In July 2015 the SEC published for comment a new rule implementing Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act)1. Section 954 added Section 10D to the US Securities Exchange Act of 1934, requiring the SEC to adopt rules directing the national securities exchanges and associations to prohibit the listing of any security of a company not in compliance with certain requirements regarding the recovery of erroneously awarded incentive-based compensation and the disclosure of the company’s clawback policy.
As currently drafted, proposed Rule 10D-1 would apply to all listed companies, including foreign private issuers (FPIs). The policy would require a listed company to recoup incentive-based compensation granted, vested or earned by current and former executive officers of the company in the event of an accounting restatement due to material non-compliance with any financial reporting requirement under applicable securities laws, whether or not as a result of misconduct. The listing standards would apply to incentive-based compensation that is tied to accounting-related metrics, stock price or total shareholder return.
Rule 10D-1 supplements, and does not replace, Section 304 of the SOX Act. Under Section 304, the SEC must recoup incentive-based compensation paid to the CEO and the CFO of companies listed on US stock exchanges (including FPIs) in the event of an accounting restatement due to material non-compliance with any financial reporting requirement under applicable securities laws as a result of misconduct, which need not to be attributable to the CEO or CFO. Section 304 of the SOX Act does not require the company to adopt a formal clawback policy because the provisions operate automatically. However, the SEC may exempt any person from the application of the section.
It is unclear how the clawback provisions of the SOX Act and Dodd-Frank Act would work together. The SEC has acknowledged that the two clawbacks together may result in double recovery against a CEO or CFO.
Scope of Rule 10D-1
In general, proposed Rule 10D-1 will require issuers of securities listed on US stock exchanges to adopt, disclose and enforce incentive-based compensation clawback policies. Issuers will be required to recover incentive-based compensation granted, vested or earned by current and former executives of the issuer if there is a restatement of the issuer’s financial statements due to errors that are material to the previously issued statements. Financial restatements that do not result from the correction of erroneously reported financial information, such as a restatement due to a retrospective change in accounting principles, would not trigger a clawback.
Recovery would apply to incentive-based compensation received by executive officers in the three fiscal years preceding the date upon which the issuer is required to restate. Incentive-based compensation is defined as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.” Awards based solely upon other performance metrics, such as obtaining regulatory approval of a project, are excluded.
Although the board has discretion concerning the manner in which the amounts are to be recovered, that does not extend to the amount to be recovered, and except in limited circumstances, whether to forego recovery.
A chart summarizing and comparing the key provisions of Section 304 of the SOX Act and proposed Rule 10D-1 appears below:
| ||SOX Act Clawback Rules||Dodd-Frank Act Proposal|
|Policy Required||No, operates automatically.||The adoption by the company of a formal policy is required.|
|Disclosure||Clawbacks applicable to NEOs must be disclosed in the proxy circular.|
The policy must be publicly disclosed.
The company must publicly disclosure status reports on recovery efforts, including names of affected individuals and amounts recovered.
|Board Discretion||Enforced by the SEC.||No discretion on whether or not the board can enforce. |
CEO and CFO only.
Misconduct need not be attributable to the CEO or CFO.
Extends to all current and former executive officers.
The term "executive officer" defined as an company’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the company in charge of a principal business unit, division or function, any other officer who performs a policy-making function, or any other person who performs similar policy-making functions of the company. In addition, executive officers of the company’s parent or subsidiaries would be deemed executive officers of the company if they perform such policy making functions for the company.
|Recovery Period||Amounts received during the 12-month period following the first public issuance or filing with the commission (whichever first occurs) of the financial document embodying such financial reporting requirement.|
Amounts received during the 3-year period preceding the date on which the company is required to prepare an accounting restatement, which is the earlier of:
- the date the board (or committee) concludes, or should reasonably have concluded, that there is a material error in the previously filed financial statements; and
- the date a court, regulatory or other authority directs the issuer to restate the previously issued financial statements to correct the material error.
Any bonus or other incentive-based or equity-based compensation.
Any profits realized from the sale of securities of the company during that 12-month period.
The amount to be clawed back is the amount of incentive-based compensation received during the recovery period that is in excess of what would have been granted, vested or paid based on the restated financial statements.
Incentive-based compensation means compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure. Incentive-based compensation includes:
- bonuses earned based in whole or in part on a financial reporting measure performance goal;
- bonuses paid from a bonus pool, if the pool size is based in whole or in part on a financial reporting measure performance goal;
- restricted stock, RSUs, PSUs, stock options and SARs and other equity awards granted or vested based in whole or in part on satisfying a performance goal based on a financial reporting measure, TSR or achieving a certain stock price; and
- proceeds received upon the sale of shares acquired under an equity award that was granted or that vested wholly or in part on satisfying a financial reporting measure performance goal.
So long as the following are not based in whole or in part on satisfying a performance goal based on a financial reporting measure, incentive-based compensation does not include:
- bonuses paid solely at the discretion of the board (or committee);
- bonuses paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) and/or completion of a specified employment period;
- non-equity incentive plan awards earned solely upon satisfying one or more strategic measures such as consummating a merger or divestiture, or operational measures such as opening a specified number of stores, completion of a project or increase in market share; and
- equity awards for which the grant is not contingent upon achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more non-financial reporting measures.
Time-vesting stock options, RSUs and PSUs are not "incentive-based" if the grant amount was not tied to achievement of performance goals or measures.
Amounts recoverable are pre-tax.
|Indemnification||No provisions.||The company cannot indemnify affected executive officers against recovery.|
|Application to Foreign Issuers||SEC may exempt a foreign company from compliance if it is of the opinion that the company’s home country practice is acceptable to the exchange (i.e. aligns with SOX Section 304) or if there was potential conflict with the foreign country’s practices.||Applies to all companies listed on US stock exchanges. FPIs are not exempted unless there is a conflict with the foreign country's laws (as supported by a legal opinion).|
|Consequences for Non-compliance||The provisions do not contemplate delisting of the company shares as a penalty for non-compliance.||The rule contemplates delisting of the company’s shares as a consequence for non-compliance.|
Reaction to the proposed rule
Over 60 comment letters were submitted to the SEC with a large majority of the commentators reflecting common areas of concern,2 including the following:
- Applicability to FPIs. Commentators noted that FPIs are already subject to home country rules regarding incentive compensation, creating enforceability concerns, and that FPIs may be forced to choose between violating home country laws and US listing standards. While there is an exemption for FPIs that are subject to conflicting home country rules, it is conditional on getting a legal opinion to this effect.
- Proposal is Overly Prescriptive. The proposal removes the board's discretion on whether or not to recover against an executive, and how much to recover.
- Enforceability. There are concerns about whether the implementation and enforcement of recoupment provisions are enforceable under employment law, whether written recoupment provisions constitute an exclusive remedy against an executive, or whether a recoupment policy can be implemented (or amended) unilaterally by companies without triggering a claim for termination without cause.
The comment period on the Dodd-Frank Act proposal ended September 14, 2015. Although it was expected the SEC’s final rules would be published in Q1 2016, it is now not certain when the SEC will publish its final rules. US stock exchanges will be required to file with the SEC listing standards that comply with Rule 10D-1 within 90 days of publication of the final version of the rule, which become effective no later than one year following that date. Once the listing standards take effect, companies will have 60 days within which to adopt a clawback policy that conforms to the rules.
Implications for Canadian Issuers
There is no requirement under Canadian securities laws or Canadian stock exchange requirements for companies to adopt clawback policies. However, a number of influential Canadian institutional investor advisors have promoted the adoption of clawback policies by Canadian public companies as a governance best practice.
Several different types of recoupment policies appear to be currently in use by Canadian companies to allow them to recover incentive-based compensation from executive officers. These include SOX-style recoupment policies requiring both an accounting restatement and misconduct, Dodd-Frank-style recoupment policies requiring only an accounting restatement without the need for misconduct, and in some instances, recoupment triggered by serious misconduct even in the absence of an accounting restatement.
While Canadian institutional investor advisors have promoted the adoption of clawback policies by Canadian public companies as a governance best practice, to date the Canadian Coalition for Good Governance is the only advisory firm that has recommended a "broader" form of clawback policy whereby the issuer can claw back all or a portion of a recently granted “transactional” cash bonus if the transaction’s goals are not materially met, irrespective of whether there was a restatement or executive misconduct.3
Provided a Canadian issuer listed on a US exchange has some form of clawback policy, an approach of "wait and see" how current developments unfold appears to be consistent with the practices of many Canadian dual-listed companies.
In the interim, it would be prudent for issuers to review the terms of their employment contracts with their executives to ensure they provide that the issuer has the right to recoup any incentive-based compensation in the circumstances described in the company’s clawback policy, and that the executive acknowledges he or she is bound by the policy and any amendments made thereto from time to time.
As well, as proposed Rule 10D-1 provides that a company cannot indemnify affected executive officers against recovery. The issuer’s insurance policies and D&O indemnity agreements should be reviewed to ensure compliance with the final version of the rule if and when enacted. However, the rule as currently drafted would not preclude an executive from securing and paying for his or her own insurance to fund any potential clawback obligation.
The authors are qualified to practice law only in the provinces of Ontario and Alberta. Any views expressed as to any laws or any matters governed by any laws other than the laws of the provinces of Ontario or Alberta and the federal laws of Canada applicable therein are based solely on a general understanding of the law.
- Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub L No 111-203, HR 4173 (111th) (2010) §954(b). See SEC Proposal – Listing Standards for Recovery of Erroneously Awarded Compensation: http://www.sec.gov/rules/proposed/2015/33-9861.pdf.
- SEC Comment Letters Received: https://www.sec.gov/comments/s7-12-15/s71215.shtml.
- See CCGG's 2015 Best Practices for Proxy Circular Disclosure, which was amended this year in order to require "a broader form of clawback policy."