On July 1, 2015, the Securities and Exchange Commission (SEC) issued proposed rules that would require publicly listed companies to recover (or "clawback") excess incentive-based compensation from current and former executives in the event of an issuer's material accounting restatement, whether or not the executive was at fault for the restatement. These are the last remaining executive compensation rules to be proposed under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

In general, the proposed rules would require the stock exchanges to enact new listing standards requiring issuers to adopt and adhere to clawback policies. Such policies must provide that if an issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirements under the federal securities laws, then the issuer will recover the excess incentive-based compensation awarded to any current or former executive officer during the three-year period preceding the date on which the restatement occurs. Failure to comply with these rules would result in delisting by the applicable stock exchange. Issuers would have only limited discretion to not clawback compensation where otherwise required.

The SEC's issuance of the proposed rules marked the beginning of an extensive comment and adoption process that makes it unlikely that the clawback rules will take effect before late 2016.

Which Issuers Are Covered?

Subject to limited exceptions, the rules would apply broadly to all issuers with listed securities, including foreign private issuers, emerging growth companies, smaller reporting companies, controlled companies, and issuers of listed debt whose stock is not listed.

Which Individuals Are Covered?

The clawback policy would apply to an issuer's current and former "executive officers" who received certain types of incentive-based compensation during the approximately three-year period preceding the date on which it is determined that a restatement is required. The proposed rules would define "executive officer" in the same way as the "officer" definition for Section 16 purposes (meaning the issuer's president; principal financial officer; principal accounting officer; any vice president that is in charge of a principal business unit, division, or function; and any other person—including executive officers of a parent or subsidiary—who performs similar policy-making functions for the issuer).

Which Compensation Is Covered?

The proposed rules would define "incentive-based compensation" as any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure. "Financial reporting measures" are: (1) measures that are determined and presented in accordance with the accounting principles used in preparing the issuer's financial statements; (2) any measures derived wholly or in part from such financial information; and (3) stock price and total shareholder return. Salaries, bonuses not tied to satisfying a financial reporting measure, and equity awards based solely on continued employment, for example, would not be subject to clawback. In order to be subject to the clawback policy, the incentive-based compensation must have been received by an individual who was an executive officer for at least a portion of the performance period relating to the incentive-based compensation.

What Triggers a Clawback?

The clawback policy would be triggered by the obligation to prepare an accounting restatement to correct an error (without regard to fault) that is material to previously issued financial statements. The SEC has specifically declined to elaborate on what types of errors would be considered material, noting that materiality must be determined in the context of particular facts and circumstances. The SEC does note that a series of immaterial corrections may be considered a material error when viewed in the aggregate. Restatements due to a change in accounting principles or organizational structure, or that result from a stock split or business combination, would not trigger a clawback under the proposed rules.

How Is the Recoverable Amount Calculated?

The proposed rules would define "recoverable amount" as the amount of incentive-based compensation received by the current or former executive officer that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement. The recoverable amount is determined on a pre-tax basis.

Where the amount of incentive-based compensation that the executive officer received was tied to the stock price or total shareholder return, the recoverable amount may be determined by the issuer based on a reasonable estimate of the effect of the accounting restatement on the applicable measure.

For incentive-based compensation in the form of equity awards, the recoverable amount would depend on whether the underlying shares have been sold. If the shares have not been sold, then the recoverable amount would be the number of shares or options received in excess of the number that should have been received based on the accounting restatement. If options have been exercised but the underlying shares have not been sold, then the recoverable amount would be the number of shares underlying the excess options. If the shares have been sold, then the recoverable amount would be the sale proceeds received from the excess number of shares. Recoverable amounts would be net of any exercise price paid by the executive officer to acquire the shares.

What Is the Applicable Time Period?

Incentive-based compensation received during the three completed fiscal years immediately preceding the date that the issuer is required to prepare an accounting restatement (not the 36 months preceding a restatement) would be subject to clawback.

Under the proposed rules, incentive-based compensation would be deemed to have been received in the fiscal period during which the financial reporting measure is attained, even if the payment or grant occurs after the end of that period or not all conditions to payment have been satisfied (e.g., additional service conditions or board of directors certification of performance criteria). If the incentive-based compensation is an equity award that vests upon the attainment of a financial reporting measure, then the award would be deemed to have been received in the fiscal period when it vested.

Clawback policies would apply to incentive-based compensation received in any fiscal period ending on or after the effective date of the new rules.

Does an Issuer Have Discretion Not to Clawback Compensation?

An issuer would be allowed to decide not to clawback compensation only if recovery would be impracticable due to either of two limited circumstances: (1) the amounts that would be paid to a third party to assist in recovery exceed the recoverable amount, or (2) recovery would violate home country laws. However, the issuer must first make a reasonable attempt to clawback compensation and provide to the applicable stock exchange documentation of its attempt before concluding that recovery would be impracticable.

Issuers would be prohibited from indemnifying or reimbursing any current or former executive officer against the application of a clawback policy. Issuers also would be prohibited from paying the premiums on an insurance policy that would cover an executive's potential clawback obligations.

What Disclosure Is Required?

Issuers would be required to file their clawback policies as an exhibit to their Form 10-K. In addition, disclosure regarding the application of the clawback policy would be required in the issuer's proxy statement if, during the prior fiscal year, there was either (1) an accounting restatement that required a clawback, or (2) an outstanding clawback balance. The required disclosure would include the following:

• For each restatement:
  • the date on which the issuer was required to prepare the restatement;
  • the aggregate dollar amount of the excess compensation attributable to the restatement;
  • the aggregate dollar amount of excess compensation outstanding at the end of the issuer's last completed fiscal year; and
  • estimates used to determine the excess compensation that was subject to any financial reporting measures relating to stock price or total shareholder return
• The name of each person subject to clawback from whom the issuer has decided not to pursue recovery, the amounts due from each such person, and a brief description of the reason the issuer decided not to pursue recovery
• The name of, and amount due from, each person at the end of the issuer's last completed fiscal year from whom clawback amounts had been outstanding for 180 days or more

Any amounts that are recovered under the clawback policy from any named executive officer's compensation for the fiscal years reported in the summary compensation table in the issuer's proxy statement will reduce the amount reported in the table for the fiscal year in which the amount recovered initially was reported. The reduction also is required to be identified by footnote to the summary compensation table.

The new disclosure would have to be tagged in the proxy statement in interactive block text tag format using eXtensible Business Reporting Language (XBRL).

What Happens If an Issuer Does Not Comply with the Rules?

Under the proposed rules, an issuer would be subject to stock exchange delisting if it does not:

• adopt a clawback policy that complies with the applicable listing standard;
• disclose the clawback policy in accordance with the proposed rules; or
• comply with its clawback policy's recovery provisions.

What Are the Key Dates?

It seems likely that the clawback rules will become effective in late 2016 at the earliest. The proposed rules are subject to a 60-day comment period. Once finalized, the stock exchanges would have 90 days to file proposed listing rules to implement the clawback policy requirements, and the new listing rules would be effective no later than one year after that publication date. Issuers, in turn, would then be required to adopt a clawback policy no later than 60 days following the date on which the new listing rules become effective.

What Should Issuers Do Now?

Issuers should consider doing the following:

• Review any existing clawback policies to determine whether any changes may be required upon adoption of the final rules.
• Review compensation policies and practices to determine the possible impact of the clawback rules.
• Add provisions to any new incentive-based compensation plans and agreements explicitly subjecting the compensation to any clawback policy that the issuer adopts. Note that this could result in unfavorable financial accounting consequences for equity awards if done wrong, so we suggest discussing any provision like this with your auditors prior to implementation.
• Review the charter of the compensation committee to determine whether clawback policy compliance language should be inserted as a compensation committee responsibility in light of the contemplated rule requirements.
• Review executive officer designations and educate those whose compensation could be subject to the proposed rules about clawbacks generally.