What boards need to know about the SEC’s new executive compensation recovery (clawback) rule 

Just two months after issuing new pay for performance rules, the Securities and Exchange Commission (SEC) fulfills another Dodd-Frank Act mandate and adopts final executive compensation recovery rules.  

The final rule (“Rule 10D-1”) implements section 10D of the Securities Exchange Act of 1934 as required by the Act. Rule 10D-1 specifies that national securities exchanges must establish listing standards that require listed issuers to adopt and comply with a compensation recovery policy, often known as a clawback policy. That policy must provide that, in the event the issuer is required to prepare an accounting restatement, the issuer will recover incentive-based compensation paid to its current or former executive officers based on any misstated financial reporting measure. Issuers are required to “look-back” during the three-year period preceding the date the issuer is required to prepare the accounting restatement in considering the amount of compensation subject to clawback. Listed issuers will also need to provide disclosure about their compensation recovery policies and how they are being implemented. An issuer will be subject to delisting if it does not adopt and comply with a compensation recovery policy that meets the requirements of the listing standards. 

Who is affected?

With limited exceptions, the final amendments will affect all entities that list securities on U.S.-registered securities exchanges. This includes emerging growth companies, smaller reporting companies and foreign private issuers.

When does the rule become effective?

The final amendments become effective on Jan. 27, 2023. To comply with Rule 10D-1, national securities exchanges will be required to file proposed listing standards no later than April 27, 2023. These listing standards will be required to be effective no later than Jan. 27, 2024. Issuers subject to such listing standards will be required to adopt a recovery policy no later than 60 days following the date on which the applicable listing exchange standards become effective and must begin to comply with these disclosure requirements in proxy and information statements and the issuer’s annual report filed on or after the issuer adopts its recovery policy.

What does and does not trigger application of the issuers’ compensation recovery policy?

Under Rule 10D-1, an issuers’ compensation recovery policy will be triggered in the event the issuer is required to prepare an accounting restatement. This includes restatements that correct an error in previously issued financial statements that is material to the previously issued financial statements (i.e. a “Big R” restatement) or corrects an error that is not material to prior period financial statements, but that would result in a material misstatement if the error were left uncorrected in the current report or if the error correction was recognized only in the current period (i.e. a “little r” restatement). Correction of errors in the current period financial statements that are immaterial to the previously issued financial statements and immaterial to the current period- commonly referred to as “out-of-period adjustments”- would not trigger an issuers’ compensation recovery policy.

How is the amount of compensation subject to clawback determined under Rule 10D-1?

Rule 10D-1 requires companies recover incentive-based compensation received by an executive officer or former executive officer during the look-back period that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the restated financial statements, computed without regard to taxes paid. In other words, issuers must recover the difference between what was actually paid in incentive compensation using incorrect financial statements and what would have been paid using the corrected financial statements. It is important to note that compensation subject to clawback under the new rule includes any incentive compensation that is based upon the attainment of a financial reporting measure, including targets based on non-GAAP financial measures, stock price and/or total shareholder return (“TSR”). Compensation awarded upon the achievement of subjective, strategic or operational measures that are not financial reporting measures (such as the achievement of ESG goals) or awarded based solely on continued employment for a period of time (e.g., base salary or time-vesting awards, unless such awards were based in whole or in part on a financial reporting measure) are not subject to clawback. 

What boards should consider and do in anticipation of the new clawback policy rules?

With the issuance of Rule 10D-1, the SEC reminds public companies about the importance of high-quality financial reporting and gives priority to the use of clawback policies as a means of preventing filing restatements. Boards specifically will play a center role in making sure their companies comply with the requirements of 10D-1. Below are several questions and suggestions boards will want to consider in this process:

• How vulnerable are the company’s current incentive compensation arrangements/plans to triggering events under Rule 10D-1? As noted above, the SEC’s definition of incentive compensation subject to recovery is wide reaching, including any compensation that is based on the attainment of any financial reporting measure that is derived in whole or in part from GAAP based financial information presented in or outside the issuer’s financial statements (such as in the Management’s Discussion and Analysis). Thus, even incentive compensation plans based on measures such as sales per square feet of retail store are susceptible to clawback if a restatement occurs. Boards should consider the need to revise current and proposed incentive compensation plans as appropriate to minimize the company’s exposure to triggering events under the new rules.
• To what extent do the company’s existing clawback policies comply with the requirements of Rule 10D-1? Specifically, board members will want to look at provisions in their clawback policies related to the length of the clawback period, what constitutes a triggering event, and the category of executives to which their clawback policies apply and adopt revisions as needed to ensure compliance with the new rule.
• How vulnerable is the company to potential future restatements? This is by far the hardest and yet most important question boards will need to consider in determining the potential impact the new compensation recovery rules may have on their companies. Having a strong and competent audit committee is crucial to minimizing the risk of firms falling victim to clawback policies. With the increasing number of issues being placed on audit committee agendas, audit committees should make sure they stay focused on their oversight of internal control and financial reporting quality. In this process, maintaining regular communication with internal and external auditors to ensure accounting and reporting issues are adequately addressed should be a priority. Proactive audit committees may also consider engaging external advisors to perform a quality of earnings study. A quality of earnings study can help audit committees identify accounting irregularities/anomalies and use of aggressive accounting policies that may heighten the risk of future restatements.

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