SEC Proposes New Rule Requiring Clawback of Executive Incentive-Based Compensation

 

August 3, 2015

 

On July 1, 2015, the Securities and Exchange Commission (“SEC”) proposed new rules and amendments to certain forms that would require, in the event of a subsequent accounting restatement, the clawback of incentive-based compensation received by executive officers and former executive officers of listed companies. The clawback would be required without regard to an executive officer’s responsibility for the erroneous financial statements.

 

The proposed rules would implement Section 10D of the Securities Exchange Act of 1934 (“Exchange Act”) added pursuant to Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

 

The section requires the SEC to adopt rules directing the national securities exchanges and national securities associations to establish standards to require listed issuers to develop and implement a policy providing:

  • for the disclosure of the issuer’s policy on incentive-based compensation that is based on financial information required to be reported under the securities laws

  • in the event the issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, to recover from the issuer’s executive officers excess incentive-based compensation received during the three-year period preceding the date the issuer is required to prepare the accounting restatement

 

An issuer would be subject to de-listing if it does not comply with the new listing standards, including complying with the policy’s clawback provisions

 

Issuers Subject to Proposed New Rule

 

Proposed new Rule 10D-1 would apply to all “listed issuers,” subject to certain limited exceptions and would include smaller reporting companies, emerging growth companies (EGCs), foreign private issuers, and controlled companies.

 

Securities Subject to Proposed New Rule

 

Section 10D applies to “any security” of an issuer, including equity, debt and preferred securities. Also, the rule would apply to security futures products, standardized options, and the securities of registered investment companies, subject to certain limited exemptions

 

Clawback Policy Trigger

 

In the event an issuer is required to prepare an accounting restatement to correct an error that is “material to previously issued financial statements,” the obligation to prepare the restatement would trigger the application of the clawback policy.

 

The SEC does not propose to describe any type or characteristic of an error that would be material under the rule; however, the SEC stated that issuers should consider whether a series of immaterial error corrections, whether or not they result in filing an amendment to previously filed financial statements, could be considered a material error when viewed in the aggregate.

 

Further, the following types of changes to financial statements would not represent error corrections and would not trigger application of the clawback policy:

  • retrospective application of a change in accounting principle

  • retrospective revision to reportable segment information due to a change in the structure of an issuer’s internal organization

  • retrospective reclassification due to a discontinued operation

  • retrospective application of a change in reporting entity, such as from a reorganization of entities under common control

  • retrospective adjustment to provisional amounts in connection with a prior business combination

  • retrospective revision for stock splits

 

Period of Clawback

 

Section 10D requires the clawback of excessive incentive-based compensation “during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement.”

 

The section does not specify when a listed issuer is “required to prepare an accounting restatement” for purposes of the clawback provisions.

 

Under the proposed rule, the date on which an issuer is required to prepare an accounting restatement is the earlier of:

  • the date the issuer’s board of directors, a committee of the board, or authorized officers conclude, or reasonably should have concluded, that the issuer’s previously issued financial statements contain a material error; or

  • the date a court, regulator or other legally authorized body directs the issuer to restate its previously issued financial statements to correct a material error.

 

The SEC stated that the first proposed date generally is expected to coincide with the occurrence of the event described in Item 4.02(a) of Form 8-K although neither is predicated on a Form 8-K having been filed.

 

Executive Officers Covered by Clawback Policy

 

Section 10D provides for the clawback of excess incentive-based compensation from “any current or former executive officer of the issuer who received incentive-based compensation.” Covered executive officers would, therefore, by a broader group than the “named executive officers” for whom executive compensation is included.

 

For purposes of the proposed rule, “executive officer” would include:

  • president

  • principal financial officer

  • principal accounting officer (or, if none, the controller)

  • 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

  • executive officers of the issuer’s parent or subsidiaries would be deemed executive officers of the issuer if they perform such policy making functions for the issuer

 

As is the case for Section 16 officer determination, if, pursuant to Item 401(b) of Regulation S-K, the issuer identifies a person as an “executive officer,” it would be presumed that the board has made that judgment and the persons identified are executive officers for purposes of the proposed rule.

 

The clawback policy would apply to any executive officer who received incentive-based compensation who served as an executive officer at any time during the performance period for that incentive-based compensation.

 

Accordingly, this would include incentive-based compensation derived from an award authorized before the individual becomes an executive officer, and inducement awards granted to new hires, as long as the individual served as an executive officer of the listed issuer at any time during the award’s performance period.

 

Compensation Subject to Clawback

 

For purposes of the proposed rule, “incentive-based compensation” is defined as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.”

 

“Financial reporting measures” would be measures that are determined and presented in accordance with accounting principles used in preparing the issuer’s financial statements, any measures derived wholly or in part from such financial information, and stock price and total shareholder return.

 

Examples of financial measures would include the following:

  • accounting-based measures (including measures derived from such measures)

  • revenue

  • net income

  • operating income

  • profitability of one or more reportable segments

  • financial ratios

  • net assets or net asset value per share (for RICs and BDCs)

  • EBITDA

  • funds from operations, and adjusted funds from operations

  • liquidity measures

  • return measures

  • earnings measures

  • sales per square foot or same store sales, where sales is subject to accounting restatement

  • revenue per user (or average revenue per user ) where revenue is subject to accounting restatement

  • cost per employee

  • any of such financial reporting measures relative to a peer group

  • tax basis income

  • performance measures based on stock price or total shareholder return

 

The definition does not encompass all types of incentive compensation.

 

An incentive plan award that is granted, earned or vested based solely upon the occurrence of certain non-financial events would not be “incentive-based compensation.”

 

Incentive-based compensation would include the following if the grant or vesting is based wholly or in part upon the attainment of any measure based upon or derived from financial reporting measures:

  • options

  • cash awards

  • bonuses paid from a bonus pool, the size of which is determined based wholly or in part on satisfying a financial reporting measure or performance goal

  • restricted stock, restricted stock units, performance share units, stock appreciation rights

  • proceeds received upon the sale of shares acquired through an incentive plan

 

The following compensation would not be incentive-based compensation:

  • salaries

  • bonuses paid solely at the discretion of the compensation committee or board that are not paid from a bonus pool, the size of which is determined based wholly or in part on satisfying a financial reporting measure or performance goal

  • bonuses paid solely upon satisfying one or more subjective standards/li>

  • non-equity incentive plan awards earned solely upon satisfying one or more strategic measures, or operational measures

  • equity awards for which grant is not contingent on achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more non-financial reporting measures

 

Clawback Time Period

 

Section 10D provides the clawback policies apply to excess incentive-based compensation received during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement.

 

The three-year look back period for the clawback policy would be the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement.  The SEC provided the following example: if a calendar year issuer concludes in November 2018 that a restatement of previously issued financial statements is required and files restated financial statements in January 2019, the clawback policy would apply to compensation received in 2015, 2016 and 2017.

 

If an issuer has changed its fiscal year end during the three-year look-back period, the issuer would be required to recover any excess incentive-based compensation received during the  transition period occurring during, or immediately following, that three-year period in addition to any excess incentive-based compensation received during the three-year look-back period (i.e., a total of four periods).  A transition period refers to the period between the closing date of the issuer’s previous fiscal year end and the opening date of its new fiscal year.  However, a transition period of 9 to 12 months would be considered a full year in applying the three-year look-back period.

 

When is Incentive-Based Compensation “Received?”

 

As proposed under the rule, incentive-based compensation would be deemed “received” in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if the payment or grant occurs after the end of the period.

Accordingly, the date of receipt would depend upon the terms of the award. 

 

If the grant of an award is based on satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when the measure is satisfied.  If an equity award vests upon satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when it vests rather than on the date issued.  A cash award earned upon satisfaction of a financial reporting measure would be deemed received in the fiscal period when the financial reporting measure is satisfied rather than the date paid.

 

Also, incentive-based compensation would be subject to clawback to the extent it is received while the issuer has a class of securities listed on an exchange or an association.  Incentive-based compensation granted before the issuer lists a class of securities would be subject to clawback so long as the incentive-based compensation is received while the issuer has a class of securities listed.  Similarly, incentive-based compensation received before the issuer’s securities become listed would not be subject to clawback.

 

Recovery Process

 

Section 10D requires an issuer’s clawback policies apply to the amount of incentive-based compensation received “in excess of what would have been paid to the executive officer under the accounting restatement.” 

 

The proposed rule establishes how excess compensation subject to clawback should be determined, as follows:

 

Determination of Excess Compensation.  The proposed new rule provides that the “excess 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.

 

Accordingly, after an accounting restatement, the issuer would recalculate the applicable financial reporting measure and the amount of incentive-based compensation based thereon and determine whether the executive officer received a greater amount of incentive-based compensation than would have been received applying the recalculated financial reporting measure. 

 

If the incentive-based compensation is based on stock price or total shareholder return, where the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement, the recoverable amount may be determined based on a reasonable estimate of the effect of the accounting restatement on the applicable measure. The issuer would be required to maintain documentation of the determination of the reasonable estimate and provide such documentation to the relevant exchange or association.

 

The clawback amount would be calculated on a pre-tax basis.

 

The SEC recognized the potential overlap between the proposed rule and Section 304 of the Sarbanes-Oxley Act of 2002, discussed below.  Accordingly, if an executive officer reimburses an issuer pursuant to Section 304, such amounts would be credited to the extent an issuer’s clawback policy requires repayment of the same compensation by that executive officer.  Recovery under the proposed rule would not preclude recovery under Section 304 to the extent any applicable amounts have not been reimbursed to the issuer.

 

Proposed Rule 10D-1 would prohibit a listed issuer from indemnifying any executive officer against loss of the recovered compensation.

 

Board Discretion Regarding Whether to Seek Recovery.  The proposed new rule does not give an issuer’s board of directors discretion to determine whether or not it is required to recover erroneously awarded compensation under the clawback policy except to the extent that pursuit of recovery would be impracticable because it would:

  • impose undue costs on the issuer or its shareholder, or

  • would violate home country law adopted prior to the date of publication of the proposed rule in the Federal Register

 

The issuer would need to make a reasonable attempt to recover incentive-based compensation, would be required to document its attempts to recover and provide such documentation to the exchange, and disclose why it determined not to pursue clawback. Before concluding it would be impracticable to clawback due to violation of home country law, an opinion of home country counsel to such effect would be required

 

Any determination that recovery would be impracticable would need to be made by the issuer’s committee of independent directors responsible for executive compensation decisions or, in the absence of such a committee, a majority of independent directors.  The reasons for such determination would be required to be disclosed.

 

Board Discretion Regarding Differential Recovery.  Under the proposed rule, an issuer’s board of directors would not be permitted to pursue differential recover among executive officers, including in “pool plans,” where the board may have exercised discretion as to individual grants in allocating the bonus pool. 

 

Clawback should be pro rata based upon the size of the original award rather than discretionary.

 

Also, issuers will not be permitted to settle for less than the full clawback amount unless impracticable from a cost standpoint.

 

Means of Recovery.  Issuers will have discretion in how to clawback incentive-based compensation but should do so reasonably promptly.

 

Compliance with Clawback Policy

 

An issuer would be subject to delisting if it does not adopt and comply with its compensation clawback policy. The exchange would determine whether the steps an issuer is taking constitute compliance with the issuer’s recovery policy.

 

Disclosure of Issuer Policy on Incentive-Based Compensation

 

Section 10D requires exchanges and associations to adopt listing standards that call for “disclosure of the policy of the issuer on incentive-based compensation that is based on financial information required to be reported under the securities laws.” 

 

The SEC stated in the proposing release it interprets this to mean that it requires disclosure of the listed issuer’s policy related to recovery of erroneously awarded compensation.  Accordingly, the proposed rule would require listed issuers to disclose their clawback policies.

Listed U.S. Issuers.  The proposed rule would require U.S. listed issuers to file their clawback policy as an exhibit to their annual report on Form 10-K.

 

Also, under a proposed amendment to Item 402 of Regulation S-K, a listed issuer will be required to disclose how it has applied its clawback policies.

 

Proposed new Item 402(w) of Regulation S-K would apply if “at any time during its last completed fiscal year either a restatement that required recovery of excess incentive-based compensation pursuant to the listed issuer’s compensation recovery policy was completed or there was an outstanding balance of excess incentive-based compensation from the application of that policy to a prior restatement.” 

 

In this circumstance, the listed issuer would be required to provide the following information in its Item 402 disclosure:

  • for each restatement, the date on which the listed issuer was required to prepare an accounting restatement, the aggregate dollar amount of excess incentive-based compensation attributable to such accounting restatement and the aggregate dollar amount of excess incentive-based compensation that remains outstanding as of the end of its last completed fiscal year

  • the estimate used to determine the excess incentive-based compensation attributable to such accounting restatement, if the financial reporting measure related to stock price or total shareholder return metric

  • the name of each person subject to recovery of excess incentive-based compensation attributable to an accounting restatement, if any, from whom the listed issuer decided during the last completed fiscal year not to pursue recover, the amount foregone for each such person, and a brief description of the reason the listed issue decided in each case not to pursue recovery

  • the name of, and amount due from, each person from whom, at the end of its last completed fiscal year, excess incentive based compensation had been outstanding for 180 days or longer since the date the issuer determined the amount the person owed

 

As proposed, the Item 402(w) disclosure will be required as a separate item along with other compensation disclosure in an issuer’s annual report or proxy statement.

 

In addition, amounts recovered under the issuer’s clawback policy reduce the amount reported in the applicable column of the Summary Compensation Table for the fiscal year in which the amount recovered initially was reported and would be identifiable by footnote.

 

The disclosure required by proposed Item 402(w) would be required to be provided in interactive data format using XBRL using block-text tagging.

 

Listed Foreign Issuers. Under the proposed rule, foreign private issuers would be required to provide the same information called for in Item 402(w) in the annual reports they file with the SEC under Section 13(a) of the Exchange Act and file their clawback policies as an exhibit.

 

Certain Other SEC Statutes and Rule Addressing Recovery of Executive Compensation

 

In addition to Section 10D, there are certain other statutory provisions and rules administered by the SEC that address the recovery of executive compensation, including:

  • Section 304 of SOX which provides that if an issuer is required to prepare an accounting restatement due to material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirements under the securities laws, the CEO and CFO of the issuer shall reimburse the issuer for any bonus or other incentive-based or equity-based compensation received from the issuer during the 12-month period following the first public issuance or filing with the SEC of the financial document embodying such financial reporting requirement, and any profits from the sale of securities of the issuer during that 12-month period.

  • Item 402(b) of Regulation S-K includes, as an example of the kind of information that should be addressed, if material, in the company’s CD&A, company policies and decisions regarding the adjustment or recovery of awards or payments to named executive officers if the relevant company performance measures upon which they are based are restated or otherwise adjusted in a manner that would reduce the size of an award or payment

 

What Action Should a Listed Issuer be Taking?

Listed issuers should:

  • update its board of directors and its compensation committee regarding the requirements of the proposed rule

  • consider the implication of the proposed rule for any existing or proposed incentive-based executive compensation, including any prior grants or awards and executive employment agreements or arrangements

  • consider the issuer’s approach to the proposed new rule and the anticipated structure of its clawback policies

 

Due Date for Comments

 

Comments on the proposed new rules and form amendments must be received by the SEC by September 14, 2015.

 

For more information, please contact: 
 

Neil R.E. Carr                                                               
Direct Dial: +1 202 587 2983                                       
neil.carr@somertons.com                                             

 

Kathleen L. Cerveny

Direct Dial: +1 202 779 9507

kathleen.cerveny@somertons.com

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