The U.S. Securities and Exchange Commission (SEC) continues to broaden the use of forfeiture of executive compensation as a regulatory tool with an increased emphasis on making employers do the clawing-back themselves.
In October 2022, the SEC adopted the new Rule 10D-1, 17 C.F. R. §240.10D-1, or “Listing Standards for Recovery of Erroneously Awarded Compensation,” that directs “national securities exchanges and associations that list securities to establish listing standards that require each issuer to develop and implement a policy providing for the recovery…of incentive-based compensation.” See “Listing Standards for Recovery of Erroneously Awarded Compensation”, Exchange Act Release Nos. 33-11126; 34-96159, 87 Fed. Reg. 73,076, 73,076 (Nov. 28, 2022).
The rule fulfills Congress’ specific command in the Dodd-Frank Act to make a compensation recovery policy a requirement for listing securities. See 15 U.S.C. §78j–4.
Under the new rule, exchanges must require issuers to adopt clawback rules to recover “the amount of erroneously awarded incentive-based compensation…[if] the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, including any required accounting restatement to correct [a material] error in previously issued financial statements.” 17 CFR §240.10D-1(b)(1). The “issuer’s recovery policy must apply to all incentive-based compensation received by” any of the issuer’s current or former executive officers who served “during the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement. 17 CFR §240.10D-1(b)(1)(i). The forfeitable compensation is “the amount of incentive-based compensation received that exceeds the amount…that otherwise would have been received had it been determined based on the restated amounts.” 17 CFR §240.10D-1(b)(1)(iii).
Rule 10D-1 builds on section 304 of the Sarbanes-Oxley Act, 15 U.S. Code §7243 (SOX), which requires a securities issuer to clawback “incentive-based compensation” paid to the “chief executive officer and chief financial officer” in the event that the issuer “is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws.”
Although very similar to section 304, the new rule departs from the SEC’s previous clawback policy in four key ways.
First, it expands whose money can be clawed-back. Under SOX §304, only the CEO and CFO were potentially liable to repay their incentive-based compensation. Rule 10D-1 expands this to all executive officers, specifically defined in the regulation as “the issuer’s president, principal financial officer, principal accounting officer (or…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 [person] who performs a policy-making function. . . for the issuer.” 17 CFR §240.10D-1(d).
Of course, there might be situations where these roles and functions are all fulfilled by the CEO and CFO. Still, the emphasis on getting at the issuer’s policy-setting employees shows the SEC’s desire to cast a wide net, focusing on responsibilities rather than titles.
Second, the new rule alters what type of activity triggers the clawback. Section 304, enacted in response to the Enron scandal, is triggered when an issuer “is required to prepare an accounting restatement” because of material noncompliance caused by misconduct. 15 U.S. Code §7243. The new rule does away with the misconduct requirement and makes the trigger simply having to file an accounting restatement due to material noncompliance generally, even if “to correct an error.” 17 CFR §240.10D-1(b)(1).
Third, Rule 10D-1 lengthens the period of time for determining which incentive-based compensation is liable to be clawed-back. Previously, section 304 only looked back 12 months. 15 U.S. Code § 7243. Now, the new rule covers compensation paid for the past three fiscal years. 17 CFR §240.10D-1(b)(1)(i)(D).
Fourth, the SEC’s new rule changes the process used to actually implement the clawbacks. Section 304 clawbacks required the SEC to get involved, usually in the form of an action against an issuer or an executive. For example, in SEC v. Jenkins, 718 F. Supp. 2d 1070 (D. Ariz. 2010), the agency sued an issuer’s former CEO to compel him to reimburse the company for incentive-based compensation paid during the period before it filed an accounting restatement due to improperly reporting inflated sales.
More recently, in SEC v. Rosenberger, No. 22CV4736 (DLC), 2024 WL 308198 (S.D.N.Y. Jan. 26, 2024), the Commission sued to order a CFO to reimburse her former employer for incentive-based compensation paid before an accounting restatement filed to correct the company’s overstated revenue.
In contrast, the new rule minimizes the agency’s involvement by making exchanges adopt a clawback policy requirement as a precondition of listing securities. The hope is that compliance will be furthered by the prospect of delisting rather than a Commission action. See Listing Standards for Recovery of Erroneously Awarded Compensation, Exchange Act Release Nos. 33-11126; 34-96159, 87 Fed. Reg. 73,076, 73,099 (Nov. 28, 2022)
By indirectly implementing this requirement, the SEC also avoids some of the thorny questions related to clawbacks. The SEC has made the firms—under threat of delisting—adopt the policy and implement it, making the logistics of clawing-back the compensation something the issuer agrees to with their executives. This way, the clawback discussion becomes a privately bargained resolution, away from the courts (and perhaps potential challenges under state wage payment laws—from which executives and incentive-based compensation are typically exempt).
Similarly, the clawback is framed more like reimbursement for erroneous enrichment—where because the issuer made a reporting mistake of any kind, incentive-based compensation pegged to that mistake has to be adjusted to the proper amount.
The SEC has since approved the New York Stock Exchange and the NASDAQ’s new, 10D-1-compliant listing standards with an effective date of Oct. 2, 2023. See “Rule Change to Establish Listing Standards Related to Recovery of Erroneously Awarded Executive Compensation”, Exchange Act Release No. 34-97687 (June 9, 2023); “Rule Change to Establish Listing Standards Related to Recovery of Erroneously Awarded Executive Compensation”, Exchange Act Release No. 34-97688 (June 9, 2023).
When issuers file their 2023 annual reports in the beginning of this year, they are required to attach their new, compliant policy as an exhibit. See Listing Standards for Recovery of Erroneously Awarded Compensation, Exchange Act Release Nos. 33-11126; 34-96159, 87 Fed. Reg. 73,076, 73,078 (Nov. 28, 2022). This will give us some insight into how firms have handled the change and maybe whether the SEC’s private-ordering-oriented approach has impacted agreements between executives’ and their employers.
Reprinted with permission from the February 22, 2024 issue date of the “New York Law Journal” © 2024 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com
