SEC Adopts Final Rules That Will Require the Recovery of Erroneously Awarded Compensation

Highlights of the Proposed Rules

Applicability	All companies listed on a national securities exchange or association, including emerging growth companies, smaller reporting companies, foreign private issuers, controlled companies and companies with listed debt only
Executive Officers Covered	Any current or former executive officer, including the president, principal financial officer, principal accounting officer (or, if none, the controller), any vice-president in charge of a principal business unit, division or function, and any other person who performs policy-making functions for the issuer
Recovery Triggers	(1) Material restatements of previously issued financial statements (also known as “Big R” restatements) and (2) restatements that correct errors that are not material to previously issued financial statements but would 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 (also known as “little r” restatements)
Recovery Period	Compensation received within a three-year recovery period that precedes the date of the accounting restatement
“No Fault” Recovery Mandate	Policy would apply even if an executive officer (or any other person) did not engage in misconduct and if the executive officer had no responsibility for the financial statement errors that resulted in the restatement
Compensation Subject to Recovery	Any compensation that is granted, earned or vested based, wholly or in part, upon attainment of any financial reporting measure, including stock price and total shareholder return (TSR)
Recoverable Amount	Incentive-based compensation received based on erroneous data in excess of what would have been paid without the accounting restatement
Discretion Not to Pursue Recovery	Recovery required except in three limited circumstances if the compensation committee (or majority of independent directors) determines that it would be impracticable: (1) if the direct costs of enforcing recovery would exceed the recoverable amount, (2) if recovery would violate home country laws applicable to the issuer that were in effect prior to the publication of the clawback rules, or (3) recovery would violate rules governing tax-qualified retirement plans
Failure to Comply	An issuer will be subject to potential delisting if it does not adopt, disclose or enforce its clawback policy
No Indemnification or Insurance to Mitigate Losses	An issuer will be prohibited from indemnifying executive officers against, or paying the premiums for an insurance policy to cover, losses incurred under the clawback policy
Required Filings	An issuer must file a clawback policy as an exhibit to its Form 10-K, Form 20-F or Form 40-F, as applicable
Required Disclosures in the Event of a Restatement	The date the issuer was required to prepare the accounting restatement and the total dollar amount of erroneously awarded incentive-based compensation resulting from the restatement An explanation of how the recoverable amount of compensation was calculated as well as any estimates used to determine the recoverable amount of compensation related to stock price or TSR The total amount of erroneously awarded compensation that had not yet been recovered as of the end of the issuer’s last completed fiscal year and the amount (for each applicable executive officer) unrecovered for more than 180 days since the date the issuer determined the amount If recovery was viewed to be impracticable, the amount of recovery forgone and the reason recovery was viewed as impracticable

Applicability

Section 10D of the Securities Exchange Act of 1934 required the SEC to adopt rules directing each national securities exchange and association to prohibit the listing of any security of an issuer that is not in compliance with the requirements to adopt and comply with a clawback policy for all erroneously awarded incentive-based compensation if the issuer is required to prepare an accounting restatement. The final rules adopted by the SEC require the exchanges to apply the disclosure and clawback policy requirements to all listed issuers, with only limited exceptions. As a result, emerging growth companies, smaller reporting companies, foreign private issuers, and controlled companies are all subject to the rules. The SEC did not grant the exchanges discretion to exempt certain categories of securities from their listing standards.

Executive Officers Covered

Exchange Act Rule 10D-1 defines “executive officer” as the “issuer’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division, or function (such as sales, administration, or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer,” which may include officers of the issuer’s parent or subsidiary. This definition conforms generally to the definition of officer in Rule 16a-1(f). This does not limit the scope of recovery to only officers who may be “at fault” for accounting errors that led to the restatement, nor does it limit application to those who were directly responsible for the preparation of the restated financial statements. However, the final rules will require recovery of incentive-based compensation received by a person only (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.

Recovery Trigger

The clawback policy must apply to both material restatements of previously issued financial statements (also known as “Big R” restatements) as well as restatements that correct errors that are not material to previously issued financial statements but would 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 (also known as “little r” restatements). The SEC’s decision to encompass little r restatements is a significant departure from the 2015 proposed rules.

Compensation Subject to Recovery

The rules define “incentive-based compensation” as “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure.” This definition was intended to be comprehensive and to capture new forms of compensation developed following the adoption of the rules. The term “financial reporting measure” was also designed to be read expansively and includes measures determined and presented in accordance with accounting principles used in preparing the issuer’s financial statements, non-GAAP measures, and other measures, metrics and ratios, such as same store sales. Included in this definition of “incentive-based compensation” are any measures derived in whole or in part from such financial measures as well as performance measures affected by accounting-related information, such as stock price and TSR. By this definition, reporting measures are subject to the rules even though they are not presented directly in financial statements or an SEC filing. Examples of financial reporting measures may include revenues, net income, operating income, profitability of one or more reportable segments and financial ratios.

The rules mandate that the clawback policy apply to compensation received within a three-year recovery period that precedes the date the restatement was required. Under the listing standards, the date on which an issuer is required to prepare an accounting restatement is the earlier to occur of (1) the date the issuer’s board of directors, a committee of the board of directors, or the officer or officers of the issuer authorized to take such action if board action is not required, concludes, or reasonably should have concluded, that the issuer is required to prepare an accounting restatement and (2) the date a court, regulator, or other legally authorized body directs the issuer to prepare an accounting restatement. The date of “receipt” of the incentive compensation is the date on which financial reporting measures are satisfied and depends on the terms of the award. For example, if an equity award vests only upon satisfaction of a financial reporting measure performance condition, then the award would be deemed received in the fiscal period in which it vests. The three-year look-back period is based on fiscal years rather than a preceding 36-month period.²

Recoverable Amount

The erroneously awarded compensation subject to clawback is defined 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.” The recoverable amount is without regard to taxes paid, and therefore the executive officer will bear the burden of any taxes previously paid on recovered compensation. Further, for incentive-based compensation based on TSR or stock price, where the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement, the amount to be recovered must be based on a reasonable estimate of the effect of the accounting restatement, and the issuer must maintain documentation of the determination of that reasonable estimate.

The SEC recognized commentators’ concerns about the subjectivity of calculating the amount of erroneously awarded incentive-based compensation that exceeds the amount that would have been properly received and emphasized that the final rules permit issuers to “use reasonable estimates” when determining the impact of the restatement. The SEC recommended the following steps to determine the amount of erroneously awarded incentive-based compensation:

1. After the accounting restatement, recalculate the applicable financial reporting measure and the amount of incentive-based compensation based thereon.
2. In cases where multiple financial reporting measures are used, determine the portion of original compensation based on the financial reporting measure(s) restated.
3. Determine whether, based on that newly calculated financial reporting measure and taking into account any compensation committee discretion that reduced the original amount received, the executive officer received a greater amount of compensation than would have been properly received.
4. To the extent that the financial metrics involve stock price and TSR, consider using reasonable estimates to determine the impact of the restatement.
5. Finally, calculate the amount of erroneously awarded compensation without respect to tax liabilities.

Discretion Not to Pursue Recovery

The recovery requirements of Section 10D apply regardless of fault or responsibility for the error or resulting restatement. Other than limited exceptions where recovery would be impracticable, the rules mandate recovery of erroneously awarded compensation. The very limited exceptions where the issuer’s board may exercise discretion not to pursue recovery are where (1) the direct costs of enforcing recovery would exceed the amount of recovery,³ (2) recovery would violate home country laws and additional conditions are met or (3) recovery would violate rules governing tax-qualified retirement plans. The manner of recovery is left to the discretion of the issuer’s board, although such discretion does not allow the board to waive recovery in whole or in part unless one of the limited exceptions is satisfied.

No Indemnification or Insurance to Mitigate Losses

Importantly, the rules prohibit issuers from indemnifying or insuring executive officers against the loss of erroneously awarded compensation.

Disclosure Requirements

Each listed issuer must file its clawback policy with its annual report on Form 10-K, Form 20-F or Form 40-F. Additionally, Item 402 of Regulation S-K was amended to require issuers to disclose how they have applied their recovery policies, if applicable. If, during its last completed fiscal year, the issuer either completed a restatement that required recovery or if there was an outstanding balance of excess incentive-based compensation relating to a prior restatement, the issuer must disclose certain information for each restatement in any Form 10-K or proxy or information statement that includes executive compensation disclosure, including (1) the date the issuer was required to prepare the accounting restatement and the total dollar amount of erroneously awarded incentive-based compensation resulting from the restatement, (2) an explanation of how the recoverable amount of compensation was calculated as well as any estimates used to determine the recoverable amount of compensation related to stock price or TSR, (3) the total amount of erroneously awarded compensation that had not yet been recovered as of the end of the issuer’s last completed fiscal year and the amount (for each applicable executive officer) unrecovered for more than 180 days since the date the issuer determined the amount, and (4) if recovery was viewed to be impracticable, the amount of recovery forgone and the reason recovery was viewed as impracticable.

The rules mandate that new check boxes be incorporated on the cover pages of Forms 10-K, 20-F, and 40-F. Listed issuers must use the check boxes to indicate (1) whether financial statements included in the filing reflect correction of an error to previously issued financial statements and (2) whether any of those error corrections are restatements that required a recovery analysis.

Process and Timeline

Each national securities exchange will be required to file its proposed listing standards no later than 90 days following the date of publication of the final rules in the Federal Register. The listing standards must be effective no later than one year following the final rules publication date. Each issuer subject to the listing standards must adopt a compliant clawback policy no later than 60 days following the date on which the applicable listing standards become effective. The mandated clawback policies must apply to any incentive-based compensation received on or after the effective date of the applicable listing standards. An issuer must file disclosures containing its clawback policy and the above-mentioned Item 402 information in its first annual report or proxy or information statement after the effective date of the new listing standards. On this time frame, which assumes typical publication timing and that the exchanges will not accelerate filing of their listing standards, issuers will likely need to comply with the clawback rules in late 2023 or early 2024. Issuers that fail to adopt and comply with the new rules, when implemented, will be subject to potential delisting.

State Law Conflicts

As listed issuers grapple with the reality of complying with the clawback rules and resulting policies, certain employers may have to further consider whether doing so will run afoul of state law, such as California Labor Code Section 221, which makes it “unlawful for any employer to collect or receive from an employee any part of wages theretofore paid by said employer to said employee."⁴ The SEC, for its part, chose to address this possibility head on in the final rules release, opining that “issuers should have strong arguments that state laws that conflict with Section 10D are preempted.” However, the SEC was careful to note that “the outcomes for any particular state law would depend on the details of that provision.” Indeed, for as long as the preemption question remains unsettled, employers will have to carefully consider whether their clawback policies will ultimately be interpreted to conflict with, and preempt, any state wage laws.

Practical Implications

Following implementation by the national securities exchanges, listed issuers must adopt a clawback policy or amend an existing clawback policy that complies with the listing standards. Companies should evaluate their existing clawback policies to determine whether they are in line with the mandates of the final rules and socialize any expected changes with their boards. Given the inclusion and potential frequency of little r restatements, companies may wish to analyze prior little r restatements to inform the board of what the historical impact of the rules would have been to give boards a sense of the practical implication of the rules. In addition, in light of the potential for recovery and the inability to waive recovery, issuers should consider whether they may need to develop processes for recovery of compensation in the event of a restatement. As always, establishment of solid internal controls related to financial reporting is imperative to reduce the likelihood of any restatement.

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