SEC (Finally) Adopts Clawback Rules

On October 26, 2022, the Securities and Exchange Commission ("SEC") adopted its long-awaited final rules on clawbacks. Under these rules, companies listed on the NYSE and Nasdaq will be required to adopt "clawback" policies – policies that mandate recovery by companies of certain incentive-based compensation awarded to current and former executives in the event of an accounting restatement.¹

Summary of the Rule

The listing standards will require issuers to adopt and comply with a written policy:

• for recovery of erroneously awarded incentive-based compensation received by current or former executive officers
• during the three completed fiscal years immediately preceding the date the issuer determines an accounting restatement is required
• due to material noncompliance with any financial reporting requirement under the securities laws.

Under the new rules, companies' clawback policies:

• must require recovery without regard to culpability;
• will be triggered by a broader range of accounting restatements than what is included many companies' existing policies, including "little r" restatements (defined below);
• will cover incentive-based compensation that was awarded on the basis of financial measures, including TSR and stock price;
• remove discretion from the board as to whether to pursue recovery, unlike many companies' current clawback policies; and
• prohibit companies from insuring or indemnifying any current or former executive officer against the loss of erroneously awarded compensation.

The rule applies to all issuers listed on any national securities exchange, including foreign private issuers, emerging growth companies, controlled companies and smaller reporting companies, as well as issuers listing only debt.² An issuer will be subject to delisting if it does not adopt and comply with a clawback policy that meets the requirements of the listing standards of the exchange on which it is listed.

What Companies Can Do Now

Companies should review their existing policies and think about potential updates that may be required under the new rules.  However, even if they draft amendments now, companies should likely wait for the exchanges to release their listing standards before actually adopting or formally amending current policies to ensure that any changes made will comply with the specifics of the new listing standards.

Effective Date

The stock exchanges will be required to file their proposed listing standards with the SEC for approval no later than 90 days following the publication of the final rules in the Federal Register, which must be effective no later than one year following such publication.  The rules are therefore not expected to take effect until mid-2023 at the earliest.

The following provides an overview of key components of the new rules, and additional detail on these items can be found in Appendix A.

Restatements that Trigger Application of Recovery Policy

To be compliant, a company's clawback policy must be triggered in the event of 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
• would result in a material misstatement if the error were recorded in the current period or left uncorrected in the current period (a "little r" restatement).³

"Little r" restatements, which do not require an Item 4.02 Form 8-K and allow companies to fix their prior periods in a periodic report without amending previously filed reports, are much more common that "Big R" restatements and often occur for run-of-the-mill accounting errors.  As a result, the new rules are likely to require clawbacks much more often and for much smaller recoveries than was originally contemplated by the proposed rules.⁴

Additionally, there is no scienter requirement, as Section 10D was "established not to punish wrongdoing, but to require executive officers to return monies that rightfully belong to the issuer and its shareholders."

Executive Officers Subject to Clawback Policy

"Executive officer" for purposes of the new rules is the same as the definition of "officer" as used in Exchange Act Rule 16a-1(f), meaning the clawback must apply to any current or former Section 16 officers.⁵

The rule requires recovery of incentive-based compensation that was received by a person:

• after they began service as an executive officer
• if that person served as an executive officer at any time during the recovery period.⁶

Incentive-Based Compensation Subject to Recovery

The final rules define "incentive-based compensation" to be "any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure."  Incentive-based compensation recoverable under the final rules is compensation that an executive officer would not have been entitled to receive had the financial statements been accurately presented.

A "financial reporting measure" upon which compensation is based need not be presented within the financial statements or included in an SEC filing.  Instead, the term includes financial measures within the financial statements, and any measure derived in whole or in part from such financial measures, including:

• a non-GAAP financial measure, such as EBITDA; or
• a metric or ratio that is not a non-GAAP financial measure.

If these measures are used for incentive compensation purposes and there is an accounting restatement that affects their calculation, a compensation recovery analysis will be required.⁷

Finally, a "financial reporting measure" under the final rules specifically includes stock price and total shareholder return ("TSR").  While neither stock price nor TSR are included in companies' financial statements, and an accounting restatement would not directly affect their calculations, the SEC explained that they were included because "improper accounting affects such measures and in turn results in excess compensation."

Board Discretion

Many current clawback policies give the compensation committee or the full board the discretion to determine whether to pursue a clawback. Under the new rule, boards do not have discretion as to whether to pursue recovery; a company must recover erroneously awarded compensation in compliance with its clawback policy except to the extent that one of the following circumstances applies:

• the cost to enforce the policy would exceed the amount to be recovered (and the issuer has made a reasonable attempt to recover, documented such attempt and provided such documentation to the exchange);
• recovery would violate home country law that existed at the time of adoption of the rule (and the issuer provides an opinion of counsel to that effect to the exchange);⁸ or
• recovery would likely cause an otherwise tax-qualified retirement plan to fail to be so qualified.

Disclosure Requirements

New Exhibit to Annual Reports

The final rules add new paragraph 97 to Item 601 of Regulation S-K and make conforming changes to Forms 20-F and 40-F to require a listed company's clawback policy to be filed as an exhibit to its Exchange Act annual report on Form 10-K, 20-F or 40-F.

Detailed Disclosures in the Event of a Restatement

The rules also add a new Item 402(w) of Regulation S-K, which in the event of an accounting restatement during or after the last fiscal year end, will require detailed disclosures regarding the restatement and the clawbacks made (or attempted) under the companies' policies.⁹

The disclosures under this item must be in tagged data format. The disclosures under Item 402(w) will be required in any proxy or information statement relating to the election of directors, as well as annual reports on Forms 10-K, 20-F and 40-F. Smaller reporting companies, emerging growth companies and foreign private issuers will be required to comply with the new disclosure requirements, even Item 402 disclosures are not otherwise applicable.

Recalculation of Amounts in Summary Compensation Table after a Clawback

Item 402(c) of Regulation S-K has also been amended to provide a new instruction to the Summary Compensation Table. If there has been a recovery of compensation pursuant to Rule 10D-1, companies will be required to reduce the amount reported in the applicable column for the fiscal year in which the amount recovered was initially reported by any amount recovered under the clawback policy, and identify such amounts in a footnote.

Check the Box Disclosures on Annual Report Cover Pages

Finally, the new rules add two new check-the-box disclosures to the cover of Forms 10-K, 20-F and 40-F to indicate:

1. whether the company's financial statements included in the filing reflect correction of an error to previously issued financial statements; and
2. whether any of those error corrections are restatements that required a recovery analysis pursuant to Rule 10D-1.

The new checkboxes will be required once the company is required to have a policy under the applicable listing standard.

Indemnification and Insurance

The rules prohibit companies from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.

Practical Considerations

• Clawback policies can exceed the new requirements. New Rule 10D-1 sets out the minimum requirements that a clawback policy must meet. A company may adopt policies that are more expansive, such as extending its clawback policy to cover individuals who are not executive officers or implementing recovery in situations not linked to financial restatements. For example, some companies have instituted policies that require clawback in situations involving employee misconduct or those that cause reputational harm to the company. Certain institutional investors¹⁰ favor these broader clawback policies, and companies should consider whether they are appropriate for their needs; companies that already have more expansive policies should be wary of removing any such broader clawback triggers in light of potential investor scrutiny of such a change.
• Review existing incentive compensation plans and agreements. Companies may want to consider incorporating language into existing incentive compensation plans, if possible, to specify that awards under the plan are subject to the company's clawback policy. Some companies already include language regarding clawbacks in their equity award agreements; these companies should revisit their form of award agreements to ensure there are no inconsistencies once they have adopted a clawback policy compliant with the final rules.
• Consider compensation more broadly. Companies may also consider a shift away from incentive-based compensation towards other forms of compensation, such as discretionary bonuses or time-vesting equity awards, in order to avoid a mandatory recovery analysis and requirement to recover compensation under Rule 10D-1. However, companies should be mindful that investors and proxy advisers will likely still want compensation to be linked to the company's financial performance.
• Consider updating your bylaws or form of D&O indemnification agreement. Issuers should assess with outside counsel whether they need to update their bylaws (or, if they are incorporated elsewhere, other organizational documents that address indemnification) and/or form of D&O indemnification agreements to indicate that an executive officer may not be indemnified for loss of compensation pursuant to the clawback policy (to the extent prohibited by the SEC rule¹¹). The SEC stated in its release that it believes that Section 29(a) of the Exchange Act would render void and unenforceable any indemnification agreement that indemnifies an executive for liability under an SEC-mandated clawback policy. However, making this explicit in the relevant documents, or at least determining with outside counsel that it is already prohibited by them, could shield companies against claims by current or former executives that they are entitled to indemnification for recovered compensation.
• When the rules become effective and a restatement occurs, don't forget to involve your HR/employee benefits team. Restatements are often work-intensive, time-consuming, around-the-clock projects for companies. Internal accounting personnel are often used to involving their external auditors and audit committees to make swift but careful determinations about whether restatements are needed. However, it will be key for companies to also involve their human resources/employee benefits teams early in the process of a potential restatement to determine if it will trigger a clawback. If it does, issuers may need to convene not only an audit committee meeting, but also a compensation committee and/or board meeting to approve the clawback.
• Following effectiveness of the rule, be sure to update your annual report exhibit index and cover pages. As discussed above, the clawback policy must be included as an exhibit and two checkboxes must be added to the first Exchange Act annual report on Form 10-K, 20-F or 40-F after the rules go into effect.

Appendix A

Incentive-Based Compensation Subject to Recovery

Incentive-based Compensation

The definition of "incentive-based compensation" in the final rule includes equity awards whose grant or vesting is based wholly or in part upon the attainment of financial reporting measures. Specific examples of "incentive-based compensation" include, but are not limited to:

• Non-equity incentive plan awards that are earned based wholly or in part on 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 satisfaction of a financial reporting measure performance goal; 
• Restricted stock, restricted stock units, performance share units, stock options and stock appreciation rights ("SARs") 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 is not "incentive-based compensation" include, but are not limited to: 

• Salaries¹²;
• Bonuses paid solely at the discretion of the compensation committee or board that are not paid from a "bonus pool" that is determined by satisfying a financial reporting measure performance goal;
• Bonuses 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, 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.

When Compensation is Received

Incentive-based compensation will be deemed "received" in the fiscal period during which the financial reporting measure is attained, not when the payment, grant or vesting occurs. This is consistent with, for example, reporting of typical non-equity incentive plan earnings, where the performance measure is satisfied as of December 31, but the payout of the award does not occur until early in the following year.

Incentive-based compensation is also deemed "received" when the financial reporting measure has been attained, even if the award remains subject to time-based vesting. An example given by the SEC is a performance-based stock unit award with the number of units determined at the end of a three-year performance period ending December 31, 2022. Even if the award is subject to continued employment until December 31, 2024, and the executive does not have a non-forfeitable interest in the award until the end of 2024, if a restatement occurred for fiscal 2020, 2021 or 2022, the clawback policy would require a recalculation of the number of units that will ultimately vest at the end of the time-based vesting period.

Additionally, incentive-based compensation is only subject to the new rules to the extent that it is received while the issuer has a class of securities listed on an exchange or an association.¹³

Three-Year Lookback

The three-year look-back period for recovery will comprise the three full fiscal years immediately preceding the date the issuer determines it is required to prepare an accounting restatement for a given reporting period. Basing the look-back period on fiscal years, rather than a preceding 36-month period, is consistent with the statutory language and issuers' general practice of making compensation decisions and awards on a fiscal year basis.¹⁴ It should be noted that the lookback begins when it is determined that the restatement is required, or when an issuer should reasonably conclude a restatement is required,¹⁵ as opposed to when the restatement is actually filed. Presumably, this would be the same date that an Item 4.02 Form 8-K is triggered for a "Big R" restatement.

Recovery Process

Calculation of Erroneously Awarded Compensation

In the event of a restatement, issuers must first recalculate the applicable financial measure and the amount of the incentive-based compensation. The issuer then would determine whether, based on the original financial statements and any discretion applied, the executive received more than would have been received applying the recalculated measure.

1. It is important to note that the calculations must be made on a pre-tax basis. It is possible that executives may have already paid taxes on the amounts that are to be recovered. In the release, the SEC noted that recovery on a pre-tax basis would simplify the recovery calculation for issuers and that any resulting tax burden should be borne by executives – not issuers and their shareholders.
2. TSR and Stock Price. For incentive-based compensation based on TSR or stock price, the amount of erroneously awarded compensation will not be subject to mathematical recalculation directly from the information in an accounting restatement. In these cases, the excess amount must be based on a "reasonable estimate" of the effect the accounting restatement had on the applicable measure. Additionally, issuers are required to provide their documentation of the determination of the reasonable estimate to the exchange. The SEC noted that there are different methods with different levels of complexity to estimate such amounts, but declined to provide any guidance or safe harbor with respect to these determinations. Commenters to the proposed rules noted that it may be necessary for issuers to engage valuation experts or other third-party advisors to conduct this type of "but for" analysis.
3. Duplicate Recoveries. The release notes that the new rule is not intended to affect other recovery provisions, such as Section 304 of the Sarbanes-Oxley Act or a foreign recovery regime. If issuers recover incentive-based compensation pursuant to other recovery obligations, those amounts would appropriately be credited to the required recovery under the issuer's clawback policy.

Timing of Recovery

Although issuers may exercise discretion in how they accomplish recovery, the final rules require issuers to recover amounts "reasonably promptly." This term is not defined in the rules, and the adopting release goes so far as to say that the rules do not prohibit the establishment of a deferred payment plan until repayment would not result in an unreasonable economic hardship to the executive.

It is unclear what will ultimately be determined to be "reasonably promptly." The adopting release leaves it up to directors, "in the exercise of their fiduciary duty to safeguard the assets of the issuer (including the time value of potentially recoverable compensation)." Additionally, the SEC noted that the exchanges are not restricted from adoption more prescriptive approaches to the timing and method of recovery under their rules.

Disclosures Required

In the event of an accounting restatement during or since the last fiscal year, Item 402(w) of Regulation S-K will require companies to disclose the following information, which is subject to Inline XBRL tagging:

1. the date the company was required to prepare the restatement and the aggregate dollar amount of erroneously awarded compensation (including an analysis of how the amount was calculated and, in the case of stock price or TSR, the estimates used and an explanation of the methodology for the estimates);
2. the aggregate amount of erroneously awarded compensation that remains outstanding at year end and, if any amounts have been outstanding for 180 or more days, the amounts due from each current and former named executive officer;
3. if the amount of erroneously awarded compensation has not yet been determined, that fact, and the reasons why it has not yet been determined, must be disclosed; and
4. if recovery of amounts is impracticable, such amounts for which recovery was forgone, for each current and former named executive officer and for all other current and former executive officers as a group, along with an explanation as to why recovery was not pursued.

Additionally, if an accounting restatement was required during or since the issuer's last fiscal year, and the issuer determined recovery was not required pursuant to its policy, the issuer must explain why application of the policy led to this conclusion.

^{1 See, the final rule, fact sheet and press release.
2 The requirements do not apply to exchanges that trade securities pursuant to unlisted trading privileges but do not list securities. Also exempted are listings of certain security futures products, standardized options, securities issued by unit investment trusts and securities issued by certain registered investment companies.
3 An out-of-period adjustment (when the error is immaterial to the previously issued financial statements, and the correction of the error is also immaterial to the current period) will not trigger a compensation recovery analysis, because it is not an "accounting restatement."  Additionally, retrospective changes to financial statements that do not represent error corrections would not trigger the analysis.  Examples include (but are not limited to): a retrospective applications of a change in accounting principle; revisions to reportable segments due to an issuer's internal reorganization; reclassifications due to discontinued operations; adjustment to provisional amounts in connection with a prior business combination (IFRS filers only); and revisions for stock splits, stock dividends or other changes in capital structure.
4 It is estimated that in 2021, excluding SPACs, "little r" restatements accounted for three times as many restatements as "Big R" restatements, but "little r" restatements may be less likely to trigger a potential recovery of compensation because they may be less likely to be associated with a decline in previously reported net income, and on average are associated with smaller stock price reactions. See SEC's Division of Economic and Risk Analysis memorandum here.
5 Executive officers of the issuer's parent(s) or subsidiaries are deemed executive officers of the issuer if they perform such policy-making functions for the issuer.  For limited partnerships, officers or employees of the general partner(s) who perform policy-making functions for the limited partnership are deemed officers of the limited partnership.  For trusts, officers or employees of the trustee(s) who perform policy-making functions for the trust are deemed officers of the trust.
6 The rules do not require recovery of compensation received by an individual before becoming an executive officer, or if that individual was not an executive officer during the period for which the compensation is subject to recovery.  Note that nothing in the rule limits an issuer's compensation recovery policy from requiring recovery more broadly.
7 Examples of metrics or ratios that are not non-GAAP financial measures that could lead to a compensation recovery analysis include same store sales, where sales are being restated, cost per employee, where costs are being restated, or revenue per user, where revenues are being restated.
8 The SEC chose the date of adoption of the rule as the relevant cut-off point "to minimize any incentive countries may have to change their laws in response to this provision."  For issuers organized in jurisdictions where the law is changed after the rule's adoption to forbid the SEC-mandated clawbacks mandated, the SEC predicts that issuers might avoid clawing back by using the other prong allowing for discretion (i.e., determining that the costs of enforcing would exceed the amount to be recovered).
9 The SEC also adopted amendments to Item 404(a) of Regulation S-K, Transactions with Related Persons (and conforming amendments to Item 7.D. of Form 20-F) to clarify that companies complying with the Item 402(w) disclosure requirements need not disclose any incentive-based compensation recovery under their related party disclosures.
10 See, e.g., BlackRock’s investment guidelines, available here: "We generally favor recoupment from any senior executive whose compensation was based on faulty financial reporting or deceptive business practices. We also favor recoupment from any senior executive whose behavior caused material financial harm to shareholders, material reputational risk to the company, or resulted in a criminal proceeding, even if such actions did not ultimately result in a material restatement of past results.  This includes, but is not limited to, settlement agreements arising from such behavior and paid for directly by the company.  We typically support shareholder proposals on these matters unless the company already has a robust clawback policy that sufficiently addresses our concerns."
11 Issuers should be sure the language sufficiently covers clawback policies under Rule 10D-1 (and not only clawbacks under Section 304 of the Sarbanes-Oxley Act of 2002, which allows the SEC to force an issuer's CEO and CFO to reimburse compensation if the issuer is required to prepare an accounting restatement as a result of misconduct).
12 To the extent that an executive officer receives a salary increase earned wholly or in part based on the attainment of a financial reporting measure performance goal, such a salary increase is subject to recovery as a non-equity incentive plan award for purposes of Rule 10D-1.
13 Incentive-based compensation received by an executive officer before the issuer's securities become listed is not required to be subject to the recovery policy.
14 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 recovery policy would apply to compensation received in 2021, 2022 and 2023.
15 An issuer is considered required to prepare an accounting restatement on the earlier of (i) date its board of directors, a committee of its board (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 such a restatement, and (ii) the date a court, regulator or other legally authorized body directs the issuer to prepare an accounting restatement.}

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