by Cydney Posner

The WSJ is reporting that the SEC is on the verge (July 1) of proposing clawback rules designed to implement Section 954 of Dodd-Frank, “recovery of erroneously awarded compensation.” Of course, actual implementation could still be a long way off, as the proposal would be subject to public comment and final adoption by the SEC, and then the exchanges will need to present their own proposals based on the SEC’s final rules.  However, the proposal may have smoother sailing than the recent pay-versus-performance proposal or the long delayed, highly controversial median pay-ratio proposal; the article quotes SEC Commissioner Michael Piwowar, a dissenter in the vote on both of those rulemakings, as favorably contrasting this proposal to the pay-ratio provision, contending that “a properly designed clawback rule could yield real benefits to shareholders.” (See this post and this news brief.)

As you may recall, Section 954 of Dodd-Frank required the SEC to direct the securities exchanges to require each listed company to develop and implement a policy for recouping executive compensation that was paid on the basis of erroneous financial information, the theory being that it is compensation to which the executives were never really entitled in the first place. Under Dodd-Frank, the policy would apply in the event the company were required to prepare an accounting restatement due to the company’s material noncompliance with any financial reporting requirement under the securities laws. The policy must provide that the company will recover from any current or former executive officer an amount of incentive-based compensation (including options awarded as compensation) equal to the excess, if any, of the amount that was paid to the executive officer, in the three years preceding the date on which the company was required to prepare the restatement, over the amount that would have been paid to the executive officer based on the accurate financial data. Additionally, the SEC must require each listed company to have a policy providing for disclosure of its policy on incentive-based compensation that is based on financial information required to be reported under the securities laws.

The WSj reported that, for 2014, there were 831 restatements, representing 8% of filings.  Of those restatements, 59% had no impact on the income statement, but the remainder had an aggregate $0.88 billion impact on net income.

The requirements of Section 954 generally go further than the clawback provisions currently required under SOX: they cover any current or former executive, while the SOX requirements apply only to the CEO and CFO. Moreover, Section 954 is essentially a faultless clawback — no culpability is required on the part of the company or the executive to trigger a clawback, while SOX requires that the company’s material noncompliance be the result of misconduct, although not necessarily misconduct of the executive subject to the forfeiture. In addition, Dodd-Frank covers a three-year period, while SOX applies only to a 12-month period. On the other hand, SOX did not limit the clawback to amounts paid in excess. In addition, Section 954 puts the onus on the company, not just the SEC, to recover the erroneously paid compensation, potentially allowing the courts to find an implicit intent to make the provision subject to enforcement through shareholder derivative actions.  By comparison, the courts have held that the SOX clawback provision may be enforced only by the SEC and may not be enforced through private rights of action.

One issue that the SEC will need to address is the definition and manner of calculation of “incentive-based compensation.” For example, will the SEC interpret the reference to stock options in the statute broadly to mean that all stock options are covered, including those with only time-based vesting, or will the SEC interpret the provision to apply only to stock options with vesting on the basis of achievement of performance goals, or only those with financial performance goals?  With regard to equity or bonuses paid, but not precisely allocated, on the basis of multiple financial and non-financial performance goals, how will the company determine how much the executive would otherwise have been paid in light of the restatement? How should the company calculate the starting point for the three-year lookback period, i.e., what is “the date on which the issuer is required to prepare an accounting restatement”? What’s more, will the SEC even address any of these issues, or leave it to companies and their boards to determine? Another issue raised in the WSJ article by Broc Romanek of, was whether the SEC will allow directors some discretion, using their business judgement, to enforce the provision only if it makes practical sense in light of any legal, administrative or other expenses.

Pay versus performance and now clawbacks….  Can adoption of pay ratio disclosure rules be next? The article paraphrases an SEC official as saying that Chair White “is committed to completing the pay-ratio rule by the fall.”

Posted by Cydney Posner