The SEC on October 26 adopted final recovery rules, commonly referred to as clawback rules, in a significant shift for executive compensation requirements.
The rules direct national securities exchanges and national securities associations to establish listing standards requiring companies to develop, implement, disclose and comply with a written policy for recovery of erroneously awarded incentive-based compensation. These will apply where the payment of such compensation was made as a result of financial measures where a subsequent accounting restatement was required. Although the final rules largely follow the proposed rules, changes were made that generally broadened their scope.
Which securities exchanges or securities associations must establish recovery listing standards for their issuers?
The NYSE and Nasdaq are among the most prominent securities exchanges affected, in addition to all other national securities exchanges registered under section 6 of the Securities Exchange Act of 1934 that list securities, and national securities associations registered under section 15A of the Exchange Act that list securities.
Securities exchanges that trade securities pursuant to unlisted trading privileges but do not list securities are not subject to this requirement.
By when must an issuer adopt a written recovery policy?
The SEC indicates that it expects issuers to have at least one year to adopt a recovery policy. Securities exchanges must adopt recovery rule listing standards that become effective within one year after the publication of the final recovery rules in the Federal Register, and issuers’ recovery policies must be adopted no later than 60 days thereafter.
Which issuers will be subject to the recovery listing standards?
All listed issuers (including emerging growth companies, smaller reporting companies, foreign private issuers and controlled companies), with a few limited exceptions, including:
Who must be subject to an issuer’s recovery policy?
Any person who served as an executive officer:
Executive officers include the issuer’s president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice president 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 and any other person who performs a similar policy-making function for the issuer.
Executive officers must include, at a minimum, the issuer’s Section 16 officers.
What triggers the requirement that an issuer apply the recovery policy?
Both ‘big R’ accounting restatements that trigger Item 4.02 of Form 8K and ‘little r’ accounting restatements trigger application of the recovery policy. The trigger occurs when an issuer is required to prepare an accounting restatement to correct:
The SEC did not provide additional guidance regarding when an error would be considered material because materiality is a determination that must be analyzed in the context of particular facts and circumstances.
Changes to an issuer’s financial statements that do not represent error corrections under accounting standards would likely not trigger application of the recovery policy, including:
What is the period during which incentive-based compensation is recoverable?
The three-year look-back period, which is the three completed fiscal years before the date the issuer is required to prepare an accounting restatement. For example, if a calendar year issuer concludes in November 2028 that a restatement of previously issued financial statements is required, the recovery policy would apply to compensation received in 2025, 2026 and 2027.
When is an issuer considered to be required to prepare an accounting restatement for purposes of starting the three-year look-back period?
The earliest to occur of:
What compensation is subject to recovery?
Any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure (including non-Gaap financial measures, other non-Gaap measures, stock price and total shareholder return or TSR) is subject to recovery.
Examples of compensation that are not subject to recovery include:
Compensation received while an individual was serving in a non-executive officer capacity before becoming an executive officer is not recoverable.
When is incentive-based compensation considered to have been received for purposes of determining which compensation was received during the three-year look-back period?
Incentive-based compensation will be considered received in the fiscal period when the financial reporting measure is attained – even if the payment or grant occurs after the end of that period and even if the award remains subject to other conditions, such as continued service-based conditions.
Do the listing standards apply to pre-existing contracts or arrangements with executive officers?
Yes, issuer compliance is required whether such incentive-based compensation is received pursuant to a pre-existing contract or arrangement, or one that is entered into after the effective date of the listing standard.
Is compensation that was received prior to the effectiveness of the recovery listing standards subject to recovery?
Not under the new SEC final recovery rules, although any other applicable clawback or recovery policy of the issuer may apply.
How is the amount of erroneously awarded compensation to be recovered determined?
The amount recoverable is the amount of incentive-based compensation received that exceeds the amount that otherwise would have been received had it been determined based on the accounting restatement, computed without regard to taxes paid.
Where the amount is not subject to mathematical recalculation directly from the information in the accounting restatement (such as compensation based on TSR or stock price), the amount must be based on a reasonable estimate of the effect of the accounting restatement on the applicable measure. This determination must be documented and provided to the exchange.
When making these calculations, consideration can be given to any negative discretion that had been applied to reduce the amount originally received.
Are there circumstances where the board may apply discretion to forego the recovery of erroneously awarded compensation?
There are three limited circumstances that permit the compensation committee of the board to forego recovery of erroneously awarded compensation:
How must an issuer seek recovery of erroneously awarded compensation?
Issuers may exercise discretion in how to accomplish recovery but they must recover erroneously awarded compensation ‘reasonably promptly’.
What are the consequences for an issuer that does not comply with the recovery rules?
Where an issuer does not adopt, disclose or comply with a recovery policy, the issuer will be:
What must a company disclose?
Issuers must file their written recovery policy as an exhibit to their annual report on Form 10K or Form 20F, and must add check boxes that indicate:
Issuers must also provide disclosure about their recovery policy and its application, including:
Issuers must use Inline XBRL to tag their recovery disclosure.
Can an issuer indemnify its executive officers for the recovery of erroneously awarded compensation?
No. Indemnification arrangements may not indemnify any executive officer or prior executive officer of the issuer for the loss of erroneously awarded compensation.
Carina Antweil, Robin Melman and Gail Stewart are partners with Baker Botts. The authors thank associates Katie Birnhak and Rob Cowan for their contributions