On July 1, 2015, the Securities and Exchange Commission (SEC) proposed for comment new “clawback” rules. The proposed rules would require the national securities exchanges (exchanges), including the New York Stock Exchange and The NASDAQ Stock Market, to prohibit the listing of any issuer that does not adopt, disclose and comply with a broad policy to recover excess incentive-based compensation from executive officers in the event of an accounting restatement. The rules would implement Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and are the last rules required by Dodd-Frank to be proposed by the SEC relating to executive compensation. The rules were approved in a three-to-two vote along party lines, with two SEC Commissioners issuing lengthy public statements expressing dissatisfaction with the rule as proposed, and the SEC time and resources devoted to the development and proposal of the rule.
The proposed rules, if implemented, would direct the exchanges to develop listing standards requiring listed companies to implement a policy to recover from executive officers, in the event of an accounting restatement, incentive-based compensation that would not have been paid under the restated financial statements. As proposed, the recovery policy requirement would apply broadly to all listed issuers, including emerging growth companies, smaller reporting companies, foreign private issuers, controlled companies and companies with listed debt that do not have listed equity, with only limited exceptions for issuers only with listed security futures products or standardized options and the securities of certain registered investment companies.
The proposed rules require the exchanges to mandate that listed companies develop, disclose and comply with a compensation recovery policy if an issuer is required to prepare an accounting restatement due to material non-compliance with the financial reporting requirements under the securities laws. Under the proposed rules, there would be “material non-compliance” if an issuer is required to prepare a restatement to correct an error that is material (or a series of non-material errors that considered together are material) to previously issued financial statements.
The recovery policy would apply broadly to all current and former “executive officers” of the issuer, extending the recoupment beyond the “named executive officers” for whom executive compensation disclosure is required under Item 402 of Regulation S-K. The term executive officer would be defined in the listing standards proposed by the exchanges, but would be modeled on the definition of “officer” in Rule 16a-1(f) under the Securities Exchange Act of 1934, and would include the president, the principal financial officer, the principal accounting officer (or controller), any vice president in charge of a principal business unit, division or function, and any other officer who performs a policy-making function (including executive officers at subsidiaries of the issuer if they perform a policy-making function for the issuer).
The SEC’s proposed clawback rules would require recovery of “incentive-based compensation,” including stock options awarded as compensation, that is received in excess of what would have been paid to the executive officer under the financial statements as restated. The SEC declined to identify each type or form of compensation to which a recovery policy would apply, instead employing a principles-based manner of identifying such compensation to permit the rule to operate effectively as new forms of compensation and financial measures of performance upon which compensation is based are developed. As a result, the proposed rules broadly 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.
The SEC similarly declined to list all financial reporting measures, but instead defined the term as “measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measures that are derived wholly or in part from such financial information, and stock price and total shareholder return” (TSR).
Incentive-based compensation includes options and other equity awards, such as restricted stock units (RSUs), performance stock units (PSUs) or stock appreciation rights (SARs), as well as non-equity awards, such as bonuses, if in each such case, they are granted or vest based wholly or in part on the attainment of any measure based on or derived from financial reporting measures.
The inclusion of stock price and TSR within financial reporting measures has generated some criticism, given the difficulty in calculating the impact of an accounting restatement on those two performance metrics. In the proposing release, the SEC notes that issuers may need to engage in complex analyses that require significant technical expertise and specialized knowledge to determine the stock price impact of a material restatement. However, issuers would be permitted to use reasonable estimates when determining the impact of a restatement on stock price and TSR, provided that such estimates are disclosed. The SEC intends both definitions to apply broadly and flexibly.
Recovery policies will apply to recoup incentive-based compensation received by executive officers during the three-year period preceding the date on which the issuer is required to prepare a financial restatement. Under the proposed rules, the recovery of excess incentive-based compensation by listed issuers would be mandatory, except to the extent that the issuer can show that pursuit of recovery would be impracticable. Listed issuers should note that these new proposed clawback rules, when implemented, will supplement the existing clawback rules under Section 304 of the Sarbanes-Oxley Act and will not alter or affect an issuer’s obligations under that provision. The rules contemplate that if an issuer undertakes a compensation recovery under Section 304, the amount of any such recovery would be credited to the recovery required under new proposed Rule 10D-1. The comment period for the proposed rules closes on September 14, 2015.