SEC Proposed Executive Compensation Clawback Rules
Posted by Securities Attorney Laura Anthony | August 3, 2015

On July 1, 2015, the SEC published the anticipated executive compensation clawback rules (“Clawback Rules”).  The rules are in the comment period and will not be effective until the SEC publishes final rules. The proposed rules require national exchanges to enact rules and listing standards requiring exchange listed companies to adopt and enforce policies requiring the clawback of certain incentive-based compensation from current and former executive officers in the event of an accounting restatement. 

In particular, the proposed rules implement Section 10D of the Securities Exchange Act of 1934, as amended (“Exchange Act”) and as added by Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).  Section 10D requires the SEC to adopt rules directing national exchanges to prohibit the listing of any security of an issuer that is not in compliance with Section 10D’s requirements for (i) disclosure of the company’s policy on incentive-based compensation that is based on financial statement results and (ii) recovery of incentive-based compensation in the event of an accounting restatement due to the company’s material noncompliance with any financial reporting requirement and which recovery is in an amount that is the excess between the compensation paid and  what would have been received under the restated financial statements, without regard to any taxes paid.

In other words, the Clawback Rules require the recovery of executive compensation following an accounting restatement, which compensation would not have been paid under the restated financial statements.  Indemnification or insurance reimbursement would be prohibited.

There are currently existing rules which require the recovery of executive compensation and disclosure of such policies.  In particular, Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”) requires the CEO and CFO to reimburse the company for any bonus or other incentive-based or equity compensation for the prior 12 months, and any profits received from the sale of securities in that time period, if a company is required to prepare a restatement as a result of the misconduct related to financial reporting.  The Compensation Discussion and Analysis (CD&A) required by Item 402(b) requires an explanation of “all material elements of the registrant’s compensation of the named executive officers” and requires general discussions of performance including disclosure of any bonus structures and performance-based compensation and company policies and decisions regarding the adjustment or recovery of awards and payments to such named executive officers.

In addition to requiring companies to adopt written policies and procedures and to disclose same, the new Clawback Rules remove fault from the consideration of recovery, broaden the effected executives to include all named executive officers and extend the existing look-back period.

Definition of Incentive-Based Compensation

Incentive-based compensation” would be defined as any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure, which includes measures presented in an issuer’s financial statements, as well as stock price and total shareholder return.  Salaries and bonuses not tied to financial performance are not included in the recovery rules.

The Clawback Rules require the recovery of “incentive-based compensation (including stock options awarded as compensation)” that is received, based on the erroneous data, in “excess of what would have been paid to the executive officer under the accounting restatement.”  The amounts recovered are determined without regard to any taxes paid.

Issuers and Securities Subject to the Clawback Rules

The Clawback Rules apply to all listed issuers and all securities, with limited exceptions.  The proposed rules’ limited exemptions include security future products, standardized options and the securities of certain registered investment companies.

Restatements Triggering Application of Recovery Policy

The Clawback Rules require issuers to adopt and comply with policies that require recovery “in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws.”  The SEC includes any error that is material to the financial statements as “material noncompliance”.  Accordingly, the Clawback Rules provide that issuers adopt and comply with a written policy providing that in the event the issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements, the obligation to prepare the restatement would trigger application of the recovery policy.

The SEC clarifies that the following changes to financial statements would not trigger the recovery policy: (i) the retrospective application of a change in accounting policy; (ii) retrospective revision to a reportable division due to a company’s internal reorganization; (iii) retrospective reclassification due to a discontinued operation; (iv) retrospective application of a change in reporting entity such as from a reorganization or change in control; (v) retrospective adjustment to provisional amounts in connection with a prior business combination; or (vi) retrospective revision for stock splits.

Applicable Date and Time Period

The Clawback Rules would require the recovery of incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement. The date on which the company is required to prepare an accounting restatement is the earlier of (i) the date the board of directors or officers of the company, if board authorization is not required, conclude that the company’s previously issued financial statements contain a material error; or (ii) the date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.

Executive Officers Subject to Recovery Policy

The SEC has proposed a broad definition for “executive officers” subject to clawback that is modeled after the definition used in the regulations implementing the short-swing profit rules set forth in Section 16 of the Securities Exchange Act of 1934, as amended. “Executive officers” subject to the Clawback Rules would include a listed company’s president, principal financial officer, principal accounting officer, any vice president in charge of a principal business unit, division or function, and any other person who performs a policy making function for the company, and would apply to both current and former executive officers during the three years preceding the date of the required restatement.

Determination of Recovery Obligation

The Clawback Rules require the recovery of executive compensation following an accounting restatement, which compensation would not have been paid under the restated financial statements.  Indemnification or insurance reimbursement would be prohibited.  The recovery, as proposed, is bright line and not based on “fault” or other subjective measures.  Executive officers would be required to return incentive-based compensation regardless of misconduct or responsibility for the accounting errors.  Indemnification or insurance reimbursement would be prohibited.

Board Discretion Regarding Whether to Seek Recovery

The Clawback Rules as proposed allow a board of directors’ discretion to determine not to pursue recovery in certain instances, such as when it would be impracticable or impose undue costs on the company or its shareholders or would violate home country law.

Disclosure Requirements

A company listed on any national exchange is required to file its clawback policy as an exhibit to its annual report on Form 10-K.  Moreover, in the event of a restatement and necessary clawback efforts, the company must disclose its recovery efforts in its proxy statement, including the aggregate dollar amount of excess incentive-based compensation attributable to the restatement and the aggregate dollar amount of incentive-based compensation that remained outstanding at the end of the last completed fiscal year.  Both Form 10-K and Schedule 14A will be amended to include the disclosure and exhibit requirements.

Compliance with Recovery Policy

Under the proposed Clawback Rules, a company would be subject to delisting if it does not (i) adopt a compensation recovery policy that complies with the rules; (ii) disclose the policy in accordance with the rules, including XBRL tagging; and (iii) comply with its written compensation recovery policy.

Transition and Timing

The Clawback Rules would require that each national exchange propose new listing standards implementing the rules no later than 90 days following SEC publication of final rules;  that such standards take effect no later than one year following  SEC publication of final rules; and that each company adopt the recovery policy required by the rules no later than 60 days following the date on which the exchanges’ rules become effective.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. The firm’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the producer and host of LawCast, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington D.C., Denver, Tampa, Detroit and Dallas.

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