On October 26, 2022, the SEC adopted final clawback rules consistent with the requirements of the Dodd-Frank Act. The new rules direct the national securities exchanges to establish listing standards requiring companies to adopt, disclose, and enforce policies to recoup, or “clawback,” incentive-based compensation erroneously awarded to executive officers.  Based upon recent SEC action, listed companies will have until December 1, 2023 to adopt compliant clawback policies. The following summarizes some key provisions of the final rules and the decisions that companies will have to make as they finalize their policies by the deadline.

Adopting Compliant Policies 

Companies that do not have existing clawback provisions in place must adopt policies that comply with the standards established by the exchanges. Companies that have clawback provisions in place must determine if and how those policies differ from what is required and either modify their existing policies or adopt a new compliant policy on a stand-alone basis. Questions to help integrate or create compliant policies include: 

Who should be covered?

Under the new rules, current and former “executive officers” are subject to clawbacks of incentive-based compensation in certain situations where excess compensation has been erroneously awarded. “Executive officers” are not limited to named executive officers, officers who had a role in preparing the financial statements, or executives who had a role in the accounting error leading to the restatement. 

Under what circumstances is recovery mandated? 

Recoupment of erroneously awarded compensation is required for (i) restatements that correct an error that is material to previously issued financial statements and are required to be reported in an 8-K filing (so-called “Big R” restatements) and (ii) restatements that correct an error that is not material to previously issued financial statements, but that would result in a material misstatement if the error was left uncorrected in the current report, or the error correction was recognized in the current period (“Little R” restatements). The recoupment does not require fault and applies even if no misconduct occurred.  

The clawback policy will only require recovery of excess incentive‑based compensation “received” by a person (1) after beginning service as an executive officer and (2) if that person served as an executive officer at any time during the recovery period, which is the three immediately completed fiscal years preceding the date on which a company is required to prepare an accounting restatement.

What constitutes incentive-based compensation and when is it considered “received?”

For purposes of the rule, incentive-based compensation is any compensation, including cash and equity, that is granted, earned, or vested based wholly or in part on the attainment of any financial reporting measure. The measures can be either GAAP or non-GAAP and include both stock and total stockholder return measures. However, discretionary cash awards not based on attainment of any financial reporting measure, and equity-based awards (including stock options and restricted stock units) subject to only time-vesting, are not included. 

Compensation is deemed to have been received in the fiscal period during which the financial reporting measure is attained, even if the actual payment or grant of the compensation occurs in a subsequent fiscal period. Awards subject to a financial performance measure that is followed by a service‑based vesting requirement would similarly be deemed received when the performance measure was attained, even if the award remains subject to service‑based vesting.

How is the recoverable amount of (or “excess”) incentive-based compensation determined? 

The recoverable amount of incentive‑based compensation is “the amount of incentive‑based compensation received by the executive officer or former executive officer that exceeds the amount of incentive‑based compensation that otherwise would have been received had it been determined based on the accounting restatement.” Companies must calculate the recoverable amount on a pre‑tax basis.

For equity awards, if an executive officer holds the shares, options, or restricted stock units (RSUs) at the time of recovery, the recoverable amount would be the excess number received. If the executive officer has exercised options or received shares in settlement of RSUs and still holds the shares, the recoverable amount would be the excess number of shares underlying the options (less the exercise price paid) or RSUs. If the executive officer has already sold the shares, the recoverable amount would be the sale proceeds received with respect to the excess shares. For incentive‑based compensation based on stock price or total shareholder return for which it may be difficult to calculate the impact of a restatement, companies may use a reasonable documented estimate of the effect of the accounting restatement on the stock price or total shareholder return to calculate the recoverable amount. Given the sensitivity and optics surrounding the amount to be recovered, companies may want to consider using a third-party provider to perform or validate such determination.

When can the board or committee administering the policy use discretion in determining whether to exercise their right to recover following a triggering event? 

Recovery is mandatory except under three narrow circumstances where recovery is considered impracticable. Those are (1) where the direct expenses paid to third parties to assist in enforcing the policy would exceed the amount to be recovered and the company has made a reasonable attempt to recover; (2) where recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet applicable tax requirements; or (3) in the case of a foreign private issuer, where pursuing such recovery would violate home country law in place at the time of adoption of the rule.

How and by when must the company recover excess incentive-based compensation? 

The new rules do not specify how companies must recover excess incentive‑based compensation—it is left to the company to determine the most appropriate means. The new rules also do not specify a time by which the company must recover the excess compensation. It is only stated that companies should recover excess incentive‑based compensation “reasonably promptly,” as undue delay would constitute noncompliance with the policy.

Can the company indemnify or insure executive officers for recovered compensation? 

Companies are prohibited from indemnifying, directly or indirectly, any current or former executive officer against the loss of erroneously paid incentive compensation. An executive officer may purchase an insurance policy to fund recovery obligations, but companies may not pay (or reimburse the premiums) for such policies.

What are the disclosure requirements under the new rules? 

Companies must file their clawback policy as an exhibit to their annual report on Form 10‑K, Form 20‑F, or Form 40‑F. These forms have been amended to include two new checkboxes on the cover pages. One checkbox is to indicate whether the financial statements reflect a correction of an error to previously issued financial statements. The other is to indicate whether any correction involved a restatement that required a compensation recovery analysis under the company’s clawback policy.

New Item 402(w) of Regulation S‑K requires disclosure in proxy and information statements if, at any time during or after the company’s last completed fiscal year, the company either (1) was required to prepare an accounting restatement that required a clawback under the company’s clawback policy or (2) there was an outstanding balance of unrecovered excess incentive‑based compensation relating to a prior restatement. The new rules require the Item 402(w) disclosure to be tagged using Inline XBRL format. If at any time during or after its last completed fiscal year a company was required to prepare an accounting restatement and concluded that recovery of erroneously awarded compensation was not required pursuant to the company’s clawback policy, the company must briefly explain why application of its clawback policy resulted in this conclusion.

The new 402(w) disclosures are not required to be included in the Compensation Discussion and Analysis (CD&A) of the proxy statement. If the disclosure is located outside the CD&A, it will not be incorporated by reference into other SEC filings and will not be captured as part of the compensation committee report.

Under a new instruction to Item 402(c) of Regulation S‑K, if recovered amounts reduce amounts previously reported in the Summary Compensation Table, the amount must be deducted from the applicable column and total column for the year in which the recovered amount was originally reported, and this amount must be identified in a footnote to the table.

What are the potential consequences for noncompliance?

Companies will face delisting for failure to adopt a clawback policy the meets the applicable listing standards, for failing to comply with the policy’s recovery provisions, and/or for failure to provide the required disclosures in accordance with SEC rules. 

Practical Tips for Adopting Compliant Policies 

  • Consider having two policies. There are several benefits to having one policy covering the SEC requirements and one policy for non-mandatory circumstances or non-covered individuals including: 
  • The ability to have discretion in determining whether and under what circumstances to recover compensation from non-executive officers.
    • The ability to maintain the confidentiality of the policy that applies to non-executive officers. 
    • In light of the Department of Justice’s focus on clawbacks in enforcements actions, having a separate discretionary clawback policy that includes material misconduct or violation of the company’s code of conduct may serve to help resolve criminal investigations. 
  • Review Existing incentive-based compensation provisions. Companies should evaluate their existing compensation programs to identify various elements potentially subject to clawback and consider whether to adjust performance metrics or the mix of incentive and non-incentive‑based compensation.
  • Update incentive compensation plans and agreements. Companies should incorporate language in incentive compensation plans and award agreements that specifically subjects incentive compensation awards to the company’s clawback policy. 
  • Review executive officer determinations. As all Section 16 officers and any other person identified as an executive officer in the company’s proxy statement or annual report will now be subject to potential clawback, companies should review their executive officer determinations to make sure that all individuals are properly classified. The determinations should be documented and updated at least annually.
  • Revise disclosure controls and procedures. Companies should review and, if necessary, revise their disclosure controls and procedures to ensure that they reflect the new disclosure requirements that apply to annual reports and proxy and information statements. 

A big and sincere shout-out to Savannah Spears and Chris Seifter for their assistance in preparing this posting.