On October 25, 2022, the SEC approved final rules for Section 954 of the Dodd-Frank Act covering compensation recovery and disclosure. The new rules require the national stock exchanges to implement new listing standards that require issuers listed on the exchanges to implement and disclose their clawback policies. These rules are a long time in the making. The rules were first proposed by the SEC in July 2015. The SEC reopened the public comment period in 2021 and again in 2022 to introduce new requirements that broadened the application of clawbacks. The final rules reflect these new requirements with the biggest change being an expansion of the clawback trigger to cover all accounting restatements.

Summary of the final rules

What Companies are covered?

Applies to all public companies or issuers of public debt; no exceptions for foreign private issuers, controlled companies, small reporting companies or emerging growth companies

What triggers a clawback?

Triggered by all accounting restatements, including both “big R” and “little R” restatements. A “big R” restatement occurs when an issuer is required to prepare an accounting restatement that corrects an error in previously issued financial statements that is material to the previously issued financial statements. This requires an 8-K disclosure. A “little R” restatement corrects an error that would result in a material misstatement if the error were not corrected in the current period or left uncorrected. This type of restatement is frequently deemed not to be material and does not require 8-K disclosure. Instead, disclosure is normally limited to the footnotes to the financial statements. This is the largest change from the proposed rules which only required a “big R” restatement to trigger a clawback. This change will greatly expand the number of situations in which a clawback will be triggered.

Who is subject to the clawback policy?

Current and former executive officers will be subject to the new clawback rules., Executive officers are defined 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. Incentive compensation received prior to becoming an executive officer is not required to be subject to the clawback policy. Importantly, compensation received by former executive officers will be subject to the clawback policy.

What compensation is subject to the clawback policy?

Consistent with the proposed rules, the clawback applies to incentive compensation that is determined based on financial measures (including TSR or stock price). Most annual incentive plans based on financial measures are subject to the clawback as are most performance share plans. Time-vested restricted stock/RSUs and stock options are not subject to clawback

How do you determine the amount to be clawed back?

Amount to be clawed back represents the difference between the amount that was originally paid and the amount that would have been paid using the restated financial performance. For amounts that depend on TSR or stock price performance, a reasonable estimate of the difference needs to be documented and provided to the exchange.

Does the Board have discretion in applying the clawback?

Generally, no. Once a clawback is triggered, the company needs to calculate the amount that will be clawed back and attempt to recover the amounts. The Board can determine not to pursue the clawback if the direct cost of seeking the clawback will be greater than the amount to be recovered. There are narrow exceptions to applying the clawback if it is deemed to violate the executive’s home country law or it would negatively impact a qualified retirement plan.

How many years back does the clawback apply?

The company is required to look-back to the three most recently completed fiscal years before the date that the issuer is required to prepare an accounting restatement.

How can the company recover the compensation?

The rules provide the company with latitude in terms of how to recover compensation (e.g., collect payment from executive, cancel outstanding awards, take out of future compensation obligations).

Can the company indemnify executives for the risk of a clawback?

Companies are not allowed to indemnify executives against the loss of erroneously awarded compensation

When do these rules go into effect?

Listing standards need to be issued by the stock exchanges within 90 days of the rules being filed in the Federal Register. The listing standards must be effective within one year of issuance. Companies must implement an incentive recovery policy within 60 days of the effective date of issuance of new listing standards.

Is incentive compensation awarded prior to the effective date subject to the rules?

No. The rules apply to incentive compensation received by executive officers on or after the effective date of the listing standards.

What new disclosure is required?

The clawback policy needs to be filed as an exhibit to the 10-K. In addition, if the company applies its clawback policy, it needs to disclose in its proxy statement how the clawback policy was applied and amend SCT amounts for any named executive officers impacted by the clawback. There is also a checkbox requirement for the 10-K for whether the financial statements reflect correction of an error to previously filed financial statements and whether any of those error corrections are restatements that require incentive-based compensation recovery analysis

How Many Companies Will These Rules Potentially Impact?

Research published by Audit Analytics indicates that 1,039 unique companies reported restatements in 2021. This was up very substantially from 2020 when only 364 companies reported restatements, due to the increase in SPAC conversions seen in 2021. Even if the number of restatements reverts to historical norms of 300 to 400 per year, we can expect to see an explosion in the number of clawback situations, and associated litigation, in 2023 and 2024!

What Do the New Rules Mean for Corporate Issuers?

Various surveys indicate that more than 80% to 90% of mid-cap and large-cap public companies already have clawback policies in place. Do the new rules represent a significant change for companies that have already addressed the clawback issue and have policies in place? We predict that it is a major change.

Here is why:

The new compensation recovery rules are much more stringent in the case of a financial restatement than the policies in effect at most major companies:

• Broader application: Will apply to all current and former executive officers. There is no doubt that recovering compensation from former executive officers will present a challenge.
• Longer time frame: Requires a 3-year look-back period. Most current policies do not specify a time frame and a look-back period is not addressed
• Takes a “no-fault” approach: The current policies at most major companies specify clawbacks in cases of fraud or misconduct. New rules require clawbacks whenever compensation was erroneously earned due to a restatement, with no requirement for fraud or misconduct.
• Lower materiality standard: New rules require clawbacks for all restatements, not just material restatements required to correct previously issued financial statements. As noted above, this is a major expansion of the scope of the proposed rules issued by the SEC in 2015.
• No Board discretion: The current policies at most major companies allow for Board discretion on whether to seek clawbacks. The new rules eliminate discretion in most instances.
• Total Shareholder Return (TSR) and stock price metrics are subject to restatement. Under the new rules, companies are required to provide estimates to the stock exchanges and disclose how their accounting restatements would have impacted performance-based compensation contingent on TSR or stock price. This is a challenging exercise and subject to a number of assumptions. We question why the SEC would go beyond calculations grounded in GAAP financial statements to apply the concept of restatements to TSR and stock price.

Certainly, there will be more to come on this in the coming months as the stock exchanges publish new listing standards that address compensation recovery and disclosure. At the very least, most companies will need to revise or implement their clawback policies and expand disclosure. Beyond the compliance perspective, companies may revisit the design of pay programs to limit the impact of the new compensation recovery rules.