SEC Adopts Final Clawback Rule
November 1, 2022
On October 26, 2022, the SEC adopted final rules to implement Section 954 of the Dodd-Frank Act that requires listed issuers to adopt, disclose and comply with a new mandatory compensation recovery policy (the “Final Rules”). This Alert summarizes some of the key features of the Final Rules, and includes our thoughts on some implementation considerations and potential action items. The full text of the adopting release for the Final Rules is available here.
The Final Rules require the national securities exchanges to adopt compliant, proposed listing standards within 90 days after the Final Rules are published in the Federal Register. The standards adopted by the national securities exchanges must be effective no later than one year after publication of the Final Rules. Listed issuers are required to adopt a compliant compensation recovery policy (referred to as a “clawback policy” in the rest of this Alert) within 60 days after the date the exchanges’ rules become effective, and to comply with the new clawback disclosure requirements described below in applicable SEC filings after the date the exchanges’ rules become effective.
Importantly, listed issuers are required to claw back erroneously awarded compensation that is received as a result of the attainment of a financial measure for any fiscal period ending on or after the effective date of the rules adopted by the national securities exchanges. This is the case even if the compensation was earned or vested under an award that had been granted before the effective date of the exchanges’ rules.
New Clawback Policy Requirements
The Final Rules require the national securities exchanges to adopt listing standards that will require listed issuers to adopt and comply with a written clawback policy providing that, in the event 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 issuer will recover the amount of erroneously awarded incentive-based compensation. Misconduct is not required in order to trigger a clawback, and a clawback may be required regardless of the fault or involvement of those subject to the policy. Issuers generally will not be permitted to have discretion to forego enforcement of the policy when a clawback is otherwise required.
While many public companies have already voluntarily adopted clawback policies that go beyond the clawback requirements of the Sarbanes-Oxley Act of 2002, it is likely that most existing policies will need to be amended to incorporate the substantive requirements that will be mandated by stock exchange listing standards pursuant to the Final Rules. The key requirements of the Final Rules’ clawback policy are highlighted below:
- Restatement Trigger: Recovery under the clawback policy is only triggered if the issuer is required to prepare a covered accounting restatement. For these purposes, an accounting restatement will trigger the clawback policy if it is prepared in order to correct an error in previously issued financial statements that is either (i) material to those prior financial statements (referred to as a “Big R” restatement), or (ii) not material to the prior financial statements, but would result in a material misstatement if the error were left uncorrected in the current period or if the error correction were recognized in the current period (referred to as a “little r” restatement). Changes to previously issued financial statements that do not represent error corrections would not trigger a clawback (e.g., retrospective changes due to a change in accounting principles, discontinued operation reclassification or change in reporting entity would not trigger a clawback).
- Covered Executives: The universe of executives potentially subject to clawback is the issuer’s “executive officers.” The definition of “executive officer” is based on the definition of “officer” used for Section 16 purposes, so that all of an issuer’s Section 16 executives will potentially be subject to clawback. The Final Rules also provide that any person identified as an executive officer in the issuer’s proxy statement or annual report who is not also a Section 16 officer will be presumed to be an executive officer subject to the clawback rules. An individual’s compensation is subject to clawback only if the individual received the compensation after beginning service as an “executive officer” and the individual served as an “executive officer” at any time during the performance period applicable to that compensation. For example, if an individual is promoted to an “executive officer” position in November 2024, and had been granted a performance-based stock unit award in February 2022, that becomes earned based on performance over a three-year period consisting of calendar years 2022-2024, all of these performance-based stock units would potentially be subject to clawback. Similarly, if the individual ceased being an “executive officer” during or after the performance period, any such incentive-based compensation would remain subject to potential clawback.
- Covered Incentive-Based Compensation: Compensation is potentially subject to clawback if it is “incentive-based compensation,” defined as compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure. Financial reporting measures include measures (including non-GAAP measures) that are determined and presented in accordance with the accounting principles used in the issuer’s financial statements (such as revenues, net income or operating income), any measures derived wholly or in part from such financial information (such as EBITDA, FFO, return on invested capital or assets, working capital, or relative performance against a peer group or index where performance is measured based on such financial information), and stock price and total shareholder return. Equity awards such as options or stock units would only be subject to clawback if the awards are either granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure. Time-based equity (and cash) awards that vest based solely on continued employment, as well as discretionary cash (or equity) bonuses, are not subject to clawback. However, supplemental non-qualified retirement or deferred compensation benefits calculated based on incentive-based compensation amounts are subject to clawback.
- Covered Time Period: Recovery under the clawback policy generally applies to covered incentive-based compensation that is received during the three completed fiscal years immediately preceding the date the issuer is required to prepare a covered accounting restatement (e.g., if an issuer is required to prepare a covered restatement in fiscal 2024, the required clawback would apply to covered incentive-based compensation received in fiscal 2023, 2022 and 2021). For these purposes, compensation is treated as received in the issuer’s fiscal period when the applicable financial reporting measure is attained (even if payment occurs in a later period or the award is subject to additional time-based vesting requirements after the financial reporting measure is attained). For example, if a restricted stock unit is subject to performance-based vesting for the 2023 fiscal year, the award will be treated as received for these purposes in the 2023 fiscal year even if the award remains subject to time-based vesting requirements in later years or actual payment of the award is deferred to later years. In addition, for these purposes, the date an issuer is required to prepare a covered accounting restatement will be the earlier of (A) the date the issuer’s board of directors (or a committee thereof) concludes or reasonably should have concluded that the issuer is required to prepare a restatement due to material noncompliance with any financial reporting requirement under the securities laws, and (B) the date a court, regulator or other legally authorized body directs the issuer to prepare an accounting restatement. Recovery under the clawback policy only applies to compensation received while the issuer has a class of securities listed on an exchange.
- Amount of Erroneously Awarded Compensation: Recovery under the clawback policy applies to erroneously awarded compensation, which is defined to mean the amount of covered incentive-based compensation received that exceeds the amount of compensation that otherwise would have been received had it been determined based on the accounting restatement. For example, if an executive earned a $1,000,000 bonus based on EBITDA performance as originally reported and would have earned a $750,000 bonus based on EBITDA performance as corrected in the restatement, the recoverable amount would be $250,000. If the erroneously awarded compensation consists of shares or options that are still held by the executive at the time of recovery, the recoverable amount is the number of shares or options received in excess of the number of shares or options that would have been received based on the accounting restatement. If the options have been exercised but the underlying shares have not been sold, the recoverable amount is the number of shares underlying the excess options based on the restatement. If the shares have been sold, the recoverable amount is the proceeds that were received in connection with the sale of the excess number of shares. For compensation based on stock price or total shareholder return where the amount of erroneous compensation is not subject to mathematical recalculation (because the issuer is required to determine the stock price impact of the restatement), issuers must use a reasonable estimate of the effect of the accounting restatement on the applicable measure to determine the recoverable amount. Importantly, the recoverable amount is determined on a pre-tax basis without giving effect to any taxes already paid by the executive on the recoverable amount.
- Recovery Options: The Final Rules do not codify any specific manner or means to accomplish a required recovery of erroneously awarded compensation amounts. Rather, the SEC stated that it believes the appropriate means of recovery may vary by issuer and by type of compensation arrangement, and that issuers should be able to exercise discretion in how to accomplish recovery, as long as the erroneously awarded compensation is recovered “reasonably promptly” (although the Final Rules do not specify what time period would be considered “reasonably promptly”).
- Limited Board Discretion: Issuers are required to recover erroneously awarded compensation unless it would be impracticable to do so. The concept of impracticability is a narrow one, and is limited to situations where the issuer concludes after making a reasonable attempt to recover the compensation that the direct expenses paid to a third party to enforce the policy would exceed the amount recovered, or where recovery would violate home country law or likely affect the tax-qualified status of a retirement plan. Before an issuer may rely upon the impracticability exception, it must satisfy certain procedural requirements (including certification by the compensation committee or other committee of independent directors responsible for executive compensation that recovery would be impractical), and the issuer will also be required to make additional disclosures described below.
- No Indemnification: Issuers are prohibited from indemnifying executive officers against the loss of erroneously awarded compensation. Issuers are also prohibited from paying or reimbursing executive officers for the premiums of an insurance policy that would cover the loss of erroneously awarded compensation.
New Disclosure Requirements
The Final Rules contain new disclosure requirements. Listed issuers will be required to file their clawback policies as exhibits to their annual reports. In addition, the Final Rules add a new Item 402(w) to the existing executive compensation disclosure rules contained in Item 402 of Regulation S-K that require disclosure if either a covered accounting restatement was prepared at any time during the last completed fiscal year or there was an outstanding balance of erroneously awarded compensation from a prior covered restatement as of the end of the last completed fiscal year. If this disclosure obligation is triggered, issuers are required to disclose for each restatement:
- The date the issuer was required to prepare a covered restatement.
- The total amount of erroneously awarded compensation attributable to the restatement (including an analysis of how that amount was calculated and a description of the estimates used to determine amounts attributable to stock price or total shareholder return metrics), or if the amount has not yet been determined, an explanation as to why the determination has not been made and disclosure in the next filing that is subject to Item 402 of Regulation S-K.
- The total amount of erroneously awarded compensation that has yet to be clawed back at the end of the last completed fiscal year (including the name of each individual for whom erroneously awarded compensation has remained outstanding for 180 or more days and the clawback amount owed by such individual).
- If the issuer determined in the last completed fiscal year not to pursue clawback in reliance upon the impracticability exception, for each current and former named executive officer and for all other current or former executive officers as a group, the amount of recovery foregone and a brief description of the reasons the issuer did not pursue a clawback.
The Final Rules also amend the cover page of Form 10-K, Form 20-F and Form 40-F to add check boxes that will require issuers to indicate whether the financial statements included in the filing reflect correction of an error to previously issued financial statements and, if so, whether any of those error corrections are restatements that required an analysis of recovery of erroneously awarded compensation amounts. The Final Rules also require tagging of any specific data points included within the required disclosures, as well as block text tagging of the disclosure, in Inline XBRL format.
Very Limited Number of Exempted Companies
The Final Rules contain exemptions for certain security futures products, standardized options, securities issued by unit investment trusts, and certain registered management investment companies that have not awarded incentive-based compensation to any executive officer in any of the last three fiscal years (or since initial listing). All other listed issuers—including emerging growth companies, smaller reporting companies, foreign private issuers and controlled companies—are subject to the requirements of the Final Rules.
Our thoughts on some implementation considerations and potential action items are highlighted below:
- Issuers Should Review Executive Officer Determinations. All of an issuer’s Section 16 executives will potentially be subject to clawback under the Final Rules. The Final Rules also provide that any person identified as an executive officer in the issuer’s proxy statement or annual report who is not also a Section 16 executive will be presumed to be an executive officer subject to the clawback rules. In light of this application of the clawback rules, issuers should review their executive officer determinations now to confirm that all individuals classified as executive officers are appropriately classified based on their current functions.
- Issuers Should Review Current Incentive-Based Compensation Agreements. It is possible that compensation awarded prior to the effective date of the Final Rules could be subject to clawback. For this reason, issuers should confirm that their existing incentive-based compensation award agreements or terms provide them with a legal right to recover compensation amounts that are subject to clawback under the Final Rules, and if not, make the appropriate changes to preserve these rights.
- Issuers Should Consider Bifurcating Certain Awards. Under the Final Rules, incentive-based compensation is subject to clawback if it is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure. In the adopting release, the SEC notes that if 60% of the target amount of an award is earned based on the attainment of a financial reporting measure and 40% is not, 100% of the award would be subject to clawback because it becomes earned, in part, upon the attainment of a financial reporting measure. For cash or equity awards that are designed to include both a financial reporting measure and some “other” component (such as a non-financial or time-based or discretionary component), in order to minimize clawback exposure, it appears advisable to bifurcate the awards so that they can be treated as separate awards where no part of the “other” component can be viewed as being tied to a financial reporting measure.
- Issuers Could Consider Minimizing Clawback Exposure by Shifting Away From Performance-Based Compensation. Under the Final Rules, issuers could structure their executive compensation program to minimize clawback exposure by granting executives discretionary annual cash bonuses and equity awards that vest based solely on continued employment, or structuring incentive-based compensation to use vesting metrics not based in any part on financial performance measures. However, this type of executive compensation program is inconsistent with the current programs of many public companies and with those favored by proxy advisory firms and many institutional investors.
- Review Clawback Policies. For issuers that have already adopted clawback policies, the policy should be reviewed to identify any material gaps between the terms of the policy and the Final Rules. This review should be conducted so that the clawback policy is in effect by no later than 60 days after the effective date of applicable listing standards adopted by the national securities exchanges to implement the requirements of the Final Rules.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. C. Brophy Christensen, an O’Melveny partner licensed to practice law in California, Jeff Walbridge, an O’Melveny partner licensed to practice law in California, Robert Plesnarski, an O’Melveny partner licensed to practice law in The District of Columbia and Pennsylvania, Shelly Heyduk, an O’Melveny partner licensed to practice law in California, Chris Del Rosso, an O’Melveny partner licensed to practice law in California and New York, and Warren Fox, an O’Melveny senior counsel licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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