On July 1, 2015, the Securities and Exchange Commission (SEC) proposed rules directing the national securities exchanges (NYSE, NASDAQ, etc.) to create listing standards requiring listed companies to implement policies that obligate a listed company to recover or “clawback” incentive-based compensation received by its executive officers as a result of materially incorrect financial statements. These proposed rules are mandated by Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and are the last of the compensation-related rules required by the Dodd-Frank Act.
Highlights of Proposed Rules
Current and Former Executive Officers Covered by Proposed Rules
A clawback policy must apply to current and former “executive officers,” which the proposed rules define as a company’s president, chief financial officer, principal accounting officer, any vice-president in charge of a principal business unit or any other person in a company policy-making position. The SEC debated including only named executive officers under the proposed rules, but it opted to include this broader group, which generally aligns with the “Section 16” definition of officers.
The proposed rules would also cover executive officers who provided services at any time during the three-year look back period (described below) even if they are not executive officers at the time the restatement is required or when the company seeks to recover the excess incentive-based compensation. All incentive-based compensation “received” (described below) by such former executive officer during the three-year look back period would be subject to clawback.
Financial Restatements Triggering Clawback
A company must recover incentive-based compensation (described below) in the event the company is “required” (described below) to prepare a restatement to correct an error that is “material” to the previously issued financial statement. Materiality is not defined; rather companies must determine materiality based on the facts, circumstances and relevant legal guidance. The proposed rules, however, do exclude certain corrections under generally accepted accounting standards, such as the retrospective application of a change in an accounting principle.
Compensation Subject to Clawback
Under the proposed rules, the “incentive-based compensation” that is subject to clawback is compensation that is granted, earned or vested based on the attainment of any financial reporting measure, which includes:
Importantly, the proposed rules exclude the following compensation from clawback as they are not deemed to be based on financial reporting measures:
These exclusions are significant and may affect the recent trend toward more performance-based equity compensation.
The amount of recoverable incentive-based compensation is the amount received by the executive officer based on the materially incorrect financial statements that exceeds the amount such executive would have received had the compensation been determined based on the financial restatement.
In the proposal, the SEC notes that it will be acceptable to use reasonable “estimates” and/or “event studies” to determine the impact of a financial restatement on stock price and TSR. Likewise, the proposed rules indicate that use of an outside expert may be appropriate for this purpose.
How a company claws back the excess compensation attributable to equity awards will depend upon whether the awards have been exercised and whether exercised shares remain outstanding. (If shares have been sold and/or exercised, the clawback may be imposed on proceeds received upon sale of the shares.) We expect significant comments and discussion regarding the calculation of equity awards to be clawed back, as well as the method of recoupment. In particular, how the clawback will be imposed on awards based on TSR will be complicated, in part because it will often be less than clear whether any incentive-based compensation was based on materially incorrect financial statements.
The Three-Year Look Back Period
A clawback policy must require recovery of excess incentive-based compensation “received” during the three fiscal years prior to the year in which it is determined that the company is “required” to prepare an accounting restatement.
The date on which a company is “required” to prepare a restatement is the earlier of:
Incentive-based compensation is deemed “received” at the time the financial measure is achieved, even if the payment or grant occurs on a later date, or there are additional payment requirements such as time-based vesting or certification by the compensation committee that have not yet been satisfied. For example, if the number of shares earned under a performance-based RSU is determined based on a company’s TSR over the three-year performance period ending in 2016 (and such award is determined to be based on materially incorrect financial statements), but the RSU then remains subject to a two-year time-based vesting requirement, the RSU is deemed “received” in 2016 at the end of the relevant performance period. Regardless of when the restatement occurs, as long as the RSUs are received within three fiscal years prior to when the restatement was “required,” the RSUs will be subject to clawback even though they remain subject to time-based vesting.
The compensation to be recovered would be calculated on a pre-tax basis.
No-Fault Standard and Limited Discretion to Not Clawback
The proposed rules do not permit a company to consider the fault or responsibility of the executive officers. A company may exercise discretion to not enforce its clawback policy in only two situations:
A company must make a reasonable attempt to recoup erroneously paid compensation (and document such attempt) prior to asserting that the expense of recovery exceeds the potential recoverable amount. Likewise, it is important to note that only direct costs (such as legal fees) may be taken into account. The decision to not recoup the compensation, which must be made by the company’s compensation committee or the majority of its independent directors, must be publicly disclosed and would be subject to review by the applicable exchange.
All Listed Companies Subject to Proposed Rules with Very Limited Exceptions
Generally, all listed issuers would be required to comply with the proposed clawback rules with the limited exception of registered investment companies and issuers of securities futures products or standardized options. Notably, there is no exception for emerging growth companies, smaller reporting companies or foreign private issuers. This lack of any exceptions has been (and will continue to be) an important issue and we expect that it will be the subject of many comment letters.
The proposed rules would require the following disclosures:
Timing for Compliance
Companies may need to comply with the proposed rules as early as the end of 2016, though this timing will depend on when the SEC’s proposed rules are finalized, and will likely be in early 2017.
Once the SEC issues final rules, which will be no earlier than September 2015 to allow for a 60-day comment period for the proposed rules, the exchanges will have 90 days to issue their proposed listing rules. The exchanges’ listing rules must be effective no later than one year following the publication of the SEC’s final rules. Companies would then be required to adopt a clawback policy no later than 60 days following the effectiveness of the exchanges’ rules.
The comment period for the proposed rules will remain open for 60 days after its publication in the Federal Register. We anticipate that comments will include, among other things, (1) how to determine whether compensation is based in whole or in part on materially incorrect financial statements, especially in the case of TSR-based metrics, (2) whether emerging growth and small reporting companies should be subject to the rules, and (3) how to recover amounts attributable to materially incorrect financial statements.
Likewise, it is possible that the impact of subjecting performance-based equity awards to a no-fault clawback policy may encourage companies to shift away from performance-based compensation to non-performance payments, such as increased salaries, discretionary bonuses or time-based equity awards. This possible shift could result in misalignment of a company’s executive compensation with its shareholders’ interests, run afoul of the stated preferences for performance-based compensation of proxy advisory firms, such as ISS, and negatively impact a company’s say-on-pay vote.
In the meantime, companies should consider taking the following actions:
The SEC’s Fact Sheet describing the proposed rules can be found here: http://www.sec.gov/news/pressrelease/2015-136.html
The SEC Release can be found here:http://www.sec.gov/rules/proposed/2015/33-9861.pdf