In June 2023, the SEC approved a new exchange listing standard for public companies under the Dodd-Frank Act that was adopted by the NYSE and Nasdaq to require listed companies to adopt a clawback policy by December 1, 2023.
This policy applies to incentive-based compensation erroneously received by executive officers during the three years prior to an accounting restatement. Now that companies have adopted a clawback policy and filed it as an exhibit to the annual report, boards and compensation committees must determine how to oversee the administration of the policy and implement a clawback in the event of a restatement.
Clawback policy requirements
The SEC clawback rule requires a listed company to recover incentive-based compensation erroneously received by current and former executive officers, regardless of fault, during the three completed fiscal years immediately preceding the date the company is required to prepare an accounting statement. Once the company determines that a restatement is needed, it must calculate the amount of any erroneously paid incentive-based compensation and pursue recoupment from impacted executives. Full recovery must be accomplished ‘reasonably promptly’ subject to limited exceptions set forth in the rule.
For the purposes of the SEC clawback rule and company policy, a restatement that triggers a clawback includes both Big R and little r restatements. With respect to a Big R restatement, the material non-compliance results from an error that was material to the previously issued financial statements. With respect to a little r restatement, material non-compliance results from an error that would be material to the current period financial statements if the error were left uncorrected, or if the correction were recorded only in the current period.
Out-of-period adjustments, which include errors that are not material to either previously issued financial statements or the current period financial statements where the correction is made, do not trigger a clawback.
Next steps
In order to be able to act ‘reasonably promptly’ once it is determined that a restatement is required, there are certain steps a company should take in advance of a restatement. First, it should determine who is going to be responsible for the oversight of the clawback policy. The SEC clawback rule is silent on this point other than requiring that an independent committee responsible for executive compensation or independent board members make the determination that a clawback is impractical.
As the clawback policy is a compensation-related policy, the board’s compensation committee is typically charged with oversight of the policy and any recoupment process. If this is the case, the charter of the compensation committee should be revised during the annual review process to incorporate this responsibility into the committee’s duties. The audit committee also plays a significant role in this process as it would generally have to review and sign-off on the restatement. As such, there is a considerable amount of collaboration between the two committees that would take place in the event that a restatement and clawback situation presents itself.
In order to react quickly in the event of an accounting restatement, the board should consider adopting an internal clawback implementation plan to advise on and designate responsibility for specific actions the company would need to take in connection with an event that triggers the clawback policy. This plan should be comprehensive and include the delegation tasks to specific committees, executives, other officers, outside counsel and third-party advisers, as necessary.
In addition to adopting a clawback plan, compliance with the SEC clawback rule and a company’s own clawback policy will likely require issuers to review current and former compensation programs to determine which compensation is incentive-based and paid to executive officers. Companies will also have to review and modify internal controls and procedures on an ongoing basis, including those related to the decision-making processes and related documentation with respect to the award of incentive-based compensation.
This will help identify compensation that qualifies as incentive-based and, as a result, could be subject to recoupment. It may also involve consideration of the means of recovery from impacted officers and 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.
Who’s covered?
In the event of a restatement, the clawback would apply to current or former executive officers who received incentive-based compensation during the three-year look-back period. For this purpose, an executive officer would include:
- The company’s president, principal financial officer, principal accounting officer (or controller if there is no such officer)
- Any vice president in charge of a principal business unit, division or function
- Any other officer who performs a policy-making function
- Any other person who performs similar policy-making functions (including subsidiary or parent officers).
As a result, the company should identify officers potentially subject to the clawback policy and update this list periodically. The clawback policy covers incentive-based compensation received by executive officers:
- After beginning service as an executive officer
- Who served as an executive officer at any time during the performance period for which incentive-based compensation subject to clawback was provided
- Who served as an executive officer while the company had securities listed on a national securities exchange
- Who served as an executive officer during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement to correct a material error.
A company should review its current compensation documentation and evaluate how this documentation needs to be revised to address recovery of compensation in the event a clawback is required.
At minimum, documentation such as hiring materials, severance or termination agreements, award agreements, award notices and benefit plans will likely need to be revised to include clawback language, as necessary. With respect to future awards and related agreements, companies should consider adding language to clarify that current awards, as well as any previously awarded compensation, that fall within the scope of the clawback policy are subject to recovery. This acknowledgement language should also provide for broad discretion with respect to recovery and offset rights in favor of the company.
The assistance of counsel may be necessary in performing this review 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. Although an exemption from the clawback is available for inconsistency with home-country laws, the SEC has stated that legal inconsistencies that may exist with respect to prior documentation and the clawback policy do not provide an excuse for non-compliance.
In light of certain case law challenging the enforceability of clawback policies before the adoption of the SEC’s clawback requirements, some companies have adopted a practice of requiring executives subject to a clawback policy to sign an acknowledgement pursuant to which the officer acknowledges the policy and agrees to comply with the terms of such policy. These include the recovery of incentive compensation, notwithstanding any other contractual obligation to the contrary. The purpose of this acknowledgment is to provide a contractual basis for the company to enforce the clawback policy, if necessary.
Following the adoption of the clawback policy, it has quickly become a best practice to include acknowledgement language in compensation arrangements going forward, including employment agreements, offer letters, short and long-term 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 are likely to be consideration for the granting of new awards or the provision of a severance package, and the acknowledgement language should clarify that current awards, as well as any previously awarded compensation that falls within the scope of the clawback policy, are subject to recovery and provide for broad discretion with respect to recovery and offset rights in favor of the company.
Defining incentive-based compensation subject to clawback
Under the SEC clawback rule, incentive-based compensation subject to clawback 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 (TSR). Financial reporting measures are metrics that are determined and presented in accordance with Gaap used in preparing the financial statements, and any measures that are derived wholly or in part from such measures, such as non-Gaap financial measures.
The determination of whether compensation is covered by the clawback policy will require a review of materials and other documentation prepared for and provided to the compensation committee – or the full board, if applicable – with respect to meetings where compensation decisions are made, including detailed information regarding the impact of financial and non-financial metrics considered by the compensation committee when making compensation decisions for impacted officers.
It will be important to clearly establish and document those compensation awards going forward that may be or are subject to the company’s clawback policy. Part of this documentation review process will entail the thorough evaluation of whether certain compensation awards may be inadvertently covered by the clawback policy as a result 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.
Delineating what compensation is covered by the policy, making clear the award calculation methodology at the start of the committee’s deliberations and including detailed and carefully crafted minutes to support that conclusion will help with the analysis of how to quantify the appropriate amount to recover under the policy and avoid the time-consuming task of trying to make these determinations at the time of an accounting restatement. Taking these steps will also theoretically create some flexibility for the company in the event the clawback policy is triggered.
Under the SEC rule, 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 of the incentive-based compensation occurs after the end of the period.
The amount of the erroneously awarded incentive-based compensation subject to recovery is the amount by which the executive officer’s incentive-based compensation exceeds the amount the executive officer otherwise would have received had such amount been determined based on the restated financial reporting measures.
Where the incentive-based compensation is based on stock price or TSR, companies are permitted to use reasonable estimates to assess the effect of an accounting restatement on their stock price or TSR in determining the amount recoverable. Additional outside resources may be necessary to calculate the amount of erroneously paid compensation under these circumstances.
Recovery resources and notice
The rule is silent regarding the method of recovery with respect to compensation received erroneously. As a result, recovery may vary based on the particular facts and circumstances of each restatement, including the executive officers involved, whether they are current or former officers of the company and the amount recoverable from each officer. Consequently, a company should identify potential resources for the recovery from both current and former officers in advance of any restatement.
This exercise will likely require a conversation with impacted officers both 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. Hiring documentation, stock-based award agreements and severance agreements when modified to reflect the adoption of the policy can include in the acknowledgement of the clawback requirements an indication of potential forms of recovery, if identified or known. A notice informing officers of the clawback and recovery can also be prepared in advance and taken off the shelf and completed, as necessary.
Implementing the policy
Establishing the process
In preparing to implement a clawback, the compensation committee should establish a written process and related timeline for required actions, as well as the identification of potential members of a clawback implementation group. This group should comprise people from the company and any outside experts necessary to implement the process.
If it is determined by the audit committee or the full board that a restatement is required, the compensation committee should meet to implement the clawback review process, set timeframes 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. The compensation committee should also consider the potential for conflicts of interest when management is involved in determining clawback amounts and making judgment calls with respect to calculations, sources of funds and taxation matters.
Depending on the dollar amounts involved, the compensation committee may decide to hire independent compensation or accounting experts and counsel to work with the internal clawback implementation group. Considerations of attorney-client privilege may dictate that counsel hire outside experts in order to maintain the privilege.
Deliverables
The clawback implementation group should provide the compensation committee with a written report that details the incentive-based compensation affected by the restatement, the time period covered, the methodology used in calculating the clawback, 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 the implementation team determines that no clawback is required, the rationale for that decision and the documentation of the process that resulted in that conclusion should be included in the report.
The preparation of this report requires a determination of:
- The applicable look-back period as defined in the SEC rule, which are the three completed fiscal years immediately preceding the date the company is required to prepare an accounting statement
- Whether incentive-based compensation was granted, paid or vested during the look-back period
- Who the company’s executive officers were at any time during the look-back period who were granted incentive-based compensation
- The amount of incentive-based compensation, if any, that must be clawed back.
Compensation review
A company’s executive officers should have been identified in advance and the list of whom this policy applies to given to the clawback implementation team. The three-year look-back 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 amounts to be clawed back can vary in terms of complexity depending on the company and financial metrics used. As a result, it is helpful if a company has determined and documented which compensation was considered incentive-based and subject to the rule before the restatement. 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 tied to net income from the prior year.
With respect to compensation that is clearly incentive-based such as the annual bonus, a determination of which portion is attributable to financial metrics vs non-financial metrics or discretion is required. This determination requires a review of applicable documentation, proxy statement disclosures, plans, award agreements and, if applicable, committee minutes. In light of this SEC rule, clear documentation of these awards is critical to avoid any ambiguity in the future.
Calculating the recoverable amount
The recoverable amount is that which ‘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. Once it is determined that a restatement is required and the clawback policy is triggered, a company must recalculate incentive-based compensation based on the restated financial reporting measure or measures, without consideration of taxes paid.
This recalculation will determine whether the executive received a greater amount of incentive-based compensation than he/she would have received if the financial statements had been prepared correctly initially. The calculation of the amount of incentive compensation that is recoverable, if any, is determined based on the type of compensation arrangement.
For example, if incentive-based compensation is paid in cash -based on a bonus pool, the size of the pool has to be recalculated based on the restated financials and the excess amount for each officer would be determined on a proportional basis. If incentive-based compensation was paid as equity in the form of shares, options or stock appreciation rights, the recoverable amount would be the number of shares received that exceeded the number that would have been obtained based on the restated financials.
In general, 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. This is particularly relevant in situations where the incentive payment received by the officer was based on the company’s stock price or TSR. In these instances, the retention of an expert will likely be required to perform the calculations.
When TSR or stock price is used, the recoverable amount may be based on a ‘reasonable estimate’ of the effect of the restatement on stock price or TSR and could require the use of a statistical tool like an event study to determine the estimated amount. Companies must:
- Maintain documentation of reasonable estimates used
- Provide the documentation to the relevant exchange.
Recovery
The SEC rule does not spell out a specific means of recovery, so a company can exercise discretion with respect to the recovery of excess compensation. The recovery may 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. Deferred recoveries are permissible depending on the officer’s financial situation at the time the clawback is implemented. The rule does not allow companies to accept less than full recovery unless they can satisfy one of a limited number of impracticality exemptions.
Limited impracticability exceptions are available only in circumstances where:
- Direct expenses paid to third parties to assist in enforcing the policy would exceed the amount to be recovered and the company has made a reasonable attempt to recover
- Recovery would violate home-country law that existed at the time of adoption of the rule and a legal opinion is provided to the exchange to that effect, or
- Recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code.
Clawback disclosure
Disclosure regarding the clawback will be included in a company’s proxy statement and annual report, which the committee will want to review. The Form 10-K, and the equivalent form for foreign private issuers, includes new check boxes on the cover of the report indicating whether the financial statements included in the filing reflect a correction of any error to previously issued financial statements, and whether any of those corrections include restated financials that required an analysis related to the recovery of incentive-based compensation.
When the recovery of excess incentive-based compensation is triggered, companies must disclose detailed information regarding the restatement and recovery in the next proxy statement or annual report. This disclosure includes:
- The date the company was required to prepare the accounting restatement
- The aggregate dollar amount of erroneously awarded incentive-based compensation attributable to that accounting restatement, including an analysis of how the amount was calculated
- Whether the company’s stock price or TSR was used as the financial reporting measure and the estimate used to determine excess incentive-based compensation based on the restatement
- The aggregate dollar amount of erroneously awarded incentive-based compensation remaining outstanding at the end of the last completed fiscal year
- Whether recovery is impracticable, the amount of forgone recovery for each current and former named officer and all current and former officers as a group, and a brief description of the reason the company decided in each case not to pursue recovery
- The amount of erroneously awarded compensation still owed by each current and former named executive officer that had been outstanding for 180 days or longer since the date the company determined the amount owed.
If no recovery is required as a result of the accounting restatement, the disclosure must explain the reason why recovery is not required. In addition, disclosure regarding reliance on an exemption must be disclosed if the company relies on one of the exceptions to recovery as outlined in the SEC rule.
Jane Storero is a corporate governance consultant in Aon’s executive and board advisory practice group. Additional contributions by Alex Noga, associate consultant at Aon
Jane Storero
Jane Storero is a corporate governance consultant in Aon’s executive and board advisory practice group
