The SEC adopted a rule to require national securities exchanges and associations to establish listing standards that require issuers to develop and implement a policy to recover erroneously awarded incentive-based compensation received by current or former executive officers.
The final rules intend to strengthen:
- Transparency and quality of corporate financial statements
- Investor confidence in corporate financial statements
- Accountability of corporate executives to investors
The new rules are provided for in Release No. 33-11126, Listing Standards for Recovery of Erroneously Awarded Compensation.
The Dodd-Frank Wall Street Reform and Consumer Protection Act added Section 10D to the Securities Exchange Act of 1934. Section 10D requires the SEC to direct the national securities exchanges and associations that list securities to establish listing standards that require each issuer to develop and implement a compensation recovery policy—also referred to as a clawback policy.
The new rules require an issuer to recover executive incentive-based compensation erroneously awarded during the three years preceding the date the issuer is required to prepare an accounting restatement.
New Exchange Act Rule 10D-1 directs exchanges and associations to establish listing standards that require a listed issuer to:
- Adopt and comply with a written policy for recovery of erroneously awarded incentive-based compensation
- Disclose compensation recovery policies
An issuer will be subject to delisting if they don’t adopt and comply with a compensation recovery policy that meets the requirements of the listing standards.
Compensation Recovery Policy
In accordance with New Exchange Act Rule 10D-1, an issuer is required to adopt a written compensation recovery policy that’s triggered in the event the issuer is required to prepare an accounting restatement.
The policy must require recovery of erroneously awarded compensation from any current or former executive officer who received incentive-based compensation during the three years preceding the date an accounting restatement was required.
The recoverable amount is the amount of incentive-based compensation received in excess of the amount that otherwise would’ve been received had it been determined based on the restated financial measure.
In accordance with US Generally Accepted Accounting Principles (GAAP), both Big R and little r restatements are considered an accounting restatement. This includes an accounting restatement to correct an error that’s material to the previously issued financial statements, or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period.
However, the recovery policy wouldn’t be triggered by an out-of-period adjustment as it isn’t considered an accounting restatement. This includes an adjustment for an error that’s immaterial to the previously issued financial statements, and the correction of the error is also immaterial in the current period.
The recovery policy applies to incentive-based compensation received during the three years preceding the date an accounting restatement was required. This occurs the earlier of:
- The date the issuer’s board of directors, committee of the board, or the officer or officers of the issuer authorized to take such action, concludes, or reasonably should’ve concluded that the issuer is required to prepare an accounting restatement due to the material noncompliance with any financial reporting requirement under the securities laws
- The date a court, regulator, or other legally authorized body directs the issuer to prepare an accounting restatement
Incentive-based compensation is deemed received for purposes of triggering the recovery policy in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained—even if the payment or grant occurs after the end of that period.
In accordance with Rule 10D-1, the term executive officer includes any current or former officer who received incentive-based compensation and served as an executive officer during the recovery period, including the issuer’s:
- Principal financial officer
- Principal accounting officer, or if there is no such accounting officer, the controller
- Any vice-president in charge of a principal business unit, division, or function
- Any other person with a policy-making function
The recovery policy applies to compensation received during the three-year recovery period by a current or former officer. It doesn’t apply to compensation received prior to becoming an executive officer.
Rule 10D-1 defines incentive-based compensation to be any compensation—including both cash and equity—that’s granted, earned, or vested based wholly or in part upon the attainment of any 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, and any measures derived wholly or in part from such measures—including stock price and total shareholder return. A financial reporting measure includes non-GAAP financial measures, as well other measures, metrics, and ratios that aren’t non-GAAP measures such as same store sales.
Financial reporting measures also includes measures presented outside the financial statements—such as those included in Management’s Discussion and Analysis of Financial Conditions and Results of Operations or a performance graph.
An issuer is required to comply with its compensation recovery policy and recover erroneously awarded compensation regardless of whether the executive officers were at fault, except if that pursuit of recovery would be impracticable.
Rule 10D-1 establishes the following limited circumstances that would allow executive offices to retain incentive-based compensation that was erroneously awarded:
- Direct expenses paid to third parties to assist in enforcing the policy would exceed the amount to be recovered and the issuer has made a reasonable attempt to recover
- Recovery would violate home country law that existed at the time of adoption of the rule, and the issuer provides an opinion of counsel to that effect to the exchange
- Recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code
The final rules amend Item 402 of Regulation S-K to require an issuer to describe its compensation recovery policy and how it applied the policy in any Form 10-K or proxy or information statements where executive compensation disclosure is required.
In accordance with amended Item 402, an issuer must also disclose the following information if, during the last completed fiscal year, it was required to recover compensation or had an outstanding balance of erroneously awarded compensation to be recovered:
- The date it was required to prepare an accounting restatement and the aggregate dollar amount of erroneously awarded compensation attributable to such accounting restatement—including the estimates used in calculating the recoverable amount in the case of awards based on stock price or total shareholder return
- The aggregate amount that remains outstanding and any outstanding amounts due from any current or former named executive officer for 180 days or more
- Details regarding any reliance on the impracticability exceptions
The final rules also require an issuer to file the policy as an exhibit to its annual report on Form 10-K.
Issuers must also indicate by check boxes on their annual report whether the financial statements included in the filing reflect correction of an error to previously issued financial statements and whether any of those error corrections are restatements that required a compensation recovery analysis.
The listing standards requirements apply to all exchanges and association that list securities, except for the listing of:
- Certain security futures products
- Standardized options
- Securities issued by unit investment trusts
- Securities issued by certain registered investment companies from the mandated listing standards
The compensation recovery policy and disclosure requirements apply to all listed issuers, including smaller reporting companies and emerging growth companies.
The final rules become effective January 27, 2023.
Exchanges and associations are required to file proposed listing standards no later than February 26, 2023, and those listing standards must be effective no later than November 28, 2023.
Issuers subject to such listing standards are required to adopt a compensation recovery policy no later than 60 days after the applicable listing standards become effective and must comply with these disclosure requirements in proxy and information statements and the issuer’s annual report filed on or after the issuer adopts its compensation recovery policy.
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