On June 9, 2023, the Securities and Exchange Commission (“SEC”) approved listing standards proposed by the NYSE and Nasdaq to implement its final Rule 10D-1 regarding recoupment of erroneously awarded compensation under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Pursuant to this approval, the effective date of the listing standards is October 2, 2023 and the deadline for U.S. listed companies to adopt a Dodd-Frank-compliant clawback policy is December 1, 2023. For detailed background information about the requirements under the Dodd-Frank clawback rules, see our client alert available here.
As companies work to adopt their clawback policy by the required deadline, they should bear in mind key practical considerations around implementing their policies, including those outlined below.
Should the Company Ask Executives to Sign Policy Acknowledgments?
Although neither SEC Rule 10D-1 nor the stock exchange listing standards require executives to acknowledge that they are subject to the Dodd-Frank clawback policy, this is likely to emerge as a best practice.
- Creating a Contract: Most importantly, an acknowledgment establishes that the signing executive has a contractual obligation to comply with the clawback policy, such that in a case of noncompliance, the company may bring a breach of contract claim against the executive seeking to enforce the required recoupment. This could be critical, given that a company can face delisting if it fails to recover erroneously awarded compensation, and may be particularly useful as a basis for enforcing the policy against former executives over whom the company has less leverage. Indeed, the importance of creating a contractual basis for enforcement was highlighted in a recent case where a federal district court granted summary judgment against a company seeking to recoup compensation from a former executive. There, the court determined that the recoupment policy that the company sought to apply was not contractually binding because the executive had not specifically acknowledged or agreed to it, notwithstanding that the policy had been incorporated into various other agreements with him. The decision is unpublished so cannot be used as precedent but nonetheless provides food for thought as companies are putting in place their clawback policies.
- Reconciling any Inconsistencies with Existing Compensation Agreements: Existing executive compensation agreements will often provide that they may not be amended except in writing signed by both parties. Such existing agreements may not reference any recoupment rights of the company or may have clawback provisions that differ from those required under the Dodd-Frank framework. An acknowledgment may be used to amend such existing agreements and establish that the mandatory Dodd-Frank clawback policy will apply to, and as needed, supersede, the terms of such agreements. It can also clarify how different policies will interrelate. Additionally, companies can seek to have executives acknowledge that any required enforcement of the clawback policy will not constitute “good reason” for a voluntary or constructive termination that may trigger severance or equity acceleration benefits under outstanding plans or agreements.
How Should the Company Determine the Means of Recovery?
The Dodd-Frank clawback framework requires a company to recover incentive-based compensation that covered executive officers erroneously received during the three completed fiscal years immediately preceding the date the company is required to prepare an accounting statement. However, in adopting Rule 10D-1, the SEC recognized that the appropriate means of recovery may vary based on the particular facts and circumstances of each executive officer that owes a recoverable amount, such that different means of recovery may be appropriate in different situations. As such, companies have discretion regarding the means of recovery, as long as such recovery is accomplished “reasonably promptly,” based on the facts and circumstances including in view of the additional cost incident to recovery. Given this flexibility, companies should identify potential sources for recoupment in view of their overall executive compensation and benefits program. For example, a company may determine that erroneous amounts of incentive-based compensation may be recouped from non-incentive-based compensation, as well as from the specific erroneous payments, if necessary to ensure timely recoupment. Companies may also consider whether to permit covered executives to repay compensation in either shares or cash, in view of their individual tax considerations, and may prioritize recovering from pre-tax amounts in order to mitigate the potentially adverse tax impact of a recoupment of previously-taxed compensation. Further under the rules, a company may be able to establish a deferred payment plan allowing the executive to repay erroneous compensation as soon as possible without unreasonable economic hardship to the executive, depending on the facts and circumstances.
As companies identify sources from which a potential future recoupment may be made, they should add appropriate clawback provisions to the applicable compensation plans and agreements, as well as to any future employment agreements, to support their ability to implement any such recoupment.
How Can a Company Prepare to Enforce Its Clawback Policy?
Once a board of directors has determined that an accounting restatement is needed, it becomes obligated to expeditiously calculate the amount of any erroneously-paid compensation and pursue recoupment. To avoid a scramble to comply with any future required clawback, companies should now consider preparing a compensation recoupment action plan, identifying the key steps to be taken once a restatement is needed, and setting out a process for communicating with current and former covered executives about any amounts owed, the means of recovery, repayment obligations, extension requests, and consequences of noncompliance. This process should involve considering the following questions, among others:
- Which of the company’s incentive-based compensation arrangements are based on financial measures that may be adjusted in a restatement, including stock price or total shareholder return, and which internal teams or outside advisors will be mobilized to calculate the recoverable amount?
- What are the company’s potential sources and means of recoupment of erroneously awarded compensation, from both current and former executives?
- Should brokerage accounts, vested payments, severance payments or other compensation sources be suspended pending completion of a restatement? Is such suspension possible from a legal and tax perspective?
- What is the likely enforceability of the clawback under the local laws of the states or countries where executives are located? Which internal legal teams or outside advisors will advise on enforceability when a clawback is required, and assist with any impracticability analysis that may be needed?
- What should the company communicate to affected executives when the board determines a restatement is necessary, and in the form of a demand letter, once a restatement is completed?
- Will the company offer a standard repayment option or will executives be permitted to choose how to repay? How will the company handle individual requests for extensions of payment deadlines?
- If a current or former executive does not comply with the recoupment policy, what is the company’s recourse against that individual under applicable law, company policies, and agreements?
Conclusion The extent to which an accounting restatement will trigger a mandatory clawback under the Dodd-Frank framework remains to be seen. But to prepare for that possibility, over the coming months, it is prudent for U.S. listed companies to collect policy acknowledgment forms, identify a clawback response team, develop a protocol for recoupment, and plan for effective communications with covered executives.