seclogoOn July 1, 2015, a divided SEC voted 3-2 to propose rules directing the securities exchanges to adopt standards requiring listed companies to adopt policies requiring the companies’ executive officers to pay back incentive-based compensation in the event the company restates its financials for the year in which the compensation was awarded. The proposed rules, which Dodd Frank Act Section 954 required the agency to adopt, are now subject to a 60-day comment period, have already generated a great deal of discussion. If the final rules bear any resemblance to the currently proposed version, the rules could prove controversial and could lead to disputes and disruption.


The SEC’s 198-pages of proposed rules can be found here. The SEC’s July 1, 2015 press release (including a “fact sheet” summarizing the proposed rules) can be found here. A good summary of the proposed rules by the Dorsey & Whitney law firm can be found here. A summary from the Ropes & Gray law firm set up in a Q&A format can be found here.  Unusually, all five of the commissioners issued separate statements about the proposed rules, including two sharply worded dissents by Commissioners Michael S. Picower (here) and Daniel M. Gallagher (here).


Under the proposed rules, the national securities exchanges are required to develop listing standards requiring companies to develop and implement policies to “claw back” incentive-based compensation that “later is shown to have been awarded in error.” The proposed rules are designed to “improve the quality of financial reporting and benefit investors by providing enhanced accountability.”


Recovery would be required from current and former “executive officers” who received incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement. The recovery is required on a “no fault” basis, without regard to whether any misconduct occurred or to an executive officer’s responsibility for the erroneous financial statements. The amount of recovery is to be measured by the amount of the compensation exceeds what the officer would have received had the compensation been based on the restated financials.


For purposes of these rules, the definition of “executive officer” is very broad, and includes not only a company’s president and principal financial officer, but also the principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs policy-making functions at the company.


Companies would have discretion not to recover the excess incentive-based compensation if the expenses of enforcing the recovery would exceed the amount of the recovery. In addition, foreign private issuers would not have to enforce the recovery if recovery would violate their home country law.


The proposed rules specify that each listed company would be required to file its compensation recovery policy as an exhibit to its Exchange Act annual report.


Of significant interest for readers of this blog, under the proposed rules issuers are not permitted to indemnify officers against any amounts recovered under its clawback policies or to pay premiums on an insurance policy covering an officer’s potential clawback obligations.


The proposal requires the exchanges to file their proposed listing rules no later than 90 days after the publication of the final rules that the agency ultimately adopts, and requires the listing rules to become effective no later than one year following the publication date.



As required by the Dodd-Frank Act, these proposed rules are considerably broader than the existing executive compensation clawback requirements under the Sarbanes-Oxley Act. The SOX clawback rules applied only to the CEO and the CFO; these rules apply to a much broader range of executive officers. In his dissent, Commissioner Gallagher argued that the list of officers to whom the rules would apply is much broader than the Dodd-Frank Act required.


From my perspective, these rules continue a deeply troublesome trend in which our system of laws increasingly seeks to impose liability without culpability. As I have previously noted on this site (most recently here), there is an unfortunate willingness to impose penalties on those who neither engaged in wrongdoing nor were even aware that wrongdoing had even occurred, contrary to our legal system’s long-standing tradition that punishments were only administered on those who were somehow at fault or at least had a guilty mind.


The dissenting commissioners have numerous other criticisms of the proposed rules. Commissioner Gallagher (whom I learned from his recent speech at Stanford Law School Director’s College — which I attended — is a colorful speaker and writer), referred to the rules as the Commission’s “newest Goya, tortured and nightmarish.” Commissioner Picower criticized the rules as “likely to impose a substantial commitment of shareholder resources and, unintentionally, result in a further increase in executive compensation,” as companies move away from incentive-based compensation that would be subject to clawbacks. In a sign of the deep divisions with the agency, both dissenters also objected to the way that the final proposed rules were put forward and proposed. Commission Picower objected to that way that “at the very end, significant changes are agreed upon by the Chair’s office in ways that diverge from Congressional intent.”


The depth of division reflected in the dissents and the level of rancor at the commission that the tenor of the dissents reflects is frankly a little disturbing. The dysfunction these divisions suggest are arguably even more disturbing given the high-profile criticism the current SEC chair has faced – from within the same party as the President who nominated her – for not moving aggressively enough.


Setting aside the debate over the merits of the proposed rules, the rules as proposed could prove to be very difficult to administer as a practical matter. As discussed in at July 1, 2015 Law 360 article entitled “SEC Clawback Plan to Create Enforcement Nightmares” (here, subscription required), the implementation of the rules’ requirements in the event of a restatement could present a  host of challenges. Among other things calculating the difference between the compensation that was awarded and the compensation that should have been awarded based on the restate financials could produce some difficult calculations, particularly for types of compensation based on total shareholder return.


There is also the “open question about how companies will go about getting back money once they determined who owes what.” As one commentator quoted in the article states, the rules “create a potentially awkward dynamic.” In addition, companies who want to determine whether or not they fall into the rules’ exception which exempts clawbacks if recovery costs exceed potential recoveries could get caught up in preliminary calculations about likely recovery costs. Many companies, eyeing the rules’ complexity and challenges, may switch to forms of compensation that would not be subject to clawback, so that less of executives’ compensation is at risk.


There are two specific features of the proposed rules that D&O practitioners will want to note. The first is that given the requirement that the rules requirement that clawback could be imposed without respect to fault, the effort to enforce the clawback may not involve an actual or alleged Wrongful Act within the usual meaning of a D&O insurance policy. (This potential issue could be circumvented to the extent the definition of the term Wrongful Act also incorporates a provision including within the term any matter claimed against them as a result of their status as such as a director or officer of the company.).


Practitioners will also want to note that the under the proposed rules issuers would not be permitted to pay premiums on an insurance policy covering an officer’s potential clawback obligations. There have been various efforts over the past several years within the D&O insurance industry to try to come up with insurance solutions that would address corporate officials’ risk of compensation clawback. These provisions of the new rules would seem to suggest that these insurance measures are no longer feasible – except that the way the proposed rules are written, they would only prohibit the company from paying the premium for the insurance; they do not appear to prohibit an individual from paying the premium for the insurance.


In any event, the rules’ prohibition seems to extend only to the payment of premium for insurance protecting against the actual clawback itself, not for the payment of premium for insurance providing defense cost protection in the event a corporate official is hit with a claim for compensation clawback. (However, another potential problem for coverage of even just the defense costs is the fact that the clawback claim is likely to come from the company itself, and therefore potentially could be subject to the insured vs. insured exclusion.)


Coming Soon: Direct Sales to the Business Insurance Industry?: In case you didn’t see it over the holiday weekend, on July 3, 2015, the Wall Street Journal had an interesting article entitled “Buffett Re-Examines Reinsurance” (here) discussing how changes in the reinsurance industry and the amount of investment capital that has been drawn into the reinsurance space has made reinsurance a less attractive proposition for Berkshire Hathaway than it has been in the past. As a result of these changes, Berkshire has moved into the direct insurance business.


Of even greater potential interest to readers of this blog, the article mentioned that Berkshire’s new insurance strategy includes a direct sales model for business insurance, along the lines that Berkshire unit Geico uses for auto insurance. Among other things, the article stated that “By next year, Berkshire plans to sell insurance to small and medium-size businesses directly over the Internet, bypassing the industry’s middlemen.” The article also stated that “Berkshire’s other big initiative is a planned move into online insurance. To be called Berkshire Hathaway Direct, it will target small and midsize businesses. Traditionally, insurers have relied on agents and brokers to sell their products, but Mr. [Agit] Jain is taking a page out of the Geico direct-to-consumer playbook, convinced the industry is ripe for disruption from this effort.”


To say that there are big changes afoot in the insurance industry these days would be one of the understatements of the year.