Employers with stock listed on a national security exchange will become subject to a new final rule mandating the implementation of a policy that will require employers to recoup incentive-based compensation from officers who were compensated on the basis of incorrect financial reporting.

Background

Section 10D of the Securities Exchange Act (added by the Dodd-Frank Wall Street Reform and Consumer Protection Act), requires the Securities and Exchange Commission (SEC) to direct national securities exchanges and associations listing securities to establish listing standards that require every issuer to develop and implement a clawback policy. The intent is to require that incentive-based compensation be recouped where the compensation paid was based on any misstated financial reporting. On November 28, 2022, more than seven years after the SEC initially proposed rules, the SEC’s final rule implementing the clawback provisions of Section 10D was published in the Federal Register.

When does the final rule take effect?

The final rule is effective January 27, 2023, 60 days after publication in the Federal Register. The exchanges will then have until April 27, 2023, 90 days from January 27, 2023, to file their proposed new listing standards (containing the clawback requirements). These new standards must become effective no later than November 28, 2023, one year following the date of publication of the final rule. Listed companies will have 60 days from the effective date of the exchanges’ new listing standards to adopt a compliant clawback policy.

What is the required clawback policy?

Affected employers will be required to adopt a clawback policy that provides for the recovery of incentive-based compensation erroneously received during “the three-year period preceding the date on which the issuer is required to prepare an accounting restatement.” In other words, employers must have a policy that provides for the recovery of erroneous payments to current and former executive officers. This clawback policy is not contingent on the officer’s misconduct or knowledge of the erroneous financial accounting. 

Under this policy, the term “received” will have a particular meaning. Specifically, the final rule provides that incentive compensation is deemed received when the financial reporting measure is attained, even if the payment occurs at a later date.  The term “incentive compensation” refers to “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure,” which may include both generally accepted accounting principles (GAAP) and non-GAAP financial measures.

If compensation is not attained based on achievement of a financial reporting measure, it is not subject to the clawback policy.  For example, discretionary bonuses or awards based solely on continued employment or individual performance would not be covered.

Employers subject to this final rule are not permitted to indemnify any affected officers for their required repayment of excess incentive compensation.

When will employers need to act upon their policy?

An employer-issuer’s clawback policy will be triggered on the first to occur of the date the company’s board of directors, committee and/or management concludes (or reasonably should have concluded) that an accounting restatement is required, or the date a regulator, court or other legally authorized entity directs the company to restate previously issued financial statements.  While employers subject to the final rule may have some discretion, they cannot settle for anything less than a full recovery, subject to certain exceptions, and recovery must be promptly made. A delay of more than 180 days would potentially require the issuer to publicly disclose the name of any current and former named executive officer from whom a balance is outstanding.

Are there exceptions to recovery?

As noted, lack of knowledge or misconduct will not exempt erroneous payments from recovery. However, employers have some relief from clawing back erroneously-paid incentive compensation if:

1. the direct expense of paying a third party to assist with enforcing the clawback policy would exceed the recoverable amount, and the employer-issuer has first made reasonable attempts to recover the sums that have been made and submitted documentation of such attempts to the listing exchange;
2. recovery would violate the law, and the employer-issuer has provided an opinion of counsel supporting such conclusion to the listing exchange; or
3. recovery would cause a tax-qualified retirement plan to fail to meet applicable requirements of the Internal Revenue Code.

Next Steps

To prepare for the eventual new listing standards to be released, employers affected by the final rule can consider the following steps to prepare for the implementation of the new clawback requirements:

• Review existing policies to evaluate whether changes may be required, such as to the applicable period for recovery, the applicability of the policy to former employees, the definition of certain terms under the policy, such as “received” and “incentive compensation,” or any indemnification, insurance, or attorneys’ fees provisions;

• Review and evaluate current compensation plans to identify potential amendments to make sure future awards are subject to a compliant clawback policy; and

• Review executive officer determinations (or make a decision about whether individuals other than executive officers will also be subject to the clawback policy, even if not required by the final rule).