Insights

SEC Proposes Rules on Clawback Policies

What you need to know:

On July 1, 2015, the SEC proposed rules, provided for as part of the Dodd-Frank Act, that will require companies listed on US stock exchanges to adopt, enforce and disclose policies with respect to the recovery or “clawback” of incentive-based compensation earned by current and former officers in the three fiscal year period prior to the date the company is required to prepare an accounting restatement resulting from material noncompliance with financial reporting requirements.

What you need to do:

While the proposed rules may not be final until 2016, US public companies should:

  • Review existing clawback policies and compensation plans to determine the extent to which they would need to be updated to comply with the rules, once finalized;
  • Review the structure of existing compensation plans and awards to officers to determine which would be subject to the proposed rules and whether structural changes would provide for a more clear – and possibly limited - application to these awards or make it easier for companies to comply with the mandatory recoupment provisions of the proposed rules; and
  • Review the company’s Section 16 executive officer determinations to confirm the scope of persons who would be subject to the rules, once finalized.

The clawback rules proposed by the SEC supplement the existing clawback provisions of Section 304 of the Sarbanes-Oxley Act of 2002.  Section 304 applies to CEOs and CFOs of public companies to require reimbursement of certain bonus and incentive-based compensation when the company is required to restate its financial results due to material noncompliance, as a result of misconduct, with financial reporting requirements.  Section 304 may be enforced by the SEC and provides no private right of action.

The currently proposed rules are separate from Section 304 and are broader in reach – applying to all current and former Section 16 officers, triggered by an accounting restatement of financial results to reflect the correction of one or more errors that are material to those financial statements (regardless of misconduct), and being mandatory in application by the company.  The proposed rules will be implemented both by requiring US securities exchanges to adopt a requirement that listed companies comply with the rules and by requiring US listed companies to disclose the existence of and occurrence of events under the company’s policy.  Below is a summary of key provisions of the proposed rules.

Companies and Persons Covered

The proposed rules apply to all US exchange listed companies, including foreign private issuers, with limited exceptions for issuers of securities futures products and standardized options, unit investment trusts and registered investment companies that do not provide incentive-based compensation to their employees.

The persons subject to the proposed clawback are “officers” within the meaning of Section 16 of the Securities Exchange Act of 1934 who received incentive-based compensation during a three-year look-back period, as described below.  The definition of officers includes the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs policy making functions for the company.

When is Proposed Clawback Triggered

The proposed clawback is triggered upon the company being required to prepare an accounting restatement of its previously issued financial statements to correct one or more errors that are material.

For purposes of the rules, a company is “required to prepare a restatement” as of the earlier of:

  • The date the company’s board, a board committee or authorized officer concludes, or reasonably should have concluded, that the company’s previously issued financial statements contain a material error; and
  • The date a court, regulator or other body directs the company to restate its previously issued financial statements to correct a material error.

 A restatement is defined as the process of revising previously issued financial statements to correct one or more errors that are material to those financial statements.  Importantly, the proposed rules do not appear to include so-called “revision” restatements, where a company corrects immaterial errors of previously issued financial statements, without reissuing the previously issued historical statements.  However, the proposing release notes that companies should consider whether a series of immaterial error corrections could be considered a material error when viewed in the aggregate.

Incentive-Based Compensation Subject to Clawback

The proposed rules limit compensation subject to the clawback as incentive-based compensation, broadly defined to include compensation granted, earned or vested based wholly or in part on the attainment of any financial reporting measure, with financial reporting measures including:

  • Measures based on the accounting principles used in preparing the company’s financial statements;
  • Measures derived in whole or in part from such financial information, including measures such as EBITDA and free cash flow; and
  • Stock price and total shareholder return.

The use of the phrase “wholly or in part” means that awards subject to the proposed clawback would include those based in part on a financial measure and in part on a non-financial measure (such as a personal performance objective), and those based on a financial measure to which permitted discretion is then applied.  As noted above, companies will want to consider the application of the proposed rules to existing compensation plans to determine whether any structural changes would clarify or limit the application of the clawback rules to compensation based entirely on financial measures, for example, by bifurcating awards between those based solely on financial measures and those based solely on operational or other non-financial measures.

The clawback of incentive-based compensation would apply to compensation received during the three fiscal years preceding the date on which the company is required to prepare the accounting restatement, or such shorter period since listing of the company.  Compensation is deemed received upon satisfaction of the financial measure, even if such determination is subsequently made or the award is subject to additional conditions such as time-based vesting.

Recovery Amount and Process

The proposed rules provide that the recovery amount is the difference between the incentive-based compensation previously earned in the applicable performance period and that which would have been earned based on the restated financial results.  The proposing release gives guidance on the clawback calculation in more complicated scenarios such as equity awards that have been subsequently disposed of and awards based on stock price or total shareholder return.

Companies would be required to pursue recovery in all but two limited situations:

  • Where the direct cost of recovery would exceed the amount to be recovered; and
  • Where recovery would violate home country law.

The proposing release does note that companies would have discretion in how to accomplish recovery, including through offset against future pay or awards, but also provides that officers may not be indemnified by the company for any clawback amount.

Disclosure of Clawback Policy and Clawbacks

The proposed rules provide that the clawback policy would need to be filed as an exhibit to the company’s annual report.  In addition, disclosure would be required if there were a restatement in the prior fiscal year or an outstanding balance of excess incentive-based compensation relating to a prior restatement.