (“SEC”) adopted regulations (the “final rules”) implementing Section 10D of the Securities Exchange Act of 1934 (“Exchange Act”), which was added by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The SEC originally proposed these rules in 2015, and reopened the comment period in October 2021 and again in June 2022. New Exchange Act Rule 10D-1 will require U.S. national stock exchanges, including the NYSE and Nasdaq, to propose and adopt new listing standards that will require listed companies to adopt and comply with policies that provide for the recovery of incentive-based compensation received by current or former executive officers based on any misstated financial reporting measure if the company is required to prepare an accounting restatement. This so-called compensation recovery or “clawback” policy must provide for recovery of the amount of pre-tax incentive-based compensation received during the three-year period preceding the date the company is required to prepare the accounting restatement that exceeds the amount that would have been received based on the restated financial reporting measure, subject to very limited exceptions for instances in which recovery would be impracticable. For incentive-based compensation based on stock price or total shareholder return, which must be covered by the clawback policy, the amount of compensation to be recovered must be based on a reasonable estimate of the effect of the accounting restatement on the stock price or total shareholder return upon which the incentive-based compensation was received. Listed companies that do not adopt and comply with these new listing standards will be subject to delisting.
New Exchange Act Rule 10D-1 also will require a listed company that has been required to prepare an accounting restatement to disclose (1) the date on which the company was required to prepare the restatement and the aggregate amount of erroneously awarded compensation attributable to the restatement, (2) the aggregate amount of compensation that remains outstanding, if any, and any amounts outstanding from current or former named executive officers and (3) the details of any reliance on any of the impracticability exceptions. The final rules will also require companies to file their policies as exhibits to their annual report and to tag any compensation recovery disclosure using Inline XBRL.
The final rules will apply to nearly all operating companies that have securities listed on a securities exchange, with limited exceptions. Securities exchanges are required to propose listing standards within 90 days of publication of the final rules in the Federal Register, and such listing standards must be effective no later than one year after the publication of the listing standards in the Federal Register. Companies subject to these listing standards must adopt a recovery policy no later than 60 days after exchange listing standards are effective. Companies would not be required to comply with the new disclosure requirements in Item 402 in Regulation S-K until after they are required to have a policy under the applicable exchange listing standard.
What Companies Can Be Doing Now
Although companies will not be required to take final action to comply with the listing standards and disclosure rules required by the final rules until the exchanges have adopted listing standards, the final rules provide a substantial basis for companies to begin taking action in anticipation of the final rules. These actions could include some or all of those discussed below.
Review the Existing Clawback Policy or Begin Considering a New Clawback Policy. Companies that will be subject to the listing standards required by the final rules can review their existing clawback policy or, if the company does not already have a clawback policy, begin to consider the terms of a new clawback policy that would comply with the minimum listing standards to be required by the final rules. The clawback policy must provide that the company will recover the amount of erroneously-awarded incentive-based compensation in the event the company is required to prepare an accounting restatement of the type covered by the final rules.
Current policies may include terms that differ from the required listing standards and companies may need to update their existing policies to the extent they include the following terms, among others:
- Discretion in determining whether to recover erroneously-awarded compensation
- More limited circumstances that would trigger compensation recovery, especially the nature of any financial statement restatements that would trigger compensation recovery or a requirement of misconduct on the part of the executive from whom recovery is sought
- More limited group of company executives who are subject to compensation recovery
- Requirements that executives who are subject to compensation recovery participated in preparation of the company’s financial statements
- Timing requirements, such as those related to the date on which a person became an executive officer, the length of the look-back period covered by the policy, the time period covered by a restatement and when an executive officer received incentive compensation, that are different than those required by the final rules
- More limited types of incentive-based compensation subject to recovery
Review Existing Employment Agreements and Incentive Compensation Plans. Companies can review existing employment agreements with persons who will be “executive officers” under the final rules to determine how these employment agreements will interact with the listing standards required by the final rules. Companies can also review existing plans and plan documents under which incentive-based compensation may be paid to executive officers. Similarly, companies can consider compliance with the listing standards required by the final rules when drafting new employment agreements and incentive compensation plan documents.
Evaluate Existing Incentive Compensation Arrangements under the Final Rules. Even in cases where an incentive-based compensation arrangement would satisfy the requirements of the final rules, companies may want to evaluate whether incentive-based compensation under current agreements and plans is based on structures, time periods or financial measures that may be treated less favorably under the final rules than alternative structures, time periods or performance measures.
Evaluate Existing Indemnification Arrangements under the Final Rules. Companies should review existing indemnification provisions contained in their organizational documents and any agreements with executive officers to determine if any changes would be needed to comply with the prohibition on indemnifying any executive officer or former executive officer against loss of erroneously awarded compensation.
Review the Company’s Financial Reporting and Disclosure Controls and Procedures. The final rules are likely to require most companies to modify their internal control over financial reporting and disclosure controls and procedures to ensure compliance with the listing standards and disclosure requirements of the final rules. For example, companies must be able to recalculate incentive-based compensation after a financial restatement, determine the amounts that were erroneously awarded to current and former executive officers, determine whether recovery of any of these amounts may be impracticable under the final rules, initiate and monitor recovery of these amounts and disclose the required information about this process and the status of compensation recovery. In addition, companies may want to clarify internal policies relating to approvals needed for accounting restatements given that the clawback recovery period is based on the date the authorized decision makers concluded, or reasonably should have concluded, that the company is required to prepare an accounting restatement. Companies should evaluate the impact of the final rules on internal control over financial reporting and disclosure controls and procedures and be prepared to implement and disclose any necessary changes.
Monitor Stock Exchange Listing Standards Status. The two key events leading up to the effectiveness of the listing standards and disclosure requirements under the final rules will be (1) the filing of proposed listing standards by the exchanges and (2) the approval of the listing standards by the SEC. Listed companies should monitor this process and ensure that they will be prepared to comply with the new listing standards and related disclosure requirements.
Implementation Timetable and Effective Dates
The exchanges must propose listing standards within 90 days after the publication date of the final rules in the Federal Register, and the new listing standards must be effective within one year after the publication date of the final rules in the Federal Register. Companies that are subject to these listing standards must adopt a clawback policy no later than 60 days after the effective date of the listing standards, and must begin to comply with the disclosure requirements in annual reports and proxy and information statements filed on or after the company adopts its clawback policy.
Companies Subject to the Final Rules
The listing standards required by the final rules apply to most listed companies including smaller reporting companies, emerging growth companies, foreign private issuers and controlled companies, with very limited exceptions. The listing standards also will apply to private companies that have listed debt or preferred securities.
The final rules also apply to investment companies with exchange-listed securities, with an exemption for funds that have not awarded incentive-based compensation to any current or former executive officer of the fund in any of the last three fiscal years (or since the fund’s initial listing, if less than three fiscal years). The only other exemptions relate to security futures products, standardized options and securities issued by unit investment trusts. This alert discusses only how the final rules apply to operating companies.
Companies that are subject to the listing standards required by the final rules will be subject to delisting if they do not adopt and comply with a clawback policy, as required by the exchange’s listing requirements.
Executive Officers Covered by the Final Rules
The final 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, which is consistent with the definition of “officer” in Rule 16a-1(f) of the Exchange Act.
The final rules do not require that an executive officer had a direct role in financial reporting, was directly involved with the accounting error, or engaged in any misconduct.
The final rules prohibit companies from indemnifying any executive officer or former executive officer against loss of erroneously-awarded compensation. In the adopting release, the SEC stated 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 and When Compensation is Deemed Received
Compensation will be deemed “received” for purposes of 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. 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.
The policy must apply to all incentive-based compensation received by a person:
- After that person begins service as an executive officer
- Who served as an executive officer at any time during the performance period for that incentive-based compensation
- While the company has a class of securities listed on an exchange
- During the three completed fiscal years immediately preceding the date that the company is required to prepare an accounting restatement that is subject to the final rules
Awards of incentive-based compensation granted to a person before that person becomes an executive officer must be subject to the recovery policy if the person serves as an executive officer at any time during the performance period for that incentive-based compensation and the compensation is “received” after the person began service as an executive officer.
The policy must require the recovery of incentive-based compensation that is received while the company has a class of securities listed on an exchange. This means that incentive-based compensation “received” prior to a company’s IPO need not be subject to the policy even if it otherwise would have been in the three-year clawback period.
The policy must apply to incentive-based compensation received during the three completed fiscal years immediately preceding the date the company is required to prepare an accounting restatement, plus any transition periods related to a change in fiscal years. The final rules do not require the policy to apply to incentive-based compensation received during the partial year period between the date the company is required to prepare an accounting restatement and the end of the prior fiscal year. For example, if a company with a calendar year end fiscal year concludes in November 2024 that a restatement of previously issued financial statements is required and files the restated financial statements in January 2025, the final rules require the policy to apply to incentive-based compensation received in 2021, 2022, and 2023.
The date a company is required to prepare an accounting restatement is the earlier to occur of:
- The date the company’s board of directors, a committee of the board of directors, or the officer or officers of the issuer authorized to take such action if board action is not required, concludes, or reasonably should have concluded, that the company is required to prepare an accounting restatement
- The date a court, regulator, or other legally authorized body directs the company to prepare an accounting restatement
The policy must apply in the event that the company is required to prepare an accounting restatement due to the material noncompliance of the company with any financial reporting requirement under the securities laws, including any required accounting restatement to correct an error in previously issued financial statements that is material to the previously issued financial statements (i.e., “Big R” restatements), or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period (i.e., “Little r” restatements). This is a change from the SEC’s 2015 proposal, which would have only required a company to recover compensation based on “Big R” restatements.
Compensation to be Recovered
Under the final rules, clawback policies must require the recovery of erroneously awarded “incentive-based compensation,” which the final rules define as any compensation that is granted, earned or vested based wholly or in part on the attainment of any “financial reporting measure.” The final rules define “financial reporting measure” 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. The final rules also provide that a company’s stock price and total shareholder return are financial reporting measures.
The final rules define financial reporting measure broadly. “Financial reporting measure” includes non-GAAP financial measures as defined in Regulation G and Item 10(e) of Regulation S-K, but also includes measures and ratios that are neither GAAP financial measures nor 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.
Because the definition of incentive-based compensation includes compensation earned “in part” upon achieving a financial reporting measure, incentive-based compensation includes compensation that is not tied to a financial reporting measure in a strictly formulaic manner. This would include discretionary bonuses paid from a bonus pool, where the size of the pool is determined based wholly or in part on the attainment of a financial reporting measure, or awards based on the attainment of a financial reporting measure that are subject to discretionary increase or decrease.
The adopting release also included several examples of types of compensation that are not incentive-based compensation, including, among others:
- Salaries, except to the extent a salary increase is earned wholly or in part based on the attainment of a financial reporting measure performance goal
- Discretionary bonuses that are not paid from a bonus pool that is determined by satisfying a financial reporting measure performance goal
- Equity awards for which neither the grant nor vesting is contingent upon achieving a financial reporting measure performance goal (e.g., stock options with purely time-based vesting that were not granted based on the achievement of a financial reporting metric would not be incentive-based compensation under the final rules regardless of when they were exercised)
Amounts Subject to Recovery
The policy 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, the amount of erroneously awarded compensation may 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 final rules require companies to recover erroneously awarded compensation in compliance with its recovery policy, except in limited circumstances where pursuit of recovery would be impracticable. These circumstances are where:
- The direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered
- Recovery would violate a home country law adopted prior to publication of the final rules, and the company provides an acceptable opinion of home country counsel to the 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.
The final rules add new Item 402(w) to Regulation S-K, which will require each listed company to provide disclosures about its compensation recovery policy and how it has applied the policy. The disclosure required by Item 402(w), including the disclosures discussed below, 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. The final rules will require companies to tag disclosures relating to recovery policies using Inline XBRL.
Changes in Annual Report Requirements. The final rules will require two new check boxes on the cover page of Form 10-K, 20-F and 40-F annual reports. The first check box will indicate whether the financial statements included in the filing reflect a correction of an error to previously issued financial statements. The second check box will indicate whether any of these corrections were restatements that triggered a compensation recovery analysis during the fiscal year. The final rules will also require a listed company to file its recovery policy as an exhibit to its annual report.
Disclosure After an Accounting Restatement. In addition, if at any time during the last completed fiscal year the company was required to prepare an accounting restatement that required recovery of erroneously awarded compensation under a recovery policy, or if there was an outstanding balance as of the end of the last fiscal year of erroneously awarded compensation to be recovered pursuant to the recovery policy, Item 402(w) will require disclosure of:
- The date on which the company was required to prepare an accounting restatement
- The aggregate dollar amount of erroneously awarded compensation attributable to the accounting restatement
- An analysis of how the amount was calculated
- If the financial reporting measure related to stock price or a total shareholder return metric, the estimates that were used in determining the erroneously awarded compensation attributable to the accounting restatement and an explanation of the methodology used for these estimates
- The aggregate recoverable dollar amount that remains outstanding at the end of the last completed fiscal year
- Any outstanding amounts due from a current or former named executive officer for 180 days or more
- If recovery would be impracticable, the amount of recovery forgone and a brief description of the reason the company decided not to pursue recovery
Disclosure of Reliance on an Impracticability Exception. If at any time after its last completed fiscal year the company was required to prepare a restatement, and the company concluded that recovery was not required under the company’s recovery policy, Item 402(w) requires a brief explanation of why application of the recovery policy resulted in that conclusion.
Summary Compensation Table. The final rules also added a new instruction to the Summary Compensation Table that will require companies to reduce the amount reported in the applicable column(s) of the Summary Compensation Table, as well as the “total” column of the Summary Compensation Table, for the fiscal year in which the amount recovered initially was reported as compensation to reflect the recovery of any amounts under the company’s recovery policy and identify these amounts in a footnote to the Summary Compensation Table. Companies should note that an equity award granted upon attainment of a financial reporting measure would be deemed received in the fiscal year that the relevant financial reporting measure performance goal was satisfied, rather than a subsequent date on which the award was issued. The adopting release notes that the fiscal year in which an incentive-based equity award is deemed received in some cases may be a fiscal year preceding the fiscal year in which the grant date occurs under ASC Topic 718 and for which the award is reported in the Summary Compensation Table and the Grants of Plan-Based Awards Table because the SEC rules that govern reporting of equity awards in the Summary Compensation Table do not utilize a “performance year” standard.
Interplay With Other Clawback Requirements
The SEC noted that there are already existing provisions of law concerning the recovery of executive compensation under certain circumstances, such as Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”), but explained that the final rules are not intended to alter or otherwise affect the interpretation of such provisions, or the determination by the SEC, or courts, of when reimbursement is required under SOX Section 304. The SEC noted that recovery of erroneously awarded compensation under the final rules would not preclude recovery under SOX Section 304, to the extent any applicable amounts have not been reimbursed to the company. The SEC also clarified that the definition of “incentive-based compensation” in the final rules does not apply to the recovery of incentive-based compensation under SOX Section 304. Unlike the final clawback rules under Exchange Act Section 10D, where the recoverable amount is the amount of incentive-based compensation received in excess of the amount that otherwise would have been received, the SEC’s Division of Enforcement has recently stated its view that it may seek the full amount of reimbursement that is required by SOX Section 304, not merely the amount by which the executive’s compensation was allegedly inflated due to the restatement.