One year after reopening the comment period, and seven years after first publishing proposed rules, on October 26, 2022, the SEC adopted final rules on listing standards for the recovery of erroneously awarded incentive-based executive compensation (“Clawback Rules”). The Clawback Rules implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification. The proposed rules were first published in July 2015 (see HERE) and have moved around on the SEC semiannual regulatory agenda from proposed to long-term and back again for years.
The final rules require a listed issuer to file the policy as an exhibit to its annual report and to include disclosures related to its recovery policy and recovery analysis where a recovery is triggered. New Exchange Act Rule 10D-1 directs national securities exchanges and associations to establish listing standards that require a listed company to: (i) adopt and comply with a written policy for recovery of erroneously awarded incentive-based compensation received by its current or former executive officers in the event it is required to prepare an accounting restatement due to its material noncompliance with any financial reporting requirement under the securities laws, during the three completed fiscal years immediately preceding the date that the company is required to prepare an accounting restatement; and (ii) disclose those compensation recovery policies in accordance with SEC rules, including providing the information in inline XBRL format.
The final rules also require disclosure of the listed company’s policy on recovery of incentive-based compensation and information about actions taken pursuant to such policy. In addition, the rules also require all listed companies to: (i) file their written recovery policies as exhibits to their annual reports; (ii) indicate by check boxes on their annual reports whether the financial statements included in the filings reflect correction of an error to previously issued financial statements and whether any of those error corrections are restatements that required a recovery analysis; and (iii) disclose any actions they have taken pursuant to such recovery policies.
Listed companies have time for compliance. Exchanges do not have to adopt new rules for another year and compliance will not be required until 60 days after the effectiveness of the new listing standards. Once implemented, however, non-compliance would result in delisting.
Background
Even before adoption of the Clawback Rules, there are existing rules which require the recovery of executive compensation and disclosure of such policies. In particular, Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”) requires the CEO and CFO to reimburse the company for any bonus or other incentive-based or equity compensation for the prior 12 months, and any profits received from the sale of securities in that time period, if a company is required to prepare a restatement as a result of the misconduct related to financial reporting. In February 2021, the SEC invoked the rule in an enforcement action, which it had rarely, if ever, done before.
There are also rules which require disclosure related to executive compensation, including Clawback provisions. The Compensation Discussion and Analysis (CD&A) required by Item 402(b) requires an explanation of “all material elements of the registrant’s compensation of the named executive officers” and requires general discussions of performance including disclosure of any bonus structures and performance-based compensation and company policies and decisions regarding the adjustment or recovery of awards and payments to such named executive officers.
The Clawback Rules require the recovery of executive compensation following an accounting restatement, which compensation would not have been paid under the restated financial statements. Indemnification or insurance reimbursement is prohibited. In addition to requiring companies to adopt written policies and procedures and to disclose same, the Clawback Rules remove fault from the consideration of recovery, broaden the effected executives to include all named executive officers and extend the existing look-back period.
Final Rule
Section 954 of the Dodd-Frank Act added Section 10D to the Exchange Act, which provides that the SEC require national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that does not develop and implement a policy providing for the recovery of erroneously awarded incentive-based compensation and for disclosure of that policy. A company would be subject to delisting if it does not adopt a compensation recovery policy that complies with the applicable listing standard, disclose the policy in accordance with SEC rules, and comply with the policy’s recovery provisions.
Specifically, the new rules:
- Require national securities exchanges and associations to establish listing standards that require listed companies to adopt and comply with a compensation recovery policy in which recovery is required from current and former executive officers who received incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement to correct a material error. The recovery must be on a “no fault” basis without regard to whether any misconduct occurred, or whether the executive officer had responsibility for the misstated financial statements.
- Require that the amount of incentive-based compensation to be recovered be the amount the executive received over what they would have received based on the restated financial statement.
- Require a company to seek recovery except to the extent it would be impracticable to do so, such as where the recovery cost would exceed the amount to be recovered, or for foreign issuers, where recovery would violate home country laws.
- Prohibit companies from indemnifying current and former executive officers against the loss of recoverable incentive-based compensation.
- Require the filing of the compensation recovery policy as an exhibit to the company’s Exchange Act annual report.
- Require specific disclosure in the executive compensation disclosure section of annual reports and proxy statements, with XBRL tagging, if the company completed a restatement that required recovery in the past fiscal year or there is any recoverable amounts outstanding from any prior year.
The implementation and impact of the rule will rest on the definitions of incentive-based compensation and executive officers. The rule defines “incentive-based compensation” as any compensation that is granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure. “Financial reporting measure” is defined as a measure that is determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measure derived wholly or in part from such financial information, and stock price and total shareholder return. For incentive-based compensation based on stock price or total shareholder return, issuers are permitted to use a reasonable estimate of the effect of the restatement on the applicable measure to determine the amount to be recovered.
The rule defines an “executive officer” to include the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs policymaking functions for the company and otherwise conforms to the full scope of the Exchange Act Section 16 definition.
The Clawback Rules apply to all listed issuers and all securities, with limited exceptions. The rules’ limited exemptions include security future products, standardized options and the securities of certain registered investment companies.
Restatements Triggering Application of Recovery Policy
The Clawback Rules require issuers to adopt and comply with policies that require recovery “in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws.” The SEC includes any error that is material to the financial statements as “material noncompliance.” Accordingly, the Clawback Rules provide that issuers adopt and comply with a written policy providing that in the event the issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements, the obligation to prepare the restatement would trigger application of the recovery policy.
The Clawback Rules will include “little r restatements” which refers to restatements that materially impact the current period but are immaterial to prior financial statements. A “little r” restatement generally does not require an Item 4.02 Form 8-K for non-reliance on previously issued financial statements. In recent years, full-blown accounting restatements have not been happening quite as often as they once did, for a variety of reasons, but the occurrence of little r restatements has grown dramatically.
When Dodd-Frank was enacted in 2010 on the heels of the Enron crisis, the concern was that executives should not be able to keep incentive compensation paid based on misstated financial statements that had to be restated as a result of fraud or other misconduct. Many industry participants are concerned with the broad scope of the new rules which are likely to result in compensation recovery policies being invoked much more often where there has been a mundane accounting error and for smaller amounts. The cost-benefit analysis may not be supported with such a broad scope.
The SEC clarifies that the following changes to financial statements would not trigger the recovery policy: (i) the retrospective application of a change in accounting policy; (ii) retrospective revision to a reportable division due to a company’s internal reorganization; (iii) retrospective reclassification due to a discontinued operation; (iv) retrospective application of a change in reporting entity such as from a reorganization or change in control; (v) retrospective adjustment to provisional amounts in connection with a prior business combination; or (vi) retrospective revision for stock splits.
Applicable Date and Time Period
The Clawback Rules require the recovery of incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement. The date on which the company is required to prepare an accounting restatement is the earlier of (i) the date the board of directors or officers of the company, if board authorization is not required, conclude that the company’s previously issued financial statements contain a material error; or (ii) the date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.
Compliance with Recovery Policy
Under the Clawback Rules, a company is subject to delisting if it does not (i) adopt a compensation recovery policy that complies with the rules; (ii) disclose the policy in accordance with the rules, including XBRL tagging; and (iii) comply with its written compensation recovery policy.
Transition and Timing
The Clawback Rules require that each national exchange propose new listing standards implementing the rules no later than 90 days following SEC publication of final rules; that such standards take effect no later than one year following SEC publication of final rules; and that each company adopt the recovery policy required by the rules no later than 60 days following the date on which the exchanges’ rules become effective.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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