The Securities and Exchange Commission has proposed a rule that will require companies with listed securities to recover incentive compensation based on erroneous financial statements. The proposed rule will also require new disclosures concerning listed companies’ clawback policies and their efforts to recover incentive compensation pursuant to the policies. The proposed rule and a fact sheet are available on the SEC’s website.

Requirement to Recover Incentive-Based Compensation

Proposed Rule 10D-1 implements Section 954 of the Dodd-Frank Act. Under the proposed rule, national securities exchanges must implement listing standards that require each listed company to adopt a clawback policy. The company’s clawback policy must provide that if the company is required to prepare an accounting restatement to correct a material error, the company will recover incentive-based compensation from all current and former executive officers who received the compensation during the preceding three years.

The “incentive-based compensation” subject to clawback is any compensation that is granted, earned, or vested based entirely or in part on the attainment of a financial reporting measure. For example, compensation based in part on stock price or total shareholder return, on GAAP financial measures such as earnings per share, or on non-GAAP financial measures such as EBITDA or free cash flow would be incentive-based compensation.

The company must recover the amount by which the incentive-based compensation actually paid to an executive officer exceeds the compensation the company would have paid under the restated financials. If the compensation is tied directly to financial measures that are adjusted in the restatement, the company should be able to determine the clawback amount relatively easily. It is less obvious how to calculate the clawback amount in cases where the incentive compensation is based on stock price or total shareholder return, however, since it will not be clear to what extent these measures are affected by the restatement. In addition, incentive compensation will, in many cases, be based in part on the discretion of the compensation committee, and the committee’s exercise of discretion to determine the original payment will add a subjective element to the calculation of the clawback amount. The proposed rule provides guidance on how companies should calculate the clawback amount in these situations.

All Executive Officers Are Potentially Affected

A listed company’s clawback policy must require recovery from all executive officers, regardless of fault. Accordingly, even if an accounting error results from a good-faith mistake or from fraud by a single officer, all current and former executive officers who received incentive-based compensation in the preceding three years are subject to clawback.

An “executive officer” is a person who is an officer for purposes of the reporting and short-swing profit rules under Section 16 of the Securities and Exchange Act. The definition includes the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit or function, and any other person who performs policy-making functions for the company.

The company may decline to pursue the clawback only if the direct expense of enforcing recovery exceeds the amount to be recovered, or if the recovery would violate home-country law. With these narrow exceptions, the company does not have discretion to decline to enforce its clawback policy. The SEC’s proposed rule does allow companies some leeway in determining how to recover clawback amounts, such as by reducing an executive’s future pay, forfeiting unvested awards, or offsetting amounts otherwise payable to the executive.

New Disclosure Requirements

Under the proposed rule, each listed company must file a copy of its clawback policy as an exhibit to its annual report.

If a material error requires restatement of the company’s financials, the company must also report the aggregate amount it is required to recover under the clawback policy. When a recovery amount is outstanding for more than 180 days, or when the company declines to pursue recovery, the company must report the name of the affected officer and the amount due from the officer.

Effective Dates

If the SEC adopts the proposed rule, national securities exchanges will have 90 days in which to propose new listing standards implementing the rule. The new listing standards must become effective within one year after the SEC publishes the adopted version of the rule.

Under the proposed rule, companies must adopt complying clawback policies within 60 days after the listing standards become effective. Compensation based on erroneous financial information for any fiscal period ending on or after the effective date of the SEC’s rule would be subject to clawback.

Compliance Steps

Although it might be some time before the new listing standards are in effect, companies with listed securities might wish to review their clawback policies, incentive plans, and executive agreements to determine how these arrangements will be affected if the SEC’s rule is adopted as proposed. At a minimum, listed companies might find it advisable to ensure that new incentive plans and employment contracts include a mechanism for enforcing the company’s clawback obligations.