The SEC Proposed Clawback Rule

Joseph E. Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. The following post is based on an article by Mr. Bachelder which first appeared in the New York Law Journal. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this column. The complete publication, including footnotes, is available here. Related research from the Program on Corporate Governance includes Excess-Pay Clawbacks by Jesse Fried and Nitzan Shilon (discussed on the Forum here).

On July 1, 2015, the Securities and Exchange Commission (SEC) issued Proposed Rule 10D-1 relating to so-called “clawbacks” pursuant to Section 10D of the Securities and Exchange Act of 1934 (the Exchange Act). Section 10D of the Exchange Act was added by Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).

(On Aug. 5, 2015 the SEC issued its final rule requiring the disclosure of the ratio of the annual pay of the CEO to the median annual pay of all employees (excluding the CEO). Issuers subject to the rule must comply with it for the first fiscal year beginning on or after Jan. 1, 2017. The pay ratio rule will be the subject of a future post.)

Proposed Rule 10D-1, reflecting the statute, directs stock exchanges to require that each listed company adopt a clawback policy and to delist any company that does not adopt, disclose and implement such a policy.

The proposed clawback policy reaches much farther than existing clawback practices. The Sarbanes-Oxley law, enacted in 2002, requires clawback of certain compensation of CEOs and CFOs under certain circumstances in the event of a financial restatement. Over the past decade, many U.S. public companies have developed their own policies of clawing back incentives paid to executives to the extent those incentives are based on erroneous corporate performance data. Most of these clawback policies give the board of directors of the corporation the discretion as to whether and how much to claw back.

Following is a short summary of how the clawback policy under Proposed Rule 10D-1 would work:

  1. The clawback would be triggered by an “accounting restatement,” as defined below.
  2. The policy would apply to “incentive-based compensation” received by an “executive officer” during the three fiscal years (including, in some cases, a transition period as noted below) preceding the date the accounting restatement is triggered (the “look-back period”).
  3. The amount clawed back would be the amount received by the executive to the extent it exceeds what the executive would have received based on the accounting restatement.
  4. The clawback would be “no-fault,” meaning that it would apply irrespective of responsibility of the executive for the accounting restatement.
  5. The clawback would be on the pre-tax amount received by the executive.

Details of Proposed Rule

Following is a more detailed discussion of the proposed rule.

What Is an “Accounting Restatement”?

Proposed Rule 10D-1(c)(1) provides that an “accounting restatement” is a “required” revision of “previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements.” A restatement is “required” on the earlier of the date the listed issuer (meaning its board of directors, a committee of the board or an authorized officer) “concludes, or reasonably should have concluded, that the issuer’s previously issued financial statements contain a material error” or “the date a court, regulator or other legally authorized body directs the issuer to restate its previously issued financial statements to correct a material error.”

What Is “Incentive-Based Compensation”?

“Incentive-based compensation,” as defined by Proposed Rule 10D-1(c)(4), means “any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure.” The proposed rule defines a “financial reporting measure” as:

  1. a measure “determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements,”
  2. a measure “derived wholly or in part from” a measure described in clause (i), or
  3. stock price or total shareholder return.

Equity awards, including stock options, that are time-vested and not tied, in whole or in part, to attainment of financial reporting measures would be excluded as incentive-based compensation under the proposed rule. Also excluded would be awards based only on attainment of strategic measures (e.g., a merger) or operational measures (e.g., store openings or increase in market share). The SEC’s discussion of these exclusions is contained at pages 45-47 of the SEC Release, Listing Standards for Recovery of Erroneously Awarded Compensation.

What Is the “Excess” Portion of Incentive-Based Compensation That Is Subject to Clawback?

According to Proposed Rule 10D-1(b)(1)(iii):

The amount of incentive-based compensation subject to the issuer’s recovery policy (the ‘erroneously awarded compensation’) shall be the amount of incentive-based compensation received that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement, and shall be computed without regard to any taxes paid.

Three points especially should be noted:

  1. The calculation of the “excess” portion of incentive-based compensation that is subject to clawback often will be a complicated calculation. First, it will involve calculating the impact of an accounting error on the financial reporting measure. Second, it will involve calculating the consequence of that impact upon the amounts received as incentive-based compensation by individual executives.
  2. If stock price or total shareholder return is the financial reporting measure for an incentive-based compensation award the issuer would be required to make an estimate as to “the effect of the accounting restatement on the stock price or total shareholder return upon which the incentive-based compensation was received.” Proposed Rule 10D-1(b)(1)(iii)(A). The issuer would be required to maintain documentation as to the basis on which it makes the estimate. Proposed Rule 10D-1(b)(1)(iii)(B). Such an estimate is bound to be complex and likely would give rise to disputes between not only the issuer and the SEC but also disputes involving shareholders and the executives subject to the clawbacks.
  3. As previously noted, a clawback would be on a pre-tax basis. Tax consequences to an executive subject to a clawback are discussed below.

When Must the “Excess” Portion of Incentive-Based Compensation Be “Received” in Order to Be Subject to Clawback?

The “excess” incentive-based compensation award would have to be “received” during the “look-back period” in order to be subject to clawback. Such an award is deemed “received,” according to Proposed Rule 10D-1(c)(6), “in the issuer’s fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if the payment or grant of the incentive-based compensation occurs after the end of that period.”

The “look-back period,” as noted at the beginning of the column, “looks back” from the date an accounting restatement is required. It applies to the last three completed fiscal years preceding that date. Also included would be a less-than-nine-month “transition period” that “results from a change in the issuer’s fiscal year” and occurs during or immediately following the three completed fiscal years.

Who Is an “Executive Officer”?

Proposed Rule 10D-1(c)(3) provides that “executive officer,” for purposes of Section 10D of the Exchange Act, means “the issuer’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer. Executive officers of the issuer’s parent(s) or subsidiaries shall be deemed executive officers of the issuer if they perform such policy making functions for the issuer.”

This is the same definition as the definition given to “officer” by Rule 16a-1(f) under the Exchange Act (17 CFR 240.16a-1(f)). The proposed rule also notes that “[p]olicy-making function is not intended to include policy-making functions that are not significant” and that “executive officer” is presumed to include any person who is designated as an executive officer by an issuer for purposes of Item 401(b) of Regulation S-K.

As of what point in time is an executive’s status as an “executive officer” determined? Proposed Rule 10D-1(b)(1)(i)(B) provides that “an individual who served as an executive officer of the issuer at any time during the performance period” of the incentive-based compensation award received by that individual will be subject to the clawback policy.


Proposed Rule 10D-1(b)(1)(v) prohibits indemnification by the issuer of an executive officer against the clawback liabilities. The SEC’s discussion of the proposed rule, at page 96 of the SEC Release, notes that executives could buy their own insurance from a third party.

Limited Board Discretion

Under the proposed rule, an issuer may choose not to pursue a claim to recover “erroneously awarded compensation” to the extent “it would be impracticable to do so.” The proposed rule provides that “[r]ecovery would be impracticable only if the direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered, or if recovery would violate home country law.”

Disclosure of Clawback Policy and Application

In addition to disclosure to be required by the stock exchanges (by listing rules still to be adopted), the SEC proposals set forth disclosure requirements in the issuer’s annual report and in its proxy statement. Those requirements are contained in a number of proposed amendments, including amendments to Item 402 and Item 601 of Regulation S-K. The proposed amendment to Item 402 includes a new Item 402(w) which provides that if a listed issuer has a required accounting restatement that results in clawback requirements, it must disclose certain information regarding that in its proxy statement.

The proposed amendment to Item 601 includes a requirement that a listed issuer file its clawback policy as an exhibit to its annual report on Form 10-K.

Effective Dates

Once the Proposed Rule 10D-1 is finalized, the securities exchanges and securities associations must propose rules implementing it within 90 days after the effective date of final Rule 10D-1. These rules are to take effect, upon SEC approval, within one year after such effective date. Each listed issuer must adopt the clawback policy required by Rule 10D-1 within 60 days following the date the applicable listing rule, as described in the preceding sentence, takes effect. Thus, it is likely to be the latter part of 2016 or even at some point in 2017 before Rule 10D-1 is implemented. Each listed issuer must provide the required disclosures in the applicable SEC filings that become due on or after the effective date of the applicable securities exchange or association listing standard.

Tax Consequences to Executives

Under Proposed Rule 10D-1, the clawback is a recovery of the pre-tax “excess” amount. For example, if an executive was paid an “excess” amount of $100 and paid tax at a 45 percent rate on it the executive would have $55 left after the tax. The clawback is of the $100. Put another way, in order to pay back the full $100 to the employer the executive would have to earn another $81.82 (to have $45 after taxes (at a 45 percent rate).

The executive might try to avoid such a confiscatory rate by claiming a deduction against ordinary income for the clawed-back amount (under Code Sections 162 and/or 165) or claiming tax recovery under provisions of Code Section 1341. Unfortunately, the availability to the executive of the deduction, or, alternatively, the Section 1341 mitigation is uncertain.

Some Observations

  1. Once Rule 10D-1 is finalized, many senior level executives of major corporations will, for the first time, face the risk of “no-fault” clawback of part of their compensation. Approximately 4,800 issuers would be subject to Rule 10D-1, as proposed, according to SEC estimates. If, on average, the number of senior executives at those issuers subject to the risk of clawback is 15, that would total 72,000 executives. The risk will vary depending on the quality of financial management at the company. (A report cited by the SEC in the Release at page 125 indicates that from 2005 to 2012 there were 4,246 financial restatements reported on Form 8-K under Item 4.02 by U.S. and foreign filers registered with the SEC. (Such a restatement is generally a more serious one than a non-Item 4.02 restatement and is one that would more likely be deemed an “accounting restatement” that would trigger a clawback under the proposed rule.)) Only a small fraction of the number of executives noted will ever have any portion of their compensation clawed back. On the other hand, many will be aware of the risk.
  1. The risk just noted may discourage not only careless financial reporting practices (which is what the law intends) but also business ventures that carry a greater risk of inaccuracies in financial statements. One example is engagement in a business venture that involves significant pressure to produce prompt results. Another example would be investment in a foreign jurisdiction in which there is a greater risk of error (meaning greater risk of error, for example, than in the United States) in reporting financial results of operations and therefore greater risk of required financial restatements based on those reports.
  1. There will be a tendency to move away from incentives based on financial performance metrics to incentives that are time-vested. For example, there may be increasing use of time-vested stock options. There also may be a tendency by issuers to “bifurcate” their equity award programs. For “executive officers” the awards may be time-vested and for executives below that level the awards may be performance-based. Generally speaking, these developments contradict common sense in the design of executive incentive programs.
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