On June 9, 2023, the U.S. Securities and Exchange Commission (the “SEC”) approved incentive-based compensation clawback listing standards adopted by the Nasdaq Stock Market (“Nasdaq”), the New York Stock Exchange (the “NYSE”) and NYSE American. Each of these standards will become effective on October 2, 2023, and public companies will have until December 1, 2023, to adopt policies that comply with their applicable listing standards.
KEY DATE: DECEMBER 1, 2023
Listed companies must have a clawback policy that complies with the new rules by December 1, 2023.
As more fully outlined in our prior client alert, Absorbing and Reacting to the SEC’s New Clawback Rules, the new listing standards1 were adopted in accordance with Rule 10D-1 under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), which satisfied one of the SEC’s outstanding obligations under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). While some companies may have existing clawback policies, the new standards provide specific qualifications in order for such policies to be compliant and, as a result, all listed companies should review their compensation policies to ensure compliance.
Now Is the Time for Clawback Policies, Whether to Amend Existing or Adopt New
Working towards the December 1, 2023, compliance deadline, companies should think carefully about a variety of timing considerations. For example, because a new or revised policy must be approved by a company’s board, consideration should be given to the company’s governance calendar. Moreover, since there may be changes that impact a number of officers, it will be important to have time to socialize and educate the board and executive officers on the new rules. In addition, the rules require additional public disclosures (also discussed below), which means enforcement mechanisms and disclosure controls will also take time to develop.
Clawback Policy To-Do List
- Board must approve compliant policy (whether new or amended), and may need to approve revisions to other executive agreements before December 1, 2023.
- Analyze existing compensation arrangements and policies and amend as needed.
- Develop an enforcement process and disclosure controls procedures.
High-level Overview of Compliant Clawback Policies
Generally, the new listing standards require (subject to limited exceptions) the recovery of incentive-based compensation received by current and former executive officers to the extent such incentive-based compensation was awarded based on a misstated financial performance measure (including, but not limited to, stock price and total shareholder return) during the prior three fiscal years.2
Notably, unlike many existing clawback policies that only apply to officers who actually engaged in fraud or misconduct related to financial statements, the new standards generally require issuers to recoup compensation erroneously awarded to any executive officer in connection with any “Big R” restatements as well as “Little r” restatements. The new rule is triggered by “an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws.” It broadly applies to (i) restatements that correct errors that are material to previously issued financial statements (“Big R”) or (ii) restatements that correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period (“Little r”). The standards eliminate discretion that previously existed for issuers to determine when and whether to pursue enforcement of existing clawback policies and there is no misconduct requirement under these new rules.
What Triggers a Clawback?
“Big R” Restatement
- are material to the previously issued financial statements;
- require a prompt, full restatement of previously issued financial statements; and
- require immediate Form 8-K disclosure that the previously issued financial statements can no longer be relied upon.
“Little r” Restatement
- not material to previously issued financial statements;
- but would result in a material misstatement if the error were corrected, or left uncorrected, in the current period; and
- do not require a prompt restatement of previously issued financial statements and may be corrected during the next required filing.
Other key requirements under the new listing standards are:
- Three-Year Lookback: Clawback policies must clawback incentive compensation erroneously paid during the three completed fiscal years immediately preceding the date on which the issuer is required to prepare an accounting restatement to correct an error that is material to previously issued financial statements. Dodd-Frank only looked back 12 months.
- All Executive Officers Subject to Clawback: Clawback policies must apply at least to current and former executive officers (substantially the same “executive officers” defined under Section 16 of the Exchange Act), which expands the scope beyond simply the current CEO or CFO as required under Section 304 of Sarbanes-Oxley of 2002.
- Covered Compensation: Clawback policies apply to all “incentive-based” compensation that is “received” during the prior three fiscal years based upon the restated financial information.
- Limited Exceptions: Limited exceptions to the mandatory clawback requirements include situations where (i) the expenses paid to a third party to enforce the policy would exceed the amount to be recovered after other reasonable attempts, (ii) recovery would violate home country law that existed at the time Rule 10D-1 was published and (iii) recovery would likely cause a tax-qualified retirement plan to no longer qualify.
New Disclosure Requirements in Annual Reports and Proxy Statements after December 1, 2023
Beginning after December 1, 2023, each listed company will need to file its clawback policy as an exhibit to its Annual Report on Form 10-K. In addition, the cover page of Form 10-K now includes a checkbox indicating (i) whether the financial statements of the registrant included in the filing reflect correction of an error to previously issued financial statements and (ii) whether any of those error corrections are restatements that required a recovery analysis of incentive compensation received by any of the registrant’s executive officers during the relevant recovery period under the new rule.
In addition, each listed company will need to include disclosure in its proxy statement pursuant to Item 402 of Regulation S-K, detailing how they have applied their clawback policy, including providing the date of any restatement, aggregate amount of erroneously awarded compensation, any outstanding compensation subject to clawback that had not been recouped within 180 days separately identified by individual and other details regarding any such compensation and officers. The Summary Compensation Table will also need to include certain disclosures regarding compensation that is recouped pursuant to a clawback policy.
Clawback Policy Drafting and Other Considerations
In addition to the basic requirements, companies should also consider the following when revising or adopting a clawback policy:
- Understand What Counts as “Incentive-Based Compensation”: There is a distinction between compensation based on the attainment of any financial reporting measure and compensation based on the completion of a project or other strategic measure (e.g., DEI metrics are not incentive-based compensation subject to the requirements of Dodd-Frank). The compensation committee and administrators of the clawback policy must have a solid understanding of which types of compensation within a company’s program are, or are not, subject to the policy.
- Be Clear How Clawbacks Will Be Calculated: The policy must at least mention that the amount of any erroneous payment be reasonably estimated by the policy’s administrator and that documentation backing up that reasonable estimation must be maintained and shared with Nasdaq or the NYSE as required. Companies should consider the level of detail with which the policy describes the process of determining an error was made and calculating the amount of any clawback. For example, should determinations be made only by independent directors and how will conflicts be handled?
- Provide the Administrator With Flexibility: The final rules set forth certain standards that are open for interpretation and, as a result, a company’s clawback policy should provide the administrator the maximum flexibility to act within the bounds of the new rules. For example, a company must pursue clawbacks “reasonably promptly,” but the rule does not adopt a definition of “reasonably promptly.” In addition, broad authority to act within the requirements could allow the administrator to establish a reasonably prompt payment plan for erroneously awarded compensation owed by an executive officer taking into consideration undue economic hardship under certain fact patterns.
- Consider Including an Enforcement Mechanism: In addition to provisions describing the general enforcement and administration of the policy, companies should consider whether to include provisions addressing what happens if an executive officer refuses or otherwise fails to repay amounts when due (e.g., timing requirements for repayment and responses to notices, mandatory arbitration provisions, indemnification of the company for expenses and fees associated with pursuing repayment).
- Analyze for Potential Inconsistent Arrangements or Policies: The adoption of a compliant clawback policy may require the renegotiation of certain executive officer’s equity grant agreements, employment agreements and/or indemnification agreements. For example, review each executive officer’s employment and indemnification agreements to confirm that these agreements do not obligate or permit the company to indemnify the executive officer from having to reimburse the company for erroneously awarded incentive-based compensation. Before seeking board approval for the new clawback policy, these other arrangements and policies should be reviewed to capture any additional changes across documents for board consideration and approval.
- Ask for Executed Acknowledgements: As a matter of good governance, we generally advise companies to include an acknowledgement and acceptance form that is executed by executive officers subject to the clawback policy. In addition to creating a strong record, certain states may require an executed acknowledgement in order to conclude that the clawback policy represents a legally enforceable contract. The acknowledgment can also serve other important goals, including reinforcing the intent that the clawback policy controls notwithstanding any conflict in other prior-executed agreements and evidencing intent by each executive officer to comply with the policy and be subject to its enforcement mechanisms.
- Consider Overlap With Other Legal Requirements: The new clawback rules apply to all executive officers, but that does not relieve a company’s obligation to comply with Section 304 of the Sarbanes-Oxley Act of 2002, which applies only to a company’s CEO and CFO in cases involving misconduct resulting in a company’s material noncompliance with any financial reporting requirement under the securities laws. If companies have written policies regarding Section 304 of Sarbanes-Oxley, consideration must be given as to how the two overlap.
- Review Internal Controls: Given that a public company may be delisted if the company fails to recover incentive compensation on a “reasonably prompt” basis, every public company should review and discuss revising its company’s internal controls over financial reporting with its auditor to ensure that (i) the events that trigger recovery of incentive compensation under the policy can be identified in a timely fashion and the details shared with the executive officer and management and (ii) the parties responsible for disclosing the event triggering a reporting obligation will be promptly informed of the event.
- Remember That the Clawback Policy Must Be Publicly Disclosed: Rule 10D-1 and the new listing standards require each registrant to file its clawback policy as an exhibit to its Annual Report on Form 10-K. Given that the SEC’s and the exchanges’ guidance on these new rules is limited, we caution against adopting policies containing defined terms that deviate appreciably from the language provided under Rule 10D-1 and the applicable listing standards.
Getting ahead of the process and taking enough time to ensure careful and thoughtful drafting of a new clawback policy will pay dividends in the long run. We generally advise educating internal stakeholders and the board on the new rules and process to help individualize long-term compliance with the new disclosure and other obligations. Even if you think your current clawback policy complies with the new rules, now is the time to double-check, as the compliance date of December 1, 2023, is fast-approaching.
1 See Sections 303A.14 and 802.01F of the NYSE Listed Company Manual, Nasdaq Listing Rule 5608 and Section 811 to the NYSE American Company Guide.
2 For a detailed overview of the SEC’s clawback rules, see our prior client alert, Absorbing and Reacting to the SEC’s New Clawback Rules.