SEC Proposes Compensation Clawback Rules – Recovering Compensation Paid to Executive Officers in the Case of Restatements of Financial Statements by Frederic W. Cook & Co.
July 7, 2015
Abstract
On July 1, 2015, nearly five years after the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Act”) was enacted, the Securities Exchange Commission (“SEC”), in a split vote of three to two, proposed rules to implement Section 954 of the Act. Section 954 requires companies to adopt and enforce a policy (a “recovery policy,” commonly referred to as a clawback policy) providing for repayment from executive officers of incentive-based compensation (“IBC”) when restated financial statements indicate there has been an overpayment.
In general, the proposed rules apply whenever there is a determination that a financial restatement is required. Recovery applies to IBC paid to executive officers in excess of what would have been received if the financial statements in the preceding three fiscal years had been correctly prepared, including IBC based on stock price or TSR metrics. Recovery is mandatory unless the direct cost of enforcing recovery would exceed the recovery or foreign law would be violated.
Within 90 days of the final SEC rule, each national securities exchange/national securities association (a “stock exchange”) must publish implementing rules that become effective within one year of the final SEC rule. Registrants will have 60 days after the effective date of the stock exchange rule to adopt a clawback policy that complies with the stock exchange rule. A registrant can be delisted if it fails to adopt and adhere to a recovery policy that complies with the stock exchange rule.
Registrants should immediately consider amending their incentive compensation plans so that the new recovery rules are applicable. While a registrant need not adopt the new recovery policy until 60 days after the stock exchange rule, the recovery policy must apply to accounting restatements for periods ending after the effective date of the final SEC rule. For example, to take an extreme case, if the SEC finalizes its rule in 2015 and the rule is effective upon finalization, a calendar year registrant must be able to recover IBC in the event the 12/31/15 financials are restated and the restatement affects currently outstanding IBC awards, including long-term incentives granted in prior years in which payment is affected by results in 2015. This contractual right of recovery will be particularly important with respect to executive officers who are no longer employed by the registrant—absent a rule requiring repayment, the registrant may be unable to collect, which could lead to delisting. As a result of the potential retroactive application, companies should consider amending their plans now to ensure compliance if the rules are approved as proposed.
The SEC has solicited comments on the proposed rule and there is a 60-day comment period.
SEC Proposes Compensation Clawback Rules – Background
Section 954 of the Act, which adds new section 10D to the Securities Exchange Act of 1934, is the third federal law to mandate recovery of incentive compensation that has been paid based on erroneous financials. The first law was section 304(a) of the Sarbanes-Oxley Act of 2002, which gave the SEC a right to bring a recovery action against the CEO or CFO of a registrant in the event of an accounting restatement due to material noncompliance of the registrant, “as a result of misconduct,” with any financial reporting requirements. Recovery was limited to incentive-based or equity-based compensation received during the 12 months preceding the erroneous financial statement. There have been numerous criticisms of 304(a), including the lack of a private right of action, the limitation to the CEO and the CFO, the requirement of misconduct, the fact that the amount of recovery was not tied to the degree to which payment was increased due to the erroneous financial statement, and the limited time period to which the recovery right applies.
The second law was section 111(b)(3)(B) of the Emergency Economic Stabilization Act of 2008, which applied to financial institutions that had not yet repaid assistance they received under the Troubled Asset Relief Program (“TARP”). Up to the 25 most senior executives could be affected in the event of “bonus, retention award, or incentive compensation” payments based on materially inaccurate financial statements if the recipient received the right to the payment during the TARP period. The TARP recipient had to exercise its recovery right unless it was “unreasonable” to do so.
In general, section 954 of the Act can be viewed as an extension, with several refinements, of the TARP clawback rules to all listed registrants.2 This summary begins by describing the timing rules with respect to the implementation of section 954 and then examines the rules themselves in more detail.
Implementation
Implementation will occur in several steps. The first step, publication in the Federal Register of the proposed rule, had not occurred as of July 7. There will be a 60-day comment period from publication, which will be followed at some point by publication of a final SEC rule. It is difficult to predict the timing of a final rule.
Once the final SEC rule is published, a stock exchange will have 90 days in which to publish rules that condition listing upon compliance with the new rule. This listing rule must be approved by the SEC and effective no later than one year after the SEC publishes its final rule. A registrant will then have 60 days after the effective date of the stock exchange rule to adopt a compliant recovery policy, which policy must be filed as an exhibit to the annual report.
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