August 7, 2015

SEC Proposes Executive Compensation Clawback Rules Pursuant to Dodd-Frank

Holland & Knight Alert
Jason Hartley Barker


  • SEC’s proposed rule defines a company’s responsibilities to adopt, apply and disclose a clawback policy.
  • Under the rule, companies must establish policies that require “executive officers” to repay incentive-based compensation that they received based on erroneous accounting figures.
  • The rule will allow companies to “clawback” incentive-based compensation due to material accounting errors.

The Securities and Exchange Commission (SEC) proposed rules on July 1, 2015, related to the design and implementation of clawback policies of listed issuers for the recovery of compensation erroneously awarded to the issuer’s executive officers. The rules, proposed as Rule 10D-1, were issued pursuant to Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Section 954 added provisions to the Securities and Exchange Act of 1934 (Exchange Act), which required the SEC to promulgate rules with the following twin aims:

  • to direct the national securities exchanges or associations to prohibit the listing of any security of an issuer that does not comply with the proposed rules
  • to require issuers to develop and implement a publicly disclosed recovery policy designed to recover any incentive-based compensation that was erroneously awarded to any current or former executive officer due to an accounting restatement in any of the three preceding fiscal years

Ultimately, an issuer that does not comply with the rules – if and when implemented – will be subject to delisting by its securities exchange.

Potential Impact of the Proposed Rules

If the proposed rules are adopted without substantial modifications, their implementation will likely influence issuer governance in the following areas:

  • the determination of Section 16 officers
  • the form and content of any existing or future clawback policy
  • the structuring of executive compensation

The Basics of the Proposed Rules

The proposed rules apply to virtually all types of securities and classifications of listed issuers, with limited exceptions. In support of the rules’ extensive reach, the SEC reasons that the potential benefit to investors outweighs the burden to any particular classification of issuer – such as a smaller reporting company.

An issuer’s recovery policy must be in writing and dictate that, if the issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, it will seek to recover the amount of erroneously awarded incentive-based compensation for its executive officers.

The concept of materiality is not defined and must be analyzed in the context of particular facts and circumstances. The SEC believes that a series of immaterial error corrections could be considered material when viewed in the aggregate, regardless of whether any one of them resulted in the filing of an amendment to previously filed financial statements.

There are certain retrospective changes to an issuer’s financial statement that will not trigger recovery under an issuer’s clawback policy, which include the following:

  • application of a change in accounting principle
  • revision to reportable segment information due to a change in the structure of an issuer’s internal organization
  • reclassification due to a discontinued operation
  • application of a change in reporting entity (such as from a reorganization of entities under common control)
  • adjustment to provisional amounts in connection with a prior business combination
  • revision for stock splits

The SEC defines “incentive-based compensation” as any compensation that is granted, earned or vested wholly or in part upon the attainment of a financial reporting measure. Financial reporting measures are:

  • measures 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 total shareholder return

The proposed rules set forth a non-exhaustive list of financial reporting measures, including revenues, net income, profitability of a reportable segment, financial ratios, return and earnings measures and EBITDA. It is irrelevant whether the financial reporting measures are included in an actual filing with the SEC or as part of the financial statements; it is enough, for example, that the financial reporting measure is described in management’s discussion and analysis of financial condition and results of operations (MD&A).

The recovery policy will apply to any incentive-based compensation received during the three completed fiscal years immediately preceding the date the issuer is required to prepare a restatement of its financial statements to correct a material error. Under the proposed rules, the erroneously awarded compensation subject to recovery under an issuer’s clawback policy includes “the amount of incentive-based compensation that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement, and shall be computed without regard to any taxes paid.” For incentive-based compensation based on stock price or total shareholder return, an issuer is permitted to use reasonable estimates in determining the impact of a restatement on the compensation, provided that the issuer’s estimates are made available to its exchange.

The “trigger date” for determining whether an accounting restatement has occurred is the date an issuer’s board, governance committee or authorized officer concludes that the issuer’s financial statements contain a material error. Or, if applicable, the trigger date will be the date a court or other authoritative body directs the issuer to restate its financial statements to correct a material error. The trigger date is generally expected to coincide with the Form 8-K disclosure requirement under Item 4.02(a) to Form 8-K; however, the actual filing of a Form 8-K is not dispositive in determining whether the trigger date occurred or whether the issuer has any affirmative obligations under the proposed rules.

No-Fault Recovery

During the three-year lookback window, an issuer’s clawback policy will apply to any executive officer who received incentive-based compensation during that period – regardless of whether the executive continues to be employed by the issuer and played any role in preparing the issuer’s financial statements. The definition of “executive officer” under the proposed rules mirrors the definition of “officer” contained in Rule 16a-1(f) of the Exchange Act. Accordingly, the definition includes the issuer’s principal officers (executive, financial and accounting), any vice president in charge of a principal business unit, division or function, and any officers who perform policy making functions.

Recoverable Compensation

Compensation that is subject to a recovery policy includes non-equity incentive plan awards that are earned or based in part upon satisfying a financial reporting measure performance goal, bonus pool bonuses (the size of which is determined with reference to satisfaction of a financial reporting measure performance goal) and equity-based awards with vesting conditions tied to the satisfaction of a financial reporting measure performance goal. Recoverable compensation also includes proceeds from the sale of shares acquired through an incentive plan that were granted or vested based on satisfying a financial reporting performance goal. Compensation that will not be strictly subject to a recovery policy includes salaries, bonuses and equity-based compensation payable without regard to a financial reporting measure performance goal.

For incentive-based awards subject to multiple conditions, the new rules target the vesting of any financial performance conditions in determining whether a recovery policy applies to the awards. For example, if an equity-based award such as restricted stock units (RSUs) includes a condition related to financial performance and a condition unrelated to financial performance – such as service-based vesting – the SEC takes the position that, for the purposes of the recovery policy, an executive receives the compensation at the time the performance related condition is met (even if the executive only has a contingent right to the actual payment of RSUs at that time). In this scenario, the recovery policy would reduce the number of RSUs to which the executive is entitled at the time he or she achieves the service-based condition.

The proposed rules mandate that an issuer recover erroneously awarded compensation unless it would be impracticable to do so. Impracticability occurs only after an issuer has made a documented attempt at recovery, and if the direct expenses, including third-party expenses, incurred to enforce the policy will exceed the amount to be recovered (or if recovery would violate home country law, in the case of a foreign private issuer).

The proposed rules limit the discretion of an issuer’s board of directors in determining the total amount to be recovered from each executive officer. The SEC notes that recovery from each executive officer should be pro rata based upon the size of the original award to the executive officer instead of allowing an issuer’s board to make recovery allocations after the fact.

In addition, indemnification arrangements between the issuer and its directors and officers may not be used to avoid or nullify the recovery required by the proposed rules.

Any amounts recovered from an executive officer by the issuer pursuant to Section 304 of the Sarbanes-Oxley Act of 2002 should be credited as recovered from the executive officer to the extent the issuer’s recovery policy requires repayment of the same compensation by that executive officer.

Public Disclosure Requirements

The proposed rules require a listed issuer to file its recovery policy as an Exhibit to its Form 10-K. If an accounting restatement is required, the issuer will be required to make select disclosures in its proxy statement, including disclosures in the Summary Compensation Table if any recoupment of executive compensation was required as the result of the accounting restatement. The required disclosure may stand alone or be made as part of the issuer’s compensation discussion and analysis (CD&A) if the executive against whom a recovery is applicable is a “named executive officer.” For each restatement, the required proxy disclosures include the following:

  • the date on which the issuer was required to prepare the restatement
  • the aggregate dollar amount of excess incentive-based compensation attributable to the restatement
  • the estimates used to determine the excess incentive-based compensation attributable to the restatement, if the financial reporting measure related to a stock price or total shareholder return
  • the aggregate dollar amount of excess incentive-based compensation that remains outstanding at the end of the last completed fiscal year

In addition, if the issuer elected not to pursue recovery of any excess compensation paid to an executive officer, the issuer must disclose the amount of such excess compensation and the name of the executive officer, and provide a brief description of why the issuer decided not to pursue recovery. Any recoverable amounts that remain outstanding for 180 days or more also must be disclosed, together with the name of the executive officer against whom recovery is mandated.

Next Steps

Given the pending comment period, the extensive topics for which the SEC has requested comment, and the additional time the SEC will need to finalize its rules (prior to the additional 90-day period the national securities exchanges and associations have to propose their listing rules), it seems unlikely that the implementation of the final rules will occur prior to 2017.

In the interim, there are key issues that listed issuers may want to discuss with company counsel.

First, the issuer’s annual determination of its Section 16 officers takes on an added importance. As detailed above, the issuer’s clawback policy will be applicable to equivalent officers and recovery will be required from all such officers in the case of an accounting restatement. Accordingly, a determination of an issuer’s Section 16 officers that is over-inclusive could be unnecessarily costly.

Second, even if the proposed rules are not adopted, or are substantially revised as the result of the comment process, best practices for clawback policies will undoubtedly begin to emerge in the coming months. This is an opportune time for an issuer to review its existing policy to determine if the provisions of the policy should be supplemented or amended in view of the SEC’s proposed rules. For issuers without a clawback policy, the issuer should examine the necessity of such a policy.

In addition to the proposed rules, listed issuers should be aware that, the two largest proxy advisory firms, ISS and Glass Lewis, consider the presence of a clawback policy as a factor in making certain corporate governance recommendations. ISS considers an issuer’s clawback policy in evaluating grant practices under a new equity-based compensation plan, and Glass Lewis considers an issuer’s clawback policy in connection with an issuer’s say-on-pay vote.

For larger listed issuers, it will be interesting to observe whether the no-fault recoupment of incentive-based awards under the proposed rules – if and when adopted – will ultimately affect change in compensation practices. Such changes would undoubtedly cause tension with the widely endorsed practice of granting performance-based compensation to executives in contrast to compensation that is predominately based upon longevity of service.

To read more detail, see the SEC's proposed rules for defining a company’s responsibilities to adopt, apply and disclose a clawback policy.   


Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.

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