Final SEC clawback rule requires significant changes to policies 

Twelve years after the Dodd-Frank Act became law and seven years after the SEC initially proposed a rule to require compensation clawbacks, the SEC approved a final rule (Securities Exchange Act Rule 10D-1) on October 26. Under the final rule, listed companies have to adopt and enforce a policy to recoup executive incentive-based compensation if payments were based on financial statements that were later restated and executives received amounts that otherwise would have been lower. Most companies will have to significantly revise their current policies to comply with the new rule even if the policies were compliant with the 2015 proposal as the final rule includes significant changes. However, based on the timing described in the release, companies could have more than a year from the date the final rule is published in the Federal Register to adopt a compliant policy.

Dodd-Frank directs the SEC to adopt a rule mandating that stock exchanges require listed companies to implement a clawback policy. The policy must apply to incentive-based compensation “received” by current and former executive officers during the three fiscal years preceding the date on which the listed company is “required to prepare an accounting restatement due to the material noncompliance…with any financial reporting requirement under the securities laws.” The SEC first proposed the rule in 2015 (the 2015 proposal). In 2021 and again in 2022, the SEC reopened the comment period in light of the changing landscape over the past seven years.

Key differences between the 2015 proposal and the final rule are that the final rule captures more restatements and requires more extensive disclosures to enhance transparency around how companies decide whether and when a clawback is triggered. The interest in capturing more restatements stems from concerns that companies may not be making appropriate materiality determinations when identifying financial statement errors (including suspicions that these determinations were intended to avoid triggering a clawback).

The final rule includes the following key provisions:

The final rule differs significantly from the 2015 proposal in several ways, including: 

• “Restatements” include both (i) restatements to correct errors that are material to the previously issued financial statements (so-called “Big R” restatements) that were covered in the 2015 proposal and (ii) additional restatements required to correct errors that would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized and corrected in the current period (so-called “little r” restatements). According to data collected by the SEC, “little r” restatements may have accounted for roughly three times as many restatements as “Big R” restatements in 2021, excluding restatements by special purpose acquisition companies (SPACs).
• Unlike the 2015 proposal, which referenced Section 16 officers, the final rule provides its own definition of executive officers that includes the same categories of people but excludes from recovery compensation received by executives prior to becoming an executive officer.
• Companies must disclose the calculation for incentive-based compensation based on stock price or TSR (instead of only having to provide documentation to the stock exchange as under the 2015 proposal).
• The requirement to check boxes on Form 10-K and certain other disclosures weren’t included in the 2015 proposal.

Stock exchanges must propose listing standards within 90 days after the SEC rule is published in the Federal Register, and the SEC must approve the listing standards within one year after publication in the Federal Register. Once the listing standards take effect, companies have 60 days to adopt a compliant policy. With all of these steps, companies could have as long as one year and 60 days to adopt or revise their policy before they are subject to delisting.

Companies must comply with the recovery policy for all executive incentive-based compensation (as defined above) received on or after the effective date of the listing standard, and disclosures are not required until then. With respect to amounts subject to the clawback, it doesn’t matter whether the compensation is received under a pre-existing contract or arrangement, or one entered into after the effective date of the listing standards.

Companies should take the following steps to prepare to comply: 

• Review their current clawback policy (or create one) to identify changes that are required for compliance. For example, many existing policies require misconduct, cover only Big R restatements, cover a narrower group of executives or don’t cover former executives, and allow for significant board discretion.
• Assess and enhance internal controls to minimize the risk of a financial restatement.
• Educate board members about the rule, designate a committee (for example, Compensation or Audit) to handle implementation and enforcement oversight, and update committee charters to reflect this decision and any new responsibilities.
• Educate covered officers so they are aware of the rule and its implications for their pay.
• Review corporate bylaws, compensation plans, and employment agreements to ensure they don’t prohibit compensation recovery, and amend provisions as appropriate to ensure a compliant clawback policy.
• Review D&O insurance to ensure it doesn’t conflict with the prohibition against insurance and indemnification.
• If incentive plans use stock price or TSR measures, consider the resources needed to prepare reasonable estimates of the impact of a restatement on stock price.
• Consider the tax implications of recoupment.
• Research US state and foreign laws that might preclude recovery.
• Establish procedures for locating former executives whose pay might be subject to recovery.