On October 26, 2022, the Securities and Exchange Commission (SEC) adopted new listing standards and rules to implement Section 954 (which added Section 10D to the Securities Exchange Act of 1934) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). A link to the SEC final rule release is included at the end of this memorandum under the heading “References.”
Consistent with Section 10D of the Exchange Act, the new rules require: (1) securities exchanges to establish listing standards that require listed issuers to implement and comply with—in the event of a required accounting restatement—an incentive-based compensation recovery policy (known as clawback policy), and (2) require listed issuers to provide disclosures about such policies and how they are being implemented.
Background
Following the 2007-2009 financial crisis, the Dodd-Frank Act of 2010 mandated the rule’s adoption to deter fraud and accounting mischief, but it was left unfinished in 2015. In October 2021 and again in June 2022, the SEC reopened the comment period for the 2015 proposed rules and provided the public with the opportunity to comment further.
The rules are intended to deter executives from engaging in questionable actions that temporarily increase share prices but ultimately result in a correction of financial statements. While many companies in recent years have embraced the practice of including similar voluntary clawback provisions in their compensation agreements, the final rule now requires companies to recover from any current or former executive officer incentive-based compensation that was erroneously awarded during the three years preceding the financial restatement.
Restatements Triggering Application of Recovery Policy
The SEC interpreted the statutory language of Section 10D— “an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities law”—broadly to involve both “Big R” and “little r” restatements.
“Big R” restatements correct errors that resulted in a material misstatement in previously issued financial statements. “Little r” restatements correct errors that would only result in a material misstatement if the errors were left uncorrected in the current report or if the error correction was recognized in the current period.
This interpretation is different from the 2015 proposal which did not include “little r” restatements. The SEC reasoned that the inclusion of “little r” restatements addresses concerns of opportunistic behavior by companies that would deliberately choose to do “little r” instead of “Big R” restatements to avoid clawbacks. Furthermore, under today’s U.S. GAAP requirement, both restatements are required.
Application of Recovery Policy
Companies and Executive Officers Subject to the Recovery Policy. The new rules apply to public companies of all sizes listed on U.S exchanges. The “executive officer” definition includes the issuer’s president, principal financial officer, principal accounting officer, any vicepresident of the issuer in charge of a principal business unit, division, or function (such as sales administration or finance), and any other officer or person who performs a policy-making function.
The compensation recovery provision applies to all executive officers irrespective of their responsibility in preparing the issuer’s financial statements. This broad application is intended to further incentivize high-quality financial reporting. However, the clawback policy does not apply to an individual who is an executive officer at the time recovery is required if that individual was not an executive officer during the period for which the incentive-based compensation is subject to recovery.
Compensation Subject to Recovery Policy. The recoverable amount is the incentive-based compensation received over the amount an executive would have earned if the revised financials had been in place during the three years preceding the date the issuer is required to prepare an accounting restatement. For example, if a calendar year issuer concludes in November 2024 that a restatement of previously issued financial statements is required and files the restated financial statements in January 2025, the recovery policy would apply to compensation received in 2021, 2022, and 2023. After recovery, the funds should be returned to the company.
Board Discretion. The rules provide three limited impracticability exceptions to the enforcement of the recovery policy where: (1) the direct cost of recovery exceeds the amount the company would claw back; (2) in the case of a foreign issuer— the recovery process would violate the law in its home country; or (3) recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code.
Direct costs include amounts paid to a third party, such as reasonable legal expenses and consulting fees. Indirect costs such as reputation or the effect of hiring new executive officers that are not readily quantifiable and susceptible to exaggeration should not be considered. Additionally, to minimize any incentive countries may have to change their laws in response to this provision, the relevant home country law must be adopted prior to the publication in the Federal Register of Rule 10D-1.
The disclosure requirements are designed to inform shareholders and the listing exchange about the substance of a listed issuer’s recovery policy as well as how that policy is implemented in practice.
The final rules become effective 60 days following publication of the adopting release in the Federal Register.
Exchanges will be required to file proposed listing standards within 90 days following publication of the release in the Federal Register, and the listing standards must be effective within one year following such publication.
Issuers subject to such listing standards will be required to adopt a recovery policy within 60 days following the date on which the applicable listing standards become effective. Issuers that do not adopt and comply with compensation recovery policies will be subject to delisting.
Under the new rules, a listed issuer must file its policy as an exhibit to its annual report and disclose how it has applied the policy, including:
- the date it was required to prepare an accounting restatement and the aggregate dollar amount of erroneously awarded compensation attributable to such accounting restatement;
- the aggregate amount that remains outstanding and any outstanding amounts due from any current or former named executive officer for 180 days or more; and
- details regarding any reliance on the impracticability exceptions.
Disclosure of Issuer Policy
The disclosure requirements are designed to inform shareholders and the listing exchange about the substance of a listed issuer’s recovery policy as well as how that policy is implemented in practice.
Under the new rules, a listed issuer must file its policy as an exhibit to its annual report and disclose how it has applied the policy, including:
- the date it was required to prepare an accounting restatement and the aggregate dollar amount of erroneously awarded compensation attributable to such accounting restatement;
- the aggregate amount that remains outstanding and any outstanding amounts due from any current or former named executive officer for 180 days or more; and
- details regarding any reliance on the impracticability exceptions.
Timing
The final rules become effective 60 days following publication of the adopting release in the Federal Register.
Exchanges will be required to file proposed listing standards within 90 days following publication of the release in the Federal Register, and the listing standards must be effective within one year following such publication.
Issuers subject to such listing standards will be required to adopt a recovery policy within 60 days following the date on which the applicable listing standards become effective. Issuers that do not adopt and comply with compensation recovery policies will be subject to delisting.
Potential Effects
While investor advocates, companies, and executives rarely criticize clawback policies in principle, SEC Commissioner Mark Uyeda and compensation consultants said the rules could lead companies to restructure compensation arrangements by increasing salaries rather than tying compensation to financial-reporting measures.
However, a study examining stock-market reactions of S&P 1500 firms after the SEC proposed the clawback rule in 2015 found that companies without existing clawback policies experienced “positive abnormal stock returns” following the announcement, suggesting that the “clawbacks are value-enhancing.”
If you have questions about how to implement or comply with the required clawback policy before the enforcement period begins, please reach out to Julie Herzog or Tim Spiel at Fortis Law Partners.
References
Final Rule: https://www.sec.gov/rules/final/2022/33–11126.pdf
Press Release: https://www.sec.gov/news/press–release/2022–192
Fact Sheet: https://www.sec.gov/files/33–11126–fact–sheet.pdf
Study: Bakke, Tor-Erik and Mahmudi, Hamed and Virani, Aazam, The Value Implications of Mandatory Clawback Provisions (June 28, 2018). Available at SSRN: https://ssrn.com/abstract=2890578 or http://dx.doi.org/10.2139/ssrn.2890578
