What You Need to Know About the SEC's Final Clawback Rules

17 minute read | November.02.2022

On October 26, 2022, the Securities and Exchange Commission (“SEC”) adopted final rules, first proposed by the SEC in 2015, requiring the recoupment of erroneously awarded incentive compensation received by current and former executive officers, pursuant to Section 10D of the Securities Exchange Act of 1934, as amended (“Exchange Act”), a provision added by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The final rules direct national securities exchanges (such as Nasdaq and NYSE) to adopt listing standards requiring listed companies to develop and implement a compensation clawback policy and to provide disclosure regarding the policy and any actions taken to recover compensation under such a policy.

The new listing standards will have an effective date no later than one year after publication of the release in the Federal Register, and companies will have to adopt a clawback policy and begin complying with the disclosure obligations within 60 days thereafter.

What are the new rules?

Pursuant to new Exchange Act Rule 10D-1, national securities exchanges are directed to adopt listing standards that require a listed company to:

  • develop and comply with a written clawback policy for the recoupment of erroneously awarded incentive compensation received by current and former executive officers in the event of an accounting restatement (either “Big R” or “little r”), regardless of whether the executive officer engaged in any misconduct and regardless of fault, with the policy applying to compensation received during the three-year period preceding the determination that an accounting restatement is required; and
  • disclose any actions the company has taken pursuant to such a policy.

Additionally, companies will be required to file a copy of the compensation clawback policy as an exhibit to annual reports on Form 10-K and to indicate compliance with the policy through new check boxes on the cover page of Form 10-K.

What type of compensation is covered?

Only performance-based cash and equity compensation that is granted, earned or vested based in whole or in part on the attainment of any financial reporting measure is covered (“Covered Compensation”). Salaries, discretionary cash bonuses not based on the attainment of financial reporting measures and purely time-based equity awards are not covered.

What is a financial reporting measure?

A “financial reporting measure” is any measure determined and presented in accordance with the accounting principles used in preparing a company’s financial statements, including “non-GAAP” financial measures (such as those appearing in earnings releases or MD&A), and any measures based in whole or in part from such measures.[1] Examples include measures based on: revenues, net income, operating income, financial ratios, EBITDA, liquidity measures, return measures (such as return on assets), profitability of one or more segments, sales per square foot, same store sales, revenue per user, and cost per employee. Additionally, the rules identify stock price and total shareholder return (“TSR”) as financial reporting measures. The SEC acknowledged concerns that inclusion of TSR “could discourage the use of TSR as a performance measure” by companies subject to these rules.

Which executives and what periods are covered?

The rules apply to all current and former executive officers (as such term is used for establishing insiders’ reporting obligations under Section 16 of the Exchange Act[2]) who receive payments of Covered Compensation during the three completed fiscal years (the “Covered Period”) preceding the date the company is required to prepare the accounting restatement. For example, if a calendar year company determines, or reasonably should have determined, in November of a calendar year that a restatement is required, the Covered Period would include the three previously completed calendar years. Under the rules, Covered Compensation received prior to a person becoming an executive officer will not be required to be recouped while the same is not true for a former executive officer who receives Covered Compensation during the Covered Period.

What must be recovered?

The recoverable amount is the amount of Covered Compensation received by the current or former executive officer in excess of the amount that otherwise would have been received had it been determined based on the restated financial measure, computed without regard to taxes paid. For Covered Compensation based on stock price or TSR, if the amount of erroneously awarded compensation is not subject to direct mathematical recalculation, the amount must be based on a “reasonable estimate” of the effect of the restatement on stock price or TSR.[3]

Covered Compensation is deemed received in a fiscal period during which the financial reporting measure specified in the award is attained, even if the payment or grant of the Covered Compensation occurred after the end of that period. For example:

  • if the grant of an award is based, either wholly or in part, on satisfaction of a financial reporting measure performance goal, the award would be deemed received in the fiscal period when that measure was satisfied;
  • if an equity award vests only upon satisfaction of a financial reporting measure performance condition, the award would be deemed received in the fiscal period when it vests;
  • a non-equity incentive plan award would be deemed received in the fiscal year that the executive officer earns the award based on satisfaction of the relevant financial reporting measure performance goal, rather than a subsequent date on which the award was paid;[4] and
  • a discretionary cash award earned upon satisfaction of a financial reporting measure performance goal would be deemed received in the fiscal period when that measure is satisfied.

In calculating recoverable amounts, companies are to apply a principles-based approach, with the determination depending on the particular facts and circumstances applicable to compensation arrangements. Companies and boards of directors are advised to “consider the statute’s goal to return erroneously awarded compensation to the [company] and its shareholders, and their fiduciary duties to those shareholders,” in making such calculations. See below for some limited examples of how recoverable amounts may be calculated:

  • for cash awards, the recoverable amount would be the 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; and
  • for equity awards, if the shares, options, or SARs are still held at the time of recovery, the recoverable amount would be the number of such securities received in excess of the number that should have been received applying the restated financial reporting measure (or the value of that excess number). If the options or SARs have been exercised, but the underlying shares have not been sold, the recoverable amount would be the number of shares underlying the excess options or SARs (or the value thereof).

How is it recovered?

The final rules provide boards of directors with discretion, subject to certain restrictions, regarding the means of recovery, which should be done reasonably promptly. Rule 10D-1 does not limit the amount of compensation the board is required to recover, but the rule does not permit boards of directors to settle for less than the full recovery amount unless they satisfy the conditions that demonstrate recovery is impracticable. Recovery is not required if: (i) the direct costs of seeking recovery would exceed the recoverable amount, (ii) recovery would violate the company’s home country laws, or (iii) recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code. To facilitate the enforcement of such measures, we recommend that companies consult with legal counsel to determine how to best build into compensation arrangements the covered executive’s acknowledgement and consent to such actions.

What types of restatements are covered?

Under the final rules, a company’s clawback policy will be triggered in the event that the company is required to prepare an accounting restatement due to the material noncompliance by the company with any financial reporting requirement under the securities laws, regardless of whether company or officer misconduct was the cause for such accounting restatement.  Specifically, recovery is required with respect to both (i) restatements that correct errors that are material to previously issued financial statements (commonly referred to as “Big R” restatements), and (ii) restatements that correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period (commonly referred to as “little r” restatements).

What must be disclosed?

Pursuant to the final rules, each listed company is required to: (i) file its written clawback policy as an exhibit to its annual report; (ii) indicate by check boxes on its annual report whether the financial statements included in the filings reflect correction of an error to previously issued financial statements (including both “Big R” and “little r” restatements) and whether any of those error corrections are restatements that required a recovery analysis; and (iii) provide disclosure of any actions the company has taken pursuant to such policy, with such disclosure included as part of a company’s Regulation S-K, Item 402, Executive Compensation disclosures in Annual Reports on Form 10-K and/or proxy and information statements calling for the same.[5]

If a company is required to prepare an accounting restatement that required recovery pursuant to its clawback policy, it must disclose, as relevant: (i) the date it was required to prepare an accounting restatement and the aggregate dollar amount of erroneously awarded compensation attributable to such accounting restatement, including an analysis of how the amount was calculated (and, if the financial reporting measure related to a stock price or TSR metric, the estimates that were used in determining the erroneously awarded compensation attributable to such accounting restatement and an explanation of the methodology used for such estimates); (ii) the aggregate dollar amount that remains outstanding at the end of the last completed fiscal year and any outstanding amounts due from any covered executive for 180 days or longer; and (iii) if recovery would be impracticable, the amount of recovery forgone and a description of the reason the company decided not to pursue recovery. Companies must use Inline XBRL to tag their compensation clawback disclosure.

Note that Items 402(c) and 402(n) of Regulation S-K (relating to summary compensation table calculations) have also been amended to clarify that summary compensation table amounts must be adjusted to reflect any clawbacks, and that such adjustments must also be explained by footnote to the summary compensation table.

When to comply?

The final rules will become effective 60 days following publication of the release in the Federal Register. The exchanges must file proposed listing standards to implement the new clawback rules within 90 days following publication of the release in the Federal Register. The listing standards must have an effective date no later than one year following such publication. Listed companies are required to adopt a clawback policy within 60 days following the date on which the applicable listing standards become effective, and they must begin complying with the disclosure requirements in proxy and information statements and their annual reports filed on or after adoption of the clawback policy. Providing limited transitional relief, a company will only be required to apply the recovery policy to incentive-based compensation received after the effective date of the applicable listing standards and only during periods the issuer has a class of securities listed on an exchange, notwithstanding the general three-year look-back requirement.

How do the new rules compare to existing clawback requirements and proxy advisor guidance?

See below for a high-level comparison of the new rules against Section 304 of the Sarbanes-Oxley Act of 2002 and the current voting guidelines of ISS and Glass Lewis (“GL”).  Note, the ISS and GL guidelines have not yet been updated to reflect SEC adoption of the new rules.

 

 

New Exchange Act Rule 10D-1

SOX 304

ISS Guidance

GL Guidance

Trigger

“Big R” or “little r” restatements, regardless of misconduct.

“Big R” restatements caused by misconduct.

“Big R” restatements, regardless of misconduct.

At a minimum, “Big R” restatements or similar revision of performance indicators upon which bonuses were based.

Officers Covered

CEO, CFO, PAO, unit vice presidents and all other policy making officers.

CEO and CFO.

All NEOs.

Not specified, but generally disfavors policies that simply satisfy the minimum legal requirements.

Recovery Period

Three years preceding the date a company determines restatement is required.

12 months after the financial information was initially reported.

Not specified, but generally disfavors policies that contain only the limited requirements under SOX.

Not specified, but generally disfavors policies that simply satisfy the minimum legal requirements.

Compensation Covered

Erroneously awarded performance-based cash and equity compensation.

Any bonus or other incentive-based or equity-based compensation received, and any profits realized from the sale of company securities.

Not specified, but generally disfavors policies that contain only the limited requirements under SOX.

All performance-related bonuses and awards.

 

What should a compensation clawback policy look like?

See the next page for a sample compensation clawback policy addressing the requirements of new Exchange Act Rule 10D-1. This sample policy only includes required content and does not reflect additional requirements that may be imposed by the national securities exchange listing standards to be ultimately adopted. Some companies may also choose to use their clawback policies to address a broader range of corporate misconduct, particularly given the Department of Justice's recent increased attention to clawbacks as part of compliance programs.

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We will continue to monitor developments under these new requirements. Stay tuned for updates, or feel free to reach out to our team with additional questions, comments, or thoughts.

 

SAMPLE COMPENSATION CLAWBACK POLICY

[Company Name]
Clawback Policy

 

Effective [Date]

 

1. Recoupment

If [Company Name] (the “Company”) is required to undertake a Restatement, then the Board shall, unless the Company’s Compensation Committee determines it impracticable to do so, after exercising a normal due process review of all the relevant facts and circumstances, recover all Recoverable Compensation Received by any Covered Person during the Applicable Period. In addition, the Board may, in its sole discretion and in the reasonable exercise of its business judgment, determine whether and to what extent additional action is appropriate to address the circumstances surrounding such Restatement to minimize the likelihood of any recurrence and to impose such other discipline as it deems appropriate.

Subject to applicable law, the Board may seek to recoup such Recoverable Compensation by requiring any Covered Person to repay such amount to the Company; by set-off of a Covered Person’s other compensation; by reducing future compensation; or by such other means or combination of means as the Board, in its sole discretion, determines to be appropriate.

2. Administration of Policy

The Board shall have full authority to administer this Policy. Actions of the Board pursuant to this Policy shall be taken by the vote of a majority of its members. The Board shall, subject to the provisions of this Policy, make such determinations and interpretations and take such actions in connection with this Policy as it deems necessary, appropriate or advisable. All determinations and interpretations made by the Board shall be final, binding and conclusive.

The Board may delegate any of its powers under this Policy to the Compensation Committee of the Board or any subcommittee or delegate thereof.

3. Acknowledgement by Covered Persons

The Board shall provide notice and seek written acknowledgement of this Policy from each Covered Person, provided that the failure to provide such notice or obtain such acknowledgement shall have no impact on the applicability or enforceability of this Policy.

4. Other Laws

This Policy is in addition to (and not in lieu of) any right of repayment, forfeiture or right of offset against any Covered Person that may be available under applicable law or otherwise (regardless of whether implemented at any time prior to or following the adoption of the Policy). Notwithstanding anything to the contrary in this Policy, in no event shall the Board seek any recoupment described in this Policy if, by doing so, the Company would be in violation of any applicable state wage or other law.

5. Amendment; Termination

The Board may amend or terminate this Policy at any time.

6. Disclosures

Appropriate disclosures and other filings with respect to this Policy will be made in accordance with Rule 10D-1 of the Securities Exchange Act of 1934, as amended, and the Company’s applicable exchange listing standards.

7. Definitions

For purposes of this Policy, the following terms shall have the following meanings:

Applicable Period. “Applicable Period” means the three complete fiscal years preceding the determination a Restatement is required, as determined by the Board.

Board. “Board” means the Board of Directors of the Company.

Covered Person. “Covered Person” means any person who is or was during the Applicable Period an Executive Officer of the Company or any affiliate thereof.

Executive Officer. “Executive Officer” means the Company’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the Company 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, or any other person who performs similar policy-making functions for the Company.

Financial Reporting Measure. “Financial Reporting Measure” means a measure that is determined and presented in accordance with the accounting principles used in preparing the Company’s financial statements (including “non-GAAP” financial measures, such as those appearing in earnings releases or MD&A), and any measure that is derived wholly or in part from such measure. Examples of Financial Reporting Measures include measures based on: revenues, net income, operating income, financial ratios, EBITDA, liquidity measures, return measures (such as return on assets), profitability of one or more segments, sales per square foot, same store sales, revenue per user, and cost per employee. Stock price and total shareholder return are also Financial Reporting Measures.

Incentive-Based Compensation. “Incentive-Based Compensation” means any compensation that is granted, earned, or vested based wholly or in part upon the attainment of a Financial Reporting Measure. Incentive-Based Compensation does not include any base salaries, discretionary cash bonuses and equity awards that vest solely on the passage of time.

Policy. “Policy” means this [Company Name] Clawback Policy.

Received. Incentive-Based Compensation is deemed “Received” in the Company’s fiscal period during which the Financial Reporting Measure specified in the Incentive-Based Compensation award is attained, even if the payment or grant of the Incentive-Based Compensation occurs after the end of that period.

Recoverable Compensation. “Recoverable Compensation” means the amount of any Incentive-Based Compensation (calculated on a pre-tax basis) Received by a Covered Person during the Applicable Period that is in excess of the amount that otherwise would have been Received if the calculation were based on the Restatement.

Restatement. “Restatement” means an accounting restatement of any of the Company’s financial statements filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, due to the Company’s material noncompliance with any financial reporting requirement under U.S. securities laws, regardless of whether company or executive officer misconduct was the cause for such restatement. “Restatement” includes any required accounting restatement to correct an error in previously issued financial statements that is material to the previously issued financial statements (commonly referred to as “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 (commonly referred to as “little r” restatements)


[1] An example of compensation that is based in part upon a financial reporting measure is an award in which 60% of the target amount is earned if a certain revenue level is achieved, and 40% of the target amount is earned if a certain number of new stores are opened.

[2] See Exchange Act Rule 16a-1(f).  These persons are commonly known as “Section 16 officers” because they must file with SEC beneficial ownership reports under Section 16 of the Exchange Act.

[3] In the event a company is required to make a reasonable estimate of such effect, the company must document how the reasonable estimate was determined and provide such documentation to the exchange.

[4] This would be the same fiscal year for which the non-equity incentive plan award earnings are reported in the summary compensation table.

[5] Such disclosures will not be deemed incorporated by reference into any Securities Act of 1933 filings unless a company specifically incorporates it by reference.