The SEC approved a new exchange listing standard for public companies required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which required listed companies to adopt a clawback policy by December 1, 2023. This policy requires the clawback of “incentive-based” compensation erroneously received by current and former executive officers, regardless of fault, during the three years prior to an accounting restatement. Although the legal requirements for a clawback policy are straightforward, the implementation of a clawback can be complicated.
Clawback Requirements
Once the company determines that a restatement is needed, the company is required to calculate the amount of any erroneously paid incentive-based compensation and pursue recoupment from impacted executives. Full recovery is generally required and must be accomplished “reasonably promptly,” subject to limited exceptions set forth in the rule where pursuing the recovery would be impractical.
The clawback covers current and former executive officers who received incentive compensation during the three-year look-back period preceding the date on which the company is required to prepare an accounting restatement to correct a material error. A restatement that triggers a clawback includes both “Big R” and “little r” restatements. Out-of-period adjustments (which include errors that are not material to either previously issued or current financial statements) where the correction is made do not trigger a clawback.
For this purpose, executive officers would include the company's president; principal financial officer; principal accounting officer (or controller); any VP in charge of a principal business unit, division or function; any other officer who performs a policymaking function; and any other person who performs similar policymaking functions.
Next Steps
In advance of a restatement, the board should determine responsibility for the oversight of the clawback policy. Since the clawback policy is a compensation-related policy, the compensation committee is typically charged with oversight of the policy and any recoupment process. The committee should also adopt an internal clawback implementation plan that includes the delegation of tasks to specific committees, executives, other officers, outside counsel and third-party advisors.
A company should review current and former compensation programs for determinations made regarding compensation that is “incentive-based” that is paid to executive officers. The review and modification of internal controls and procedures on a going-forward basis, including those related to the decision-making processes and related documentation with respect to the award of incentive-based compensation, is recommended. This process involves the consideration of the means of recovery from impacted officers, as well as whether to defer payment of a portion of incentive-based compensation paid to executives to avoid situations where a clawback is required and taxes have already been paid on amounts required to be recouped.
Review of Compensation Documentation
The company should review and revise compensation documentation to address recovery. Acknowledgement language should be added to appropriate documents to provide for broad discretion with respect to recovery and offset rights in favor of the company. In performing this review, advice of counsel is necessary to determine how to align SEC clawback requirements with other applicable state or local laws that protect wages from forfeiture and restrictions on the recovery of taxes paid on clawed-back amounts under applicable tax rules. While an exemption from the clawback is available for inconsistency with home country laws, the legal inconsistencies that may exist with respect to prior documentation and the clawback policy do not provide an excuse for noncompliance.
Since the rule's adoption, it has quickly become a best practice to include acknowledgement language in compensation arrangements, including employment agreements, offer letters, cash or equity incentive plans and the related award agreements or award notices, and severance or termination agreements with executives leaving the company. The acknowledgements can act as consideration for the granting of new awards or the provision of a severance package.
Identifying “Incentive-Based” Compensation
The company should also identify “incentive-based” compensation in advance of a restatement. Incentive-based compensation includes any compensation that is granted, earned or vested, wholly or in part upon the attainment of any financial reporting measure that includes stock price and total shareholder return. Financial reporting measures are metrics that are determined and presented in accordance with GAAP and any measures that are derived wholly or in part from such measures, such as non-GAAP financial measures.
Identifying compensation that is incentive-based will require a review of materials prepared for and provided to the compensation committee, including information regarding the impact of financial (as well as nonfinancial) metrics, considered by the compensation committee when making compensation decisions. The review process will entail the evaluation of whether certain compensation awards may be inadvertently covered by the clawback policy because of the award being in recognition of the prior achievement of financial goals, even if the award itself is not subject to the achievement of specifically defined future financial metrics.
Implementing the Clawback
Establishing the process. The company should establish a written process and related timeline for required actions, as well as the identification of potential members of a clawback implementation group, comprised of people from the company and any outside experts. The compensation committee will meet to implement the clawback review process, set actual time frames for required actions and establish the clawback implementation group members responsible for the collection of relevant information and the determination of the impact of the restatement on incentive compensation.
Consideration of the potential for conflicts of interest is required when management is involved in the determination of clawback amounts and related matters. The compensation committee may determine to hire independent compensation or accounting experts and counsel to work with the internal clawback implementation group. Also, considerations of attorney-client privilege may dictate that counsel hire outside experts to maintain the privilege.
Deliverables. The clawback implementation group will be required to provide the compensation committee a written report that details the incentive-based compensation impacted by the restatement, the time period covered (including the look-back), the methodology employed in calculations, the individuals impacted, if any, and the amount of funds subject to clawback for each individual. This report may also include potential sources of repayment. If it is determined that no clawback is required, the rationale for that decision and the documentation of the process that resulted in that conclusion should be documented.
Review of compensation. The three-year lookback period is defined in the SEC rule and determined based on the date of the financial restatement. Determining whether incentive-based compensation was granted to executives during the look-back period and the actual amounts to be clawed back can vary in terms of complexity depending on the economy. Incentive-based compensation is deemed “received” in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if payment or grant occurs after the end of the period.
It is important to review all compensation paid during the look-back period, how compensation levels were determined and how payment was made to ensure that any compensation that is not clearly incentive-based but may still be covered by the rule is identified, such as salary increases based on net income in a prior year. With respect to compensation that is clearly incentive-based, a determination of which portion is attributable to financial metrics vs. nonfinancial metrics or discretion is necessary.
Calculating the recoverable amount. The recoverable amount is an amount that “exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement” and is based on the gross amount paid. The company must recalculate incentive-based compensation payment based on the restated financial reporting measure (without consideration of taxes paid).
Generally, the calculation of this clawback amount, if any, is a simple math calculation but, in some cases, sophisticated statistical analysis will be necessary to calculate the value of erroneously paid incentive-based compensation, particularly where the payment received was based on the company's stock price or TSR. In these instances, the retention of an expert will be required to perform the calculations. When TSR or stock price is utilized, the recoverable amount may be based on a “reasonable estimate” of the effect of the restatement on stock price or TSR in determining the amount recoverable.
Recovery. The company may exercise discretion with respect to the recovery of excess compensation, which can vary depending on the facts and circumstances of each impacted officer and the amount recoverable, as well as the applicability of state and local laws. The company should identify potential resources for the recovery from officers. This exercise will likely require a conversation with impacted officers in the planning stage and when a clawback is triggered. For current officers, the form of repayment can come from the vesting of awards not subject to clawback or cash bonus payments. Deferred recoveries are permissible depending on the officer's financial situation at the time the clawback is implemented.
A notice informing officers of the clawback and recovery can be prepared in advance as well and taken off the shelf and completed, as necessary.
Disclosure Requirements
The clawback disclosure of the clawback is required in the company's proxy statement and annual report. The Form 10-K includes new check boxes on the cover indicating whether a restatement has occurred and whether it resulted in a recovery of excess compensation. When the recovery is triggered, the company is required to disclose detailed information regarding the restatement and recovery in the next proxy statement or annual report, as outlined in the rule.
If no recovery is required, the disclosure must explain the reason why recovery is not required. Further, if one of the exceptions to recovery is relied upon by the company, information regarding reliance on an exemption is required.
Implementing a clawback policy effectively is a complex and multifaceted process. The rules are clear, but the devil is in the details and implementation can prove to be difficult. Careful preparation and planning will help to make the clawback situation go more smoothly and efficiently when it is encountered.
The author thanks Alex Noga, associate consultant for Aon, for assisting in the crafting of this article.