On July 1, the Securities and Exchange Commission (“SEC”) proposed new rules that would direct securities exchanges to establish listing standards requiring listed issuers to adopt so-called “clawback” policies relating to incentive-based payments to executives.
Under proposed Rule 10D-1, listed issuers would be required to claw back from current and former executive officers any incentive-based compensation tied to accounting-related metrics, stock price or shareholder return they earned based on erroneous financial statements that later required restatement and correction. The look-back period would be three fiscal years.
New listing standards for national exchanges would compel delisting of issuers that do not:
SEC Chair Mary Jo White stated that “the proposed rules would result in increased accountability and greater focus on the quality of financial reporting.”
The SEC issued the proposed rules for public comment as required by the Dodd-Frank Act which we previously summarized in our July 2010 Securities Law Update: “Summary of Corporate Governance Changes in the Dodd-Frank U.S. Financial Regulatory Reform Act.”
This update provides an overview of the proposed changes and some of the supporting rationale. For a more detailed examination of the rule proposals, see the 198-page SEC Release no. 33-9861; 34-75342. Comments on the SEC proposals must be received on or before September 14, 2015.
The new rules would require national securities exchanges and associations to adopt clawback disclosure and recovery policy requirements for all listed issuers with few limited exceptions (for example, registered management investment companies that do not pay incentive compensation to executives).
However, emerging growth companies, smaller reporting companies, foreign private issuers and controlled companies, which are often exempt from (or benefit from delayed implementation of) new SEC rulemaking, would not be exempt from clawback compliance.
New listing standards would mandate clawbacks in the event that an issuer “is required to prepare an accounting restatement due to the material non-compliance of the issuer with any financial reporting requirement under the securities laws.”
The following changes to an issuer’s financial statements are examples of material error corrections that would trigger clawbacks:
The SEC cautioned that other clawback triggers may exist based on each case. In addition, issuers should consider whether a series of immaterial errors might be material in the aggregate, thus triggering restatement requirements.
The date on which an issuer would be required to prepare an accounting restatement is the earlier of:
Section 10D of the Securities Exchange Act of 1934 (“Exchange Act”), does not define “executive officers.” The SEC concluded that the law’s recovery policy was intended to apply to all executive officers of an issuer. The SEC therefore chose to use the broad definition of “executive officer” under Section 16 of the Exchange Act, which includes an issuer’s: president, principal financial officer, principal accounting officer, any vice-president of the issuer in charge of a principal business unit, division or function, any other officer who performs a policy-making function or any other person who performs similar policy-making functions for the issuer.
The SEC chose to define “incentive-based compensation” in a principles-based manner as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.” In doing so, the SEC did not want to limit the types of compensation that would be covered, including “new forms of compensation and new measures of performance upon which compensation is based are developed.”
Examples of financial reporting measures would include, but not be limited to:
Forms of compensation that would be subject to applicable recovery policies include:
Compensation that would not be incentive-based compensation would include:
Since compensation decisions and awards are generally made on a fiscal year basis, the three-year look-back period for an applicable recovery policy would consist of the three completed fiscal years immediately preceding the date an issuer is required to prepare an accounting restatement.
The proposed rules define the recoverable amount of executive compensation in the event of a restatement as “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.”
For incentive-based compensation based on stock price or total shareholder return, the recoverable amount may be determined based on “a reasonable estimate of the effect of the accounting restatement on the applicable measure.” An affected issuer would need to determine what the stock price would have been on the relevant date “but for” the release of erroneous financial information.
The recoverable amount for equity awards would be the amount received in excess of the number that should have been received based on the restated financial reporting measure.
There are circumstances in which pursuit of excess incentive-based compensation may not be in the interest of shareholders. Proposed Rule 10D-1 would provide that an issuer must recover erroneously awarded compensation “except to the extent that pursuit of recovery would be impracticable because it would impose undue costs on the issuer or its shareholders or would violate home country law,” provided that the home country law was adopted prior to the date of publication.
The extent to which an executive officer was not responsible for the financial statement errors, however, is not a legitimate factor for the issuer to consider in determining not to pursue recovery.
To prevent potential conflicts of interest, only the issuer’s committee of independent directors responsible for compensation decisions should make any determination that recovery is impracticable. In the absence of such a committee, a majority of independent directors should make the decision.
Issuers would be able to exercise some discretion in how to accomplish recovery, provided that recovery is reasonably prompt. This will provide flexibility in dealing with deferred compensation or compensation already granted, but difficult to pay back all at once. Thus, a reasonable recovery from future pay or from forfeiture of current rights to unvested equity might be permitted under the right conditions.
An issuer would be subject to delisting if it does not adopt and comply with its own compensation recovery policy. According to the SEC, failure to make good faith efforts at prompt recovery could constitute non-compliance.
Listed issuers would need to disclose their recovery policies, and append them as exhibits to annual reports on Form 10-K.
Issuers would also be required to provide, among other things, the following information in Item 402 disclosure:
A new instruction to the Summary Compensation Table would also require that any amounts recovered pursuant to an issuer’s recovery policy would reduce the amount reported in the applicable column for the relevant fiscal year with appropriate footnote identification.
Rule 10D-1, as proposed, would prohibit a listed issuer from indemnifying any executive officer or former officer against the loss of erroneously awarded compensation, or an issuer from paying for an insurance policy purchased by an executive.
The listing rules applicable to exchanges would have to be filed with the SEC no later than 90 days following publication of the final adopted version of the rule changes. The listing rules would have to go into effect no later than one year following that publication date.
Each listed issuer would also have to adopt the applicable required compensation recovery policies not later than 60 days following the date on which the rules become effective.