On October 26, 2022, the SEC adopted final rules implementing the Dodd-Frank Act’s requirement for issuers to recover from current and former executives compensation that was erroneously paid due to an accounting restatement. The final rules require securities exchanges to adopt listing standards that will require listed companies to implement and disclose policies requiring the erroneously paid compensation to be recovered, on a “no fault” basis – that is, without regard to whether any misconduct occurred or whether an executive bears responsibility. The SEC’s Release covers a broad range of topics, including — importantly for readers of this blog — considerations relating to indemnification or insurance for the clawed-back compensation. The SEC’s October 26, 2022 press release about the new rules can be found here. The SEC’s fact sheet about the new rules can be found here. The SEC’s Release document (referred to below as the “Release”) can be found here.
I summarize the new rules below, but the SEC’s Release regarding the new rules is quite detailed. For a more complete understanding of the new Rules beyond what can be gleaned from the summary below, readers will want to refer to one of the many memos that law firms have published about the Rules, such as the October 27, 2022 memo from the Gibson Dunn law firm (here) and the November 2, 2022 memo from the Cleary Gottlieb law firm (here).
The SEC adopted the new rules pursuant to Section 954 of the Dodd Frank Act, which is codified as Section 10D of the Securities Exchange Act. The agency originally proposed clawback rules in July 2015, but the proposed rules languished for years until October 2021, when the agency reopened the period for comment. The press release concerning the rules’ adoption quotes SEC Chair Gary Gensler as saying that the new rules “fulfill Dodd-Frank’s mandate and Congress’s intention to prevent executives from keeping compensation received based on misstated financials.” He also said that the new rules should strengthen both transparency and “the accountability of corporate executives to investors.”
Summary of the Rules’ Requirements
What Do the New Rules Provide?: In general terms, the new rules direct national securities exchanges to establish listing standards that require each listed company to (1) adopt and comply with a written policy for recovery of erroneously awarded incentive-based compensation received by their current or former executive officers if the company is required to prepare an accounting restatement during the three fiscal years preceding the date of the restatement; and (2) to disclose the compensation recovery policies consistently with SEC rules. The rules apply to all listed companies, including foreign private issuers, emerging growth companies, and smaller reporting companies.
Who does the Compensation Recovery Requirement Apply To?: The term “executive officers” includes the company’s president, principal financial officer, principal accounting officer, and vice president in charge of a principal unit, division, or function, and any other person who performs policymaking functions for the company. Importantly, the rules specify that the clawback requirements must apply regardless of whether or not there is any misconduct and regardless of whether the individual executive officer had any responsibility for the restated financials.
What Constitutes Incentive-Based Compensation?: The Rules define “incentive-based compensation” as any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure – based, for example, on revenues, net income, operating income, EBIDTA, earnings measures, and so on. The clawback rules do not apply to performance-based compensation that is granted, earned, or vested based solely on the occurrence of strategic or operational goals (e.g., opening a certain number of stores, completing a transaction, etc.) or that are based solely on the discretion of the board or compensation committee, or on continued service.
What Triggers the Recoupment?: The new rules require the compensation to be recouped when the company is required to make an accounting restatement that corrects a material error in previously issued financial statements (a so-called “Big R” restatement), and when the company is required to prepare an accounting restatement that corrects an error that is not material to previously issued financial restatements but that would result in a material misstatement if the error were left uncorrected in the current period (a so-called “little r” restatement).
How is the Amount of the Recovery Calculated?: The amount of the clawback is to be measured by the amount of incentive-based compensation the executive received in excess of what the executive would have received if the incentive-based compensation were determined based on the restated financial.
What are the Exceptions to the Recoupment Requirement?: The compensation clawback requirements are meant to be mandatory. There is little room for company discretion and there are few exceptions to the recoupment requirement. The only occasion on which recoupment is not mandatory is when the recovery is “impracticable” because the expenses incurred in enforcing the policy would exceed the amount of recovery or if pursuing the recovery would violate the applicable home country law, or if would cause an otherwise tax-qualified retirement plan to fail to meet the IRS requirements.
What are the Disclosure Requirements?: In addition to the requirements about the implementation and adoption of clawback policies, the new Rules also specify a number of disclosure requirements. An issuer must file its clawback policy as an exhibit to its annual report. Companies that have completed a financial restatement must provide extensive disclosures, including, among other things, the date the company was required to prepare an accounting restatement; the amount of erroneously awarded compensation and how the amount was calculated.
What Else Do the Rules Provide?: The rules address a host of other specific details, including how the date of restatement is calculated; how the recovery period is to be calculated; how the rules are to be applied to individuals, such as, for example, individuals who only became an executive officer during the recovery period; what it means for compensation to be “received,” and how vesting and continued service requirements apply; how the amount to be recovered is calculated. The details are important and anyone seeking a better understanding of how the rules are to work would be well advised to read the law firm memos to which I linked above if not the full Release document itself.
When Will Companies Need to Have the Clawback Policies in Place?: The rules specify that they are effective 60 days after their publication in the Federal Register. The exchanges’ applicable listing standards must be effective no later than one year after publication, and listed issuers will be required to adopt a clawback policy no more than 60 days after that. The Cleary Gottlieb memo says that “Issuers should be prepared to have policies in effect no later than fall of 2023.”
Indemnification and Insurance
The SEC’s Release document also addresses indemnification and insurance issues. The SEC specifies, on page 118-19 of the Release, that the final Rules “prohibit issuers from insuring or indemnifying any executive officer against the loss of erroneously awarded compensation.” The Release further states that “while an executive officer may be able to purchase a third-party insurance policy to fund potential recovery obligations, the indemnification prohibition prohibits an issuer from paying or reimbursing the executive officer for premiums for such an insurance policy” (emphasis added).
The Release goes on to state, on pages 169-70, that “the insurance market may develop an insurance product that would allow an executive officer, as an individual, to purchase insurance against the loss of incentive-based compensation when the material accounting error is not attributable to the executive” (emphasis added). The Release observes that if an executive purchased such a policy, the insurance could reduce the executive officer’s incentive to ensure accurate financial reporting, but that “to the extent an insurance policy does not cover losses resulting from recovery of compensation attributed to a material accounting error that resulted from inappropriate actions by the insured executive officer, then incentives would remain for the executive to avoid inappropriate actions.”
The Release further observes that “If an active insurance market develops such that the executive officer could hedge against the uncertainty caused by the recovery policy, then market-determined compensation packages would likely increase to cover the cost of such policy.” This increase, the Release notes, “may be less than the increase in the market-determined compensation packages if an insurance policy was unavailable because an insurance company may be more willing to bear uncertainty than a risk-averse executive.”
The details with respect to the new clawback rules are extensive and complicated. I also suspect there are going to be a lot of fights, for example, over whose compensation is subject to clawback, or how the amount of the recovery is calculated. These issues will be further complicated when applied to “former executives.”
It may be important for readers of this blog to consider that the rules leave enforcement to the securities exchanges, specifying that the exchanges are to seek delisting for issuers that fail to adopt a follow a compensation clawback policy. The Rules do not specify a mechanism for the SEC to directly compel an issuer to pursue a compensation clawback or to adjust the amount to be recovered.
However, the new rules could lead to shareholder litigation. The Cleary Gottlieb law firm’s memo to which I linked above says that the rules “likely will lead to an increase in shareholder derivative suits seeking to force companies to pursue clawback under their policies, or to compel the companies to adjust their calculation of the timing or amount of the clawback to increase the recovery.” The memo notes that when similar suits were filed in the past, they were evaluated under the deferential business judgment rule. The fact that the new rules “curtail management and board discretion” could “lead to different outcomes in such cases.”
The Clearly Gottlieb memo goes on to suggest that the SEC’s Enforcement Division and plaintiffs’ lawyer are likely to scrutinize the new required disclosures for potential antifraud claims, particularly with respect to disclosures about how the company calculated the recoverable amount of incentive-based compensation and when the company decided, or reasonably should have decided, that it had to restate financials.
Were there to be this type of shareholder derivative or securities fraud litigation, the claims presumptively would be covered by the defendant company’s D&O insurance (subject of course to all of the applicable terms and conditions).
However, a more interesting question is whether or not existing D&O insurance would provide an executive with insurance protection for the amount of recouped compensation. For purposes of considering this question, I am choosing to disregard the SEC’s statement that it is “prohibited” for an issuer to purchase insurance to reimburse an individual for clawed back compensation.
A company’s effort to recoup the erroneously paid compensation would represent a classic Entity vs. Insured claim that could run afoul of the Entity vs. Insured Exclusion typically found in most public company D&O insurance policies. Other basic questions would arise, such as whether the recovery action meets the policy’s definition of “Claim,” and whether there is an actual or alleged “Wrongful Act” (since, under the rules, the recoupment is to be without respect to misconduct or responsibility).
Insurers might also take the position that the amount for which recovery is sought does not represent “Loss” because it is in the nature of a disgorgement or restitution. Insurers might also seek to rely on the exclusion typically found in most D&O insurance polices precluding coverage for claims seeking recovery of “compensation to which the insured was not legally entitled” (although those exclusions typically are only applicable if there has been an adjudication of the absence of legal entitlement). An insurer might also seek to rely on the SEC’s statement in the Release that “any issuer indemnification or insurance of an executive officer’s obligation to return erroneously awarded compensation would be contrary to the statute.”
The most interesting question (at least for me) from the SEC’s release has to do with the agency’s comments about the possibility that the insurance market might develop a product that would allow the individual executive to insure against the loss of incentive-based compensation. The fact that the SEC raised this itself in its Release suggests that the SEC recognizes that individuals might be interested in that type of product and that insurers might be interested in providing that product – and that there is nothing wrong with that.
All of which makes me think that those of us in the D&O industry are about to start getting questions about the availability of this type of product. (I feel confident about making this prediction because I have already started receiving questions).
Anyone thinking about the possibility of this type of product will want to keep at least a couple of things in mind.
First, the SEC is clear that the company itself couldn’t pay for this kind of compensation clawback insurance; it would have to be paid for by the individual executive (although, interestingly, the Release expressly contemplates the possibility that the executive’s compensation could be increased to “cover the cost of such policy”).
Second, the Release contains some guidance about what appropriately could be insured against and what should not be insured against. The insurance product that the SEC has in mind would only insure the individual “against the loss of incentive-based compensation when the material accounting error is not attributable to the executive.” The SEC goes on to state that “to the extent an insurance policy does not cover the losses resulting from the recovery of compensation attributed to a material accounting error that resulted from inappropriate actions by the insured executive officer, then incentives would remain for the executive to avoid inappropriate actions.” It isn’t clear from this whether the SEC is actually saying the insurance can’t or shouldn’t insure individuals who engaged in inappropriate actions, but it is clear that the SEC is saying that the insurance would maintain the right incentives only if it does not provide coverage for individuals who acted inappropriately. From the insurer’s perspective, prohibiting payment for individuals who acted inappropriately would eliminate (or at least reduce) the potential moral hazard associated with this type of product.
Beyond these threshold concerns, there are a host of other issues that immediately come to mind for me in thinking about the possibility for this type of insurance product.
First, there is the question of cost. On the one hand, how much would executives be willing to pay? On the other hand, how does the insurer collect enough premiums (given the likely smaller size of the premiums) to allow for payment of losses. What would insurers charge? There is also the interrelated concern about how to underwrite for this product, and whether the amount of financial underwriting required would entail an overhead cost structure that would make the product uneconomical?
Second, there are the concerns about adverse selection. Which executives are the likeliest to purchase the product? Perhaps executives that have concerns about their company’s accounting practices or history. Perhaps executives who worked in the past at companies that had restatements (not a reassuring detail). Executives that have left the company may be interested in the product as well, which could raise concerns about why the executive left in the first place.
Third, there are the details. Are there types of compensation (e.g., equity compensation or compensation based on total shareholder returns) that the insurer might not want to insure against? Would the insurance provide legal expense coverage for insured executives that wants to dispute the recoupment effort or the amount of the recoupment? Would the policy pay the insured’s legal expenses incurred to fight with the IRS about taxes previously paid on the recouped compensation?
And finally, there is the question of limits of liability. The incentive compensation packages for some corporate executives are enormous, in some cases running into the millions or even tens of millions of dollars. How much of this would any individual insurer or even group of insurers taken collectively be willing to insure? Would buyers be able to buy the full extent of protection they might feel they need?
I am sure readers undoubtedly will have many other questions as well. However, I suspect that as an industry we are about to have an extended conversation on this topic, for the simple reason that prospective buyers and their advisors are going to start asking about the availability of this type of product. We are also going to get questions about how much a product like this might cost, because the executives (consistent with the SEC”s comments) are going to want to try to negotiate their compensation packages to provide for the cost of the insurance.
Stay tuned, I suspect we are all going to be hearing a lot more on this topic in the months ahead. particularly as the deadlines for the exchanges to propose their new issuing standards and as companies are moving toward adopting their own policies.
In the meantime, I expect that many companies will be having internal conversations about which of their officers should be subject to the compensation clawbacks; about whether and the extent to which any existing voluntarily adopted clawback policies are compliant with the new rules’ requirements; the extent to which current compensation practices reflect incentive-based measure and whether the companies should alter their practices; and how the company can shore up its reporting practices to reduce the likelihood of future restatements.
Very special thanks to a loyal reader who flagged many of these issues for me.