SEC Proposes Listing Standards for Clawback of Erroneously Awarded Incentive-Based Compensation

Author(s): Andrew MacDougall, Sandra Cohen, James Lurie, Matthew Sadofsky

July 10, 2015

On July 1, 2015, the Securities and Exchange Commission proposed rules to require issuers of securities listed on U.S. stock exchanges to adopt, disclose and enforce incentive-based compensation clawback policies. Issuers would be required to recover incentive-based compensation granted, vested or earned by current and former executive officers of the issuer in the event of a restatement of financial statements due to errors that are material to the previously issued financial statements. The policies must apply to incentive-based compensation received in the three-year period preceding the date the issuer is required to restate previously issued financial statements due to an error. The amount to be clawed back is the excess of what would have been granted, vested or paid based on the restated financial statements. Whether or not the executive officer engaged in misconduct contributing to the financial restatement or otherwise shares any responsibility for the error prompting the financial misstatement is irrelevant to determining both whether the executive officer is affected and the amount to be clawed back.

Highlights

• Applies to all issuers listed on U.S. stock exchanges with very limited exceptions
• Affects all persons who were executive officers during the relevant period
• Relevant period is the three completed financial years preceding the date the issuer is required to restate financial results
• Covers all incentive-based compensation where the amount granted, vested or earned is based, whether in whole or in part, on a financial reporting measure, stock price or total shareholder return
• The degree to which an executive is “at fault” is not relevant
• Amounts to be recovered are pre-tax
• Board has discretion to determine the manner of recovering amounts but not as to the amount to be recovered or, except in limited situations, whether to forego recovery
• Issuer cannot indemnify affected executive officers against recovery
• Must publicly file a copy of the compensation recovery policy
• Must publicly disclose status reports on recovery efforts, including the names of individuals for whom recovery is not being pursued or for which unrecovered amounts have been outstanding for more than six months, including the amounts to be recovered from each person
• Proposed disclosure requirements may facilitate challenges by plaintiffs’ bar to the issuer’s administration of its clawback policy

If implemented, the SEC’s proposed rules would have a wide-ranging impact on all issuers listed on U.S. stock exchanges and would strongly influence practice for Canadian issuers who are not listed on U.S. stock exchanges. We strongly encourage issuers to submit comments during the 60-day comment period and we can help you do so. At this time, we recommend that issuers not change their existing compensation clawback or recoupment arrangements to align with these proposals.

What are the Canadian implications of the proposed rules?

The SEC’s proposed rules will apply to foreign private issuers listed on U.S. stock exchanges. Although some U.S. stock exchange listing standards permit foreign private issuers to follow home country practice in lieu of certain corporate governance requirements, the SEC’s proposed rules would not permit exchanges to exempt foreign private issuers from compliance. However, foreign private issuers would be permitted to forgo recovery if recovery would violate applicable home country law, but only if the home country law was in effect prior to the date the SEC’s proposed rules were published in the Federal Register and only if the issuer has obtained and provided to the exchange an opinion from home country counsel that recovery would violate home country law and such opinion is acceptable to the exchange. It is unclear whether recovery pursuant to a clawback policy that conforms to the SEC’s proposal is enforceable in Canada or would violate Canadian employment laws.

A significant number of Canadian issuers, including Canadian issuers not listed on a U.S. stock exchange, have adopted compensation clawback arrangements. Generally, these arrangements contemplate a double-trigger, involving both a financial restatement and misconduct on the part of the executive contributing to the restatement, aligning to provisions under Section 304 of the Sarbanes-Oxley Act of 2002. However, some Canadian issuers have already adopted a “no fault” standard where compensation may be clawed back in the event of a financial restatement even if the executive did not engage in any misconduct. SEC adoption of final rules on compensation clawbacks is likely to accelerate clawback arrangement adoption rates in Canada and increase the number of arrangements triggered by a financial restatement even in the absence of misconduct.

Which issuers would be affected?

The new rules would apply to all listed issuers, including foreign private issuers, emerging growth companies, smaller reporting companies and controlled companies, and issuers of listed debt and preferred stock, with limited exceptions for issuers of securities futures products or standardized options, unit investment trusts and registered management investment companies that have not awarded incentive-based compensation to any executive officer in the last three fiscal years (or, if shorter, since initial listing).

When and for what period is the clawback obligation triggered?

A clawback would be triggered when an issuer is required to prepare a restatement to correct an error (as defined in ASC Topic 250 and IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, paragraph 5) that is material to previously issued financial statements. Financial restatements which do not result from the correction of an error would not trigger application of the clawback policy. For example, restatements due to changes to accounting principles, certain internal restructurings, certain adjustments in connection with business combinations and revisions due to stock splits would not be considered “errors” triggering clawbacks. Materiality must be analyzed in the context of particular facts and circumstances, and should be considered on an individual and collective basis. In the proposing release, the SEC stated that “issuers should consider whether a series of immaterial error corrections, whether or not they resulted in filing amendments to previously filed financial statements, could be considered a material error when viewed in the aggregate.

An issuer’s obligation to recover excess incentive-based compensation is not dependent on if or when the restated financial statements are filed; instead the obligation is triggered when the issuer “is required to prepare an accounting restatement” which the SEC has defined as the earlier to occur of:

• 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’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 first proposed date generally is expected to coincide with the occurrence of the event described in Item 4.02(a) of Form 8-K [non-reliance on previously issued financial statements], although neither the actual filing of a Form 8-K nor a determination of the precise amount of the error is required. The policy must apply for the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement, with a special rule for issuers changing fiscal years.

Which executive officers are subject to the clawback policy?

The clawback policy would apply to current and former “executive officers” of the issuer who received incentive-based compensation during the applicable three-year fiscal period. For this purpose, the SEC has defined “executive officers” in the same way as the “officer” definition for Section 16 purposes, namely “an 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.” Executive officers of the issuer’s parent(s) or subsidiaries would be deemed executive officers of the issuer if they perform such policy-making functions for the issuer.

Former executive officers would include any individual who served as an executive officer at any time during the performance period for the incentive-based compensation received during the applicable three-year fiscal period. Accordingly, incentive-based compensation derived from an award authorized before the individual becomes an executive officer, and inducement awards granted in new hire situations, would be recoverable under the clawback rules as long as the individual served as an executive officer of the listed issuer at any time during the award’s performance period. However, recovery would not apply to an individual who is an executive officer at the time recovery is required if that individual had not been an executive officer at any time during the performance period for the incentive-based compensation subject to recovery.

What compensation is “incentive-based” and what compensation is not “incentive-based”?

The proposed 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. Financial reporting measures are measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measures derived wholly or in part from those measures,^[1] and stock price and total shareholder return (TSR).

Incentive-based compensation includes:  

• bonuses earned wholly or in part based on satisfying a financial reporting measure performance goal;
• bonuses paid from a bonus pool, if the pool size is based wholly or in part on satisfying a financial reporting measure performance goal;
• equity awards (such as restricted stock, restricted stock units, performance share units, stock options and stock appreciation rights) granted or vested based wholly or in part on satisfying a performance goal based on a financial reporting measure, TSR or achieving a certain stock price; and
• proceeds received upon the sale of shares acquired under an equity award that was granted or that vested wholly or in part on satisfying a financial reporting measure performance goal.

Incentive-based compensation does not include:

• salaries (other than any portion of a salary earned wholly or in part based on the attainment of a financial reporting measure);
• 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 performance goal;
• bonuses paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) and/or completion of a specified employment period;
• non-equity incentive plan awards earned solely upon satisfying one or more strategic measures such as consummating a merger or divestiture, or operational measures such as opening a specified number of stores, completion of a project or increase in market share; and
• equity awards for which the grant is not contingent upon 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.

Accordingly, time-vesting stock options, restricted share units and restricted shares are not “incentive-based” if the grant amount was not tied to achievement of performance goals or measures.

When is erroneously awarded compensation deemed to be “received”?

Incentive-based compensation “received” during the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement is subject to recovery. Incentive-based compensation would be deemed received in the fiscal year during which the financial reporting measure specified is attained (regardless of when granted or paid), even if not all conditions to payment have been satisfied (such as additional service conditions or board certification of performance criteria). Accordingly, even if other conditions to an award exist, if (i) the grant of an award is based, either wholly or in part, on satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when that measure was satisfied; (ii) an equity award vests upon satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when it vests; and (iii) a cash award is earned upon satisfaction of a financial reporting measure, it would be deemed received in the fiscal period when that measure is satisfied.

What is the recoverable amount under the clawback policy?

The SEC has proposed to define “recoverable amount” 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 SEC anticipates that the issuer would recalculate the applicable financial reporting measure based on the restated financial results and recalculate the amount of incentive-based compensation that would have been received based on such recalculated measure. Any negative or positive discretion used in determining the amount originally received by the executive officer would also be applied to the recalculated amount.

Where incentive-based compensation is based only in part on the achievement of a financial reporting measure performance goal, the issuer would first determine what portion of the original incentive-based compensation was based on or derived from the financial reporting measure that was restated and the recalculated amount would reflect only the portion affected.

For incentive-based compensation that is based on stock price or TSR, and 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. In the proposing release, the SEC noted that there are a number of possible methodologies with different levels of complexity that could be used to obtain such reasonable estimates and related costs, and the issuer would be required to maintain documentation of the determination of that reasonable estimate and provide such documentation to the relevant exchange. It also noted that an “event study” may need to be conducted and that outside experts may be necessary to give an estimate deemed “reasonable,” as well as the possibility that an executive officer could challenge the estimate.

For incentive-based compensation where the financial reporting measure is applied to a pool from which individual awards are made, if the size of the aggregate pool determined based on applying the recalculated financial reporting measure would be less than the aggregate amount awarded from the pool, a pro rata share of the deficiency would be applied to the incentive-based compensation received by each executive officer or former executive officer from the pool. For non-qualified deferred compensation, the executive officer’s account balance or distributions would be reduced by the excess incentive-based compensation contributed to the non-qualified deferred compensation plan and the interest or other earnings accrued thereon under the non-qualified deferred compensation plan. In addition, for retirement benefits under pension plans, the excess incentive-based compensation would be deducted from the benefit formula, and any related distributions would be recoverable.

For equity awards, if the shares, options or SARs are still held at the time of recovery, the recoverable amount would be the number received in excess of the number that should have been received applying the restated financial reporting measure. If the underlying shares have been sold, the recoverable amount would be the sale proceeds received by the executive officer with respect to the excess number of shares. In any case in which the shares have been obtained upon exercise and payment of an exercise price, the recoverable amount would be reduced to reflect the applicable exercise price paid.

In all cases, the recoverable amount would be calculated on a pre-tax basis to ensure that the company recovers the full amount of incentive-based compensation that was erroneously awarded. The SEC believes recovery on a pre-tax basis also avoids the burden and administrative costs associated with calculating recoverable amounts based on the particular tax circumstances of individual executive officers. We note that issuers that have adopted their own compensation clawback arrangements often take into account tax implications to the affected executive officer, or provide discretion to the issuer to do so. The SEC’s proposals would not permit this.

Is the issuer required to pursue recovery and what discretion may be applied?

The issuer must pursue recovery unless it would be impracticable because it would impose undue costs on the issuer or its shareholders or, in the case of foreign private issuer, would violate home country law. The SEC’s proposing release is unclear on whether a clawback of incentive-based compensation from an executive officer residing in a foreign country, but employed by a U.S. domestic listed issuer, would be permissible if the clawback violated the laws of such foreign country.

The SEC stated in its proposing release that only the direct costs of enforcing recovery may be considered, and an issuer may forego recovery only if the direct costs of enforcing recovery would exceed the recoverable amounts.

Any decision on impracticability would need to be made by the issuer’s committee of independent directors that is responsible for executive compensation decisions. Before concluding that it would be impracticable to recover amounts, the issuer would first need to make a reasonable attempt to recover such compensation and would be required to document its attempt to recover and provide such documentation to the relevant exchange. Generally, the issuer cannot settle for less than full recovery, but issuers may exercise discretion with respect to how to accomplish recovery as long as it is done reasonably promptly.

Subject to any decision on impracticability with respect to any executive officer, issuers cannot exercise discretion to forego recovery or pursue differential recovery among executive officers. However, issuers may exercise discretion in how to accomplish recovery, although the SEC states that issuers should recover amounts reasonably promptly.  

What disclosure would be required regarding use of the clawback policy?

The proposed rules will require listed issuers to disclose written clawback policies. In addition, the proposed rules would require disclosure of whether a triggering restatement occurred within the last year and what actions the issuer is taking in connection therewith. Specifically, the proposed rules would implement the following amendments to facilitate disclosure requirements:

• Item 601(b) of Regulation S-K would be amended to require that a listed issuer file its clawback policy as an exhibit to its annual report on Form 10-K.
• Item 402 of Regulation S-K would be amended to add a new Item 402(w) to require listed issuers to disclose in its annual report and any proxy and consent solicitation materials that require executive compensation disclosure pursuant to Item 402 of Regulation S-K how they have applied their recovery policies 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 such cases, the listed issuer would be required to provide:
  • 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 at the end of its last completed fiscal year;
  • the estimates used to determine the excess incentive-based compensation attributable to such accounting restatement, if the financial reporting measure related to a stock price or TSR metric;
  • the name of each person subject to recovery of excess incentive-based compensation attributable to an accounting restatement from whom the issuer decided during the last completed fiscal year not to pursue recovery, the amount forgone for each such person, and a brief description of the reason the listed issuer decided in each case not to pursue recovery; and
  • the name of, and amount due from, each person from whom, at the end of the issuer’s 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.
• The Summary Compensation Table disclosure requirements would be amended to require that any amounts recovered pursuant to a listed issuer’s erroneously awarded compensation recovery policy reduce the amount reported in the applicable column of the SCT for the fiscal year in which the amount recovered initially was reported, and be identified by footnote. The “total” column would also be revised in the same way.

Foreign private issuers, including Canadian issuers using the MJDS, would be required to (i) file their clawback policy as an exhibit to their Form 20-F or Form 40-F and (ii) provide the same information called for by proposed Item 402(w) of Regulation S-K as required to be provided by domestic U.S. issuers. However, because securities of foreign private issuers are exempt from Section 14(a) of the Exchange Act, they would not be required to disclose the information required by item 402(w) in any proxy or consent solicitation materials with respect to their securities. The disclosure required by proposed Item 402(w) would also need to be provided in interactive data format using XBRL, using block-text tagging as exhibits to the definitive proxy statement and annual report filed with the SEC. Foreign private issuers that prepare their financial statements in accordance with IFRS are not required to submit Interactive Data Files until the SEC provides a taxonomy for IFRS.

The proposed disclosure requirements will provide information that may facilitate the ability of the plaintiffs’ bar to challenge the issuer’s administration of its clawback policy, including the issuer’s reasonable estimate of amounts to be clawed back, the determination of whether recovery is impractical and delays in achieving full recovery.

How do the new rules interact with Section 304 of the Sarbanes Oxley Act of 2002?

The SEC acknowledged in its proposing release that proposed Rule 10D-1 and Section 304 of the Sarbanes-Oxley Act of 2002 (SOX) could provide for recovery of the same incentive-based compensation. If an executive officer reimburses an issuer pursuant to SOX Section 304, under proposed Rule 10D-1, such amounts are to be credited to the extent recovery is also required under the issuer’s written clawback policy. The reverse is not true, however, and whether or not amounts are collected under the issuer’s written clawback policy does not alter or affect the interpretation of SOX Section 304 or the collection of amounts thereunder.

Is indemnification or insurance available?

The proposed rules would prohibit a listed issuer from indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation. In addition, while an executive officer may be able to purchase a third-party insurance policy to fund potential recovery obligations, the indemnification prohibition would prohibit an issuer from paying or reimbursing the executive for premiums for such an insurance policy.

What is the timing for final rules and potential next steps?

The comment period on the proposed rule ends 60 days after the proposing release is published in the Federal Register.

The SEC has proposed that the stock exchanges file proposed listing rules to implement the clawback rule no later than 90 days after publication of the final version of Rule 10D-1, and that those rules be effective no later than one year after that publication date.

Listed issuers would then be required to adopt a clawback policy no later than 60 days following the date on which the exchanges’ rules become effective. However, when adopted the clawback policies would be required to apply to all incentive-based compensation received by covered individuals based on or derived from financial information for any fiscal period ending on or after the effective date of the final version of Rule 10D-1 and that is granted, earned or vested on or after the effective date of the final version of Rule 10D-1, even though that date may be more than a year prior to the date the listed issuer is required to adopt a clawback policy.

Given the breath and strict nature of the proposed rules, we anticipate numerous comment letters to be submitted to the SEC and that the earliest a final rule could be adopted by the SEC would be the fourth quarter of 2015, but more likely the first quarter of 2016. Under that time frame, it is unlikely that revisions to stock exchange listing standards would become effective before the third or fourth quarters of 2016.

More details can be found in the SEC Release No. 34-74835.

This Osler Update is for general informational purposes only and is not to be construed as legal advice. Please contact the authors of this Osler Update if you wish to assess the impact of these developments on your specific circumstances.