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SEC releases proposed rules covering clawback policies

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SEC proposed clawback ruleCompensation and Benefits Bulletin
The SEC proposed a rule implementing Section 954 of the Dodd-Frank Act on July 1, 2015. The rule requires listed companies to implement clawback policies to recover incentive-based compensation received by current or former executive officers in the event of certain financial restatements.

Under the proposed new Rule 10D-1, listed companies would have to adopt recovery policies that, in the event of an accounting restatement, would require “clawing back” incentive-based compensation from current and former executive officers that wouldn’t otherwise have been received based on the restatement. The proposed rule would also require listed companies to disclose recovery policies and any actions taken under those policies.

What you need to know
National securities exchanges would be required to establish listing standards requiring listed companies to adopt clawback policies that address the following:
  • Recovery would be required from both current and former executive officers who received incentive-based compensation during the three fiscal years prior to the date on which the company was required to prepare an accounting restatement to correct a material error. The materiality may be determined as the aggregate of several minor changes.
  • Recovery would be on a “no fault” basis, regardless of any misconduct or an executive officer’s responsibility for the erroneous financial statements.  
  • Companies would be required to recover the amount of incentive-based compensation received by an executive officer that exceeded the amount he or she would have received if the incentive-based compensation had been determined based on the accounting restatement. For incentive-based compensation based on stock price or total shareholder return, companies could use a reasonable estimate of the effect of the restatement on the applicable measure to determine the amount to be recovered.
  • Companies would be prohibited from indemnifying executives from loss or financial exposure to their clawback policies.
  • Companies could forgo recovering the excess incentive-based compensation received by executive officers only if the direct expense of enforcing recovery would exceed the amount to be recovered.  However, full disclosure would likely still be required.

Why you should care
The rule presents some potential concerns, such as the following:

  • No-fault and pretax issues — The rule would impose the same clawback provisions on those executives who were not involved in the restatement as on those deemed directly responsible for it. This treatment will be seen as necessary to create collective accountability and align shareholders’ interests, but it will likely add risk and uncertainty to most incentive pay packages. This heightened risk — combined with the possibility of repaying pretax awards with post-tax dollars — could also encourage increased executive compensation, either to make executives whole for a no-fault triggered clawback or to expand the base or other compensation for the increased risk.
  • Elimination of board discretion — Without the determination that enforcement fees would exceed the amount to be recovered, the rule would remove the board’s ability to determine that electing not to claw back amounts otherwise subject to the policy is in the best interest of the company and its shareholders. This lack of flexibility may cause any additional awards, grants or retention payments made after a clawback subject to challenge as a form of reimbursement or indemnification.
  • Adjustments to stock awards or total shareholder return plans — Awards that are determined by or tied to the company’s stock price will in many cases need to be modified or adjusted in light of the revised financial information. Because it’s unknown what the impact of the restatement would have been on the stock price at the time the award is determined, the clawback amount will need to be estimated. This will be challenging for most incentive arrangements and may lead to legal challenge by the plan participants who are subject to the clawback.
  • Legal right to clawback — Once the clawback rules are finalized and the policies are adopted, companies must enforce them or face delisting from the stock exchange. That said, a company’s legal right to recover the excess compensation may be complicated by certain employment agreements or plan documents that predate the policy. Therefore, it’s important for all companies to determine which agreements may need to be modified to allow for compliance with this policy. These potential modifications need to be reviewed for possible tax, accounting and financial implications.

Comments on the proposed rules are due Sept. 14, 2015. Once the SEC finalizes Rule 10D-1 and publishes the new rule in the Federal Register, the exchanges will have 90 days to file their proposed listing rules. Those rules would become effective no later than one year after the publication date. Companies would then have 60 days to adopt a clawback policy that complied with the new rule. Assuming this timeline, companies are likely to need their policies in place by the end of 2016.

Given the technical and strategic impact of this required clawback, listed companies should begin planning for 2016. Many organizations have already adopted clawback policies in anticipation of the pending regulation and because of shareholders’ perceptions.  However, even these organizations will need to review whether their clawbacks are too broad or not broad enough.


Contact
Ken Troy
+1 213 596 6770
ken.troy@us.gt.com

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