U.S.-listed companies will soon be required to adopt compensation clawback policies

Twelve years after being mandated to do so by Congress, the U.S. Securities and Exchange Commission (the “SEC”) has adopted a rule that directs U.S. exchanges to establish listing rules requiring companies to adopt policies to recover incentive-based compensation awarded on the basis of materially misreported financial information that requires an accounting restatement, even when there is no misconduct on the part of the executive (so-called “clawback” policies). U.S.-listed issuers will likely need to have compliant clawback policies in place by January 2024 at the latest, but possibly earlier. 

New Rule 10D-1 under the U.S. Securities and Exchange Act of 1934 (the “Exchange Act”) directs U.S. national securities exchanges and associations to adopt listing standards that subject an issuer to delisting if the issuer does not: 

• Adopt a clawback policy that complies with the applicable listing standard within 60 days of the listing standard’s effective date.
• Comply with the clawback policy for all incentive-based compensation received by executive officers; and
• Provide the disclosures required by the SEC, including: (i) the amount of erroneously awarded compensation attributable to the restatement; (ii) an analysis of how the erroneously awarded compensation was calculated; (iii) the estimates used to determine the amount of erroneously awarded compensation linked to stock price or total shareholder return (“TSR”); and (iv) an explanation of the methodology; and (v) amounts recovered and amounts still owed and forgone.

Which issuers must comply? 

The final rule applies to almost all U.S.-listed issuers, including foreign private issuers (“FPIs”), emerging growth companies, controlled companies and smaller reporting issuers, subject to very limited exceptions. The requirements also generally apply without regard to the type of securities listed, including to issuers of listed debt or preferred securities that do not have listed equity. The exchanges do not have the discretion to exempt certain categories of securities from the listing standards. 

As discussed further below, however, the final rule allows FPIs to forgo a clawback as impracticable if the clawback would violate home country law and certain other conditions are met. Issuers, including FPIs, may also forgo a clawback as impracticable due to costs or for tax-qualified retirement plans.

When do issuers have to adopt clawback policies? 

Each exchange has up to 90 days after the rule’s publication in the Federal Register (likely sometime in November 2022) to file its proposed listing standards, which should become effective within one year of the final rule’s Federal Register publication date. In other words, the exchanges’ new listing standards must be effective at the latest by sometime in November 2023, but the exchanges could choose an earlier effective date. Issuers will then have 60 days after that effective date to adopt clawback policies and must begin making the required disclosures (as described further below) in annual reports, and proxy and information statements filed on or after the date issuers are required to have a clawback policy under the listing standard. 

What kind of restatement triggers a clawback?  

Under Rule 10D-1, the clawback policy must be triggered when the 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 (a “Big R” restatement), or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period (a “little r” restatement). A “Big R” restatement requires a listed issuer (including an FPI) to amend its filings promptly to restate the previously issued financial statements (and file an Item 4.02 Form 8-K if it is a U.S. domestic issuer). In the case of a “little r” restatement, an issuer may make any corrections the next time the issuer files the prior year financial statements (and U.S. domestic issuers are generally not required to file an Item 4.02 Form 8-K). By contrast, when the correction of an error is recorded instead in the current period financial statements because it is immaterial to the previously issued financial statements and to the current period (commonly referred to as an “out-of-period adjustment”), a clawback analysis would not be triggered.

In a change from the 2015 proposal, Rule 10D-1 does not provide separate definitions of “accounting restatement” or “material noncompliance,” as existing accounting standards and guidance already set out the meaning of those terms. 

The adopting release does note, however, that changes to an issuer’s financial statements that do not represent error corrections – such as retrospective application of a change in accounting principle or retrospective revision for stock splits – would not trigger the clawback policy.

Is any fault or misconduct required? 

No, clawbacks would be triggered when the issuer is required to prepare an accounting restatement due to its material noncompliance with any financial reporting requirement under securities laws, regardless of issuer or executive misconduct or the role of the executive in preparing the financial statements. 

How would the restatement date be determined?

Under the final rule, the date on which an issuer is required to prepare an accounting restatement for purposes of determining the three-year period covered by the clawback is not the date when the erroneous financial statements were filed. Instead, in order to remove an issuer’s incentive to delay the clawback period, the date is the earlier to occur of:

• The date the issuer’s board of directors, a committee of the board of directors, or the officer or officers of the issuer authorized to take such action if board action is not required, concludes, or reasonably should have concluded, that the issuer is required to prepare a restatement; or
• The date a court, regulator or other legally authorized body directs the issuer to prepare a restatement.

The SEC retained the “reasonably should have concluded” concept from its proposing release to reduce the incentive for issuers to delay the investigation of a known error and the decision that a restatement is necessary, because the delayed decision date does not determine the beginning of the recovery period. 

Which executive officers are covered? 

Section 10D requires the clawback policy to cover “any current or former executive officer.” The definition of “executive officer” includes: the 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. 

Executive officers of the issuer’s parents or subsidiaries would be deemed executive officers of the issuer if they perform such policy making functions for the issuer. Generally, these would be the same officers who, in the case of U.S. domestic issuers, are required to disclose their beneficial ownership of the issuer’s securities under Section 16 of the Exchange Act. 

What is incentive-based compensation?

Rule 10D-1 takes a principles-based approach to identifying incentive-based compensation that would be subject to the required clawback policy. Incentive-based compensation is defined as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.” 

The adopting release provides the following as examples of incentive-based compensation: 

• Non-equity incentive plan awards that are earned based wholly or in part on the basis of satisfying a financial reporting measure performance goal;
• Bonuses paid from a “bonus pool,” the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal;
• Other cash awards based on the satisfaction of a financial reporting measure performance goal;
• Restricted stock, restricted stock units, performance share units, stock options, and stock appreciation rights that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal; and
• Proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based wholly or in part on satisfying a financial reporting measure performance goal.

Examples of compensation that are not incentive-based compensation include: 

• Salaries;
• Bonuses/equity awards paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) and/or completion of a specified employment period;
• Non-equity incentive plan awards earned solely upon satisfying one or more strategic measures (e.g., consummating a merger or divestiture), or operational measures (e.g., opening a specified number of stores, completion of a project, or increase in market share); and
• Equity awards for which the grant is not contingent upon achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more nonfinancial reporting measures.

What are financial reporting measures?

Financial reporting measures are measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measures derived wholly or in part from such financial information, stock price and TSR. The SEC specifically rejected calls to limit the rule to incentive-based compensation that is linked to the achievement of specific financial measures, noting that improper accounting affects measures such as stock price and TSR. 

When would incentive-based compensation be deemed received?

Incentive-based compensation is deemed received in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if the payment or grant occurs after the end of that period. Ministerial acts or other conditions necessary to effect issuance or payment, such as calculating the amount earned or obtaining the board of directors’ approval of payment, would not affect the determination of the date on which the compensation is deemed received.

How would the clawback amount be calculated? 

The amount of incentive-based compensation subject to clawback would be the amount received that exceeds the amount of the compensation that otherwise would have been received had it been determined based on the accounting restatement, computed without regard to any taxes paid. 

For incentive-based compensation based on stock price or TSR, where the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement, the amount should be based on a reasonable estimate of the effect of the accounting restatement on the stock price or TSR during the period for which the incentive-based compensation was received. In such case, the issuer should maintain documentation of the determination of that reasonable estimate and provide the documentation to the exchange.

What time period must be covered by the clawback policy?

Rule 10D-1 generally sets a three-year look-back policy. The clawback policy must apply to all incentive-based compensation received by a person:

• After beginning service as an executive officer;
• Who served as an executive officer at any time during the performance period for that incentive-based compensation;
• While the issuer has a class of securities listed on a national securities exchange or a national securities association; and
• During the three completed fiscal years immediately preceding the date on which the issuer is required to prepare an accounting restatement.

For example, if a calendar year issuer concludes in November 2024 that a restatement of previously issued financial statements is required and files the restated financial statements in January 2025, the clawback policy would apply to compensation received in 2021, 2022 and 2023.

Are there any exceptions to the clawback requirement?

As adopted, Rule 10D-1 requires an issuer to recover erroneously awarded compensation in compliance with its clawback policy, with no de minimis exception, but provides exceptions for cases where it would be “impracticable” to do so. 

The rule provides for only a few instances where recovery would be impracticable: 

• If the direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered. However, the issuer must first make a reasonable attempt at recovery and must document such attempt.
• If recovery would violate home country law. The issuer must obtain an opinion of home country counsel (acceptable to the exchange) that the recovery would result in such a violation, and provide such opinion to the exchange. The home country law must have been adopted in the home country prior to the date of the final rule’s publication in the Federal Register.
• If recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code.

In each case, an issuer’s committee of independent directors responsible for executive compensation decisions (or in the absence of such a committee, a majority of the independent directors serving on the board), would have to make such determination that recovery would be impracticable.

The rule provides issuers with discretion as to how to accomplish the clawback, but they must act “reasonably promptly.” Also, boards may not settle for less than the full recovery amount unless they satisfy the conditions that demonstrate recovery is impracticable. 

What disclosures are required?

Along with filing their clawback policies as exhibits to their annual reports on Form 20-F or 10-K, listed issuers must also make disclosures relating to their clawback policies and the recovery of erroneously awarded compensation. 

If at any time during or after its last completed fiscal year, an issuer was required to prepare an accounting restatement that required recovery of erroneously awarded compensation under its clawback policy, or there was an outstanding balance as of the end of the last completed fiscal year of erroneously awarded compensation to be recovered from the application of the policy to a prior restatement, the issuer must, in its annual report on Form 20-F or 10-K, provide the following information:

• For each restatement:

(a) The date on which the issuer was required to prepare a restatement;

(b) The aggregate dollar amount of erroneously awarded compensation attributable to the restatement, including an analysis of how the amount was calculated;

(c) If the financial reporting measure related to a stock price or TSR metric, the estimates that were used in determining the erroneously awarded compensation attributable to the restatement and an explanation of the methodology used for the estimates;

(d) The aggregate dollar amount of erroneously awarded compensation that remains outstanding at the end of the last completed fiscal year; and

(e) If the aggregate dollar amount of erroneously awarded compensation has not yet been determined, disclose this fact, explain the reason(s) and disclose the information required in (b) through (d) in the next filing subject to these disclosure requirements;

• If recovery was impracticable, the issuer must disclose, for each current and former named executive officer and for all other current and former executive officers as a group, the amount of recovery forgone and a brief description of the reason it decided in each case not to pursue recovery (including which element caused the impracticability, and some context regarding the element, such as identification of the foreign law precluding the recovery);
• For each current and former named executive officer from whom, as of the end of the last completed fiscal year, erroneously awarded compensation had been outstanding for 180 days or longer since the date the issuer determined the amount the individual owed, the issuer must disclose the dollar amount of outstanding erroneously awarded compensation due from each such individual; and
• If at any time during or after its last completed fiscal year the issuer was required to prepare an accounting restatement, and the issuer concluded that recovery of erroneously awarded compensation was not required pursuant to its clawback policy, it must briefly explain why application of the clawback policy resulted in this conclusion.

For foreign private issuers, the information must appear with, and in the same format as, the rest of the disclosure required by Item 6 of Form 20-F (disclosures regarding directors, senior management and employees). The disclosures are only required in annual reports and not in registration statements on Form 20-F, and will not be deemed to be incorporated by reference into any filing under the Securities Act, except to the extent that the listed issuer specifically incorporates it by reference. 

These disclosures must also be tagged in an interactive data format using eXtensible Business Reporting Language (“XBRL”).

Issuers must also check boxes on the cover pages of Form 20-F or Form 10-K to indicate separately (a) whether the previously issued financial statements in the filing include an error correction, and (b) whether any such corrections are restatements that triggered a compensation recovery analysis during the fiscal year.

Is indemnification allowed?

No. Rule 10D-1 expressly prohibits an issuer from indemnifying an executive officer against clawbacks. An executive officer may be able to purchase his or her own third-party insurance, but an issuer may not pay or reimburse the executive for premiums for such an insurance policy.

What are next steps?

Although a number of listed issuers have already adopted clawback policies, issuers should take a fresh look at their policies now to ensure compliance with new Rule 10D-1, particularly since many current clawback policies are only triggered by executive misconduct. Note that in adopting the rule, the SEC has taken the approach that issuers’ discretion to implement and execute the mandated clawback policies should be limited. The SEC has also left the exchanges with limited discretion to create further exceptions.

In order to prepare for implementation and compliance with the new rules,  issuers should:

• Consider any current clawback policies and any amendments that may be required to comply with the new listing standards to be adopted by the applicable stock exchanges;
• Review executive compensation plans and arrangements to determine which are based on financial reporting metrics and thus potentially subject to clawback;
• Consider any potential changes to such policies in light of increased risks imposed by the new rules;
• Review internal controls for evaluating restatements;
• Educate the board as to the impact of the new rules and any changes to be made in light of adoption or amendment of the company’s clawback policies; and
• Review directors and officers insurance policies and indemnification agreements in light of the new rules and limitations on indemnification.

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We are working with a number of our clients on the drafting of clawback policies and we invite you to reach out to your regular Linklaters contact if you would like to discuss approaches and options. We will also soon be publishing a note that compares the U.S. rules regarding clawback policies with the rules of other jurisdictions, such as the UK. 

We will continue to monitor developments in this area and welcome any queries you may have.