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<h5>Key Takeaways</h5>
<ul>
 	<li>National securities exchanges must adopt listing standards that require listed companies to adopt, disclose and enforce a “compensation recovery policy” that does all of the following:
<ul>
 	<li>Claws back executives’ incentive-based compensation to the extent paid in error based on financial reporting measures that are restated.</li>
 	<li>Provides for strict liability (i.e., culpability level not relevant).</li>
 	<li>Discloses the progress over time of recovering compensation from impacted executive officers.</li>
</ul>
</li>
 	<li>New rules regarding compensation recovery apply to exchange-listed companies regardless of size or home country, including accelerated filers, emerging growth companies, smaller reporting companies, foreign private issuers and controlled companies.</li>
 	<li>Compensation recovery policies do not apply to salaries, compensatory options that vest over time only, discretionary bonuses, milestone compensation based on strategic measures (e.g., acquisition) or operational measures (e.g., projects), or other compensation unrelated to financial reporting measures.</li>
</ul>
<h5>Rulemaking Background</h5>
The Dodd-Frank Act of 2010 added Section 10D to the Exchange Act, which requires the U.S. Securities and Exchange Commission (SEC) to direct national securities exchanges<a title="" href="#_ftn1" name="_ftnref1">[1]</a> to prohibit the listing of issuers who do not develop and implement a policy for the recoupment of compensation as specified in Section 10D. The policy must apply when listed issuers are required to make a financial accounting restatement under the securities laws. Such issuers must recover incentive-based compensation from current and former executive officers to the extent received in error by such executives; namely, executive officers must return all such compensation received in excess of what should have been received under the restated financials. In 2015, the SEC proposed new Rule 10D-1 to implement Section 10D, and comments for that proposal were reopened in October 2021 and then again in June 2022.
<h5>Overview of New Rule</h5>
On Oct. 26, the SEC announced that it adopted a final rule (the Release) implementing Section 10D that will impact more than 5,300 exchange-listed companies. This rule requires listed companies to implement, disclose and enforce a compensation recovery policy to claw back or otherwise recover excess incentive-based compensation that executive officers received based on financial reporting measures that are later restated. Affected executive officers are strictly liable for the recovery, which means that an executive officer need not be culpable with respect to the facts that led to the restatement, and a company may not provide its executive officers with indemnity or insurance to insulate them from recovery (although executive officers may obtain their own insurance through a third party).

The scope of potential recovery extends to all incentive-based compensation received by any current or former executive officer who served at any time during the three fiscal years prior to when a restatement becomes required (i.e., when the board concludes a restatement is necessary or when it should have reasonably so concluded, or when ordered by a court or agency to restate). Incentive-based compensation is defined to include any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure.

Financial reporting measures that could be affected by a restatement include accounting measures and any other measure that may be derived from them, whether provided in SEC filings, company websites, earnings releases, speeches, interviews or elsewhere. The Release provided the following as examples of these measures: stock price, total stockholder return, revenues, net income, profitability of one or more reportable segments, net assets or net asset value, EBITDA, working capital, operating cash flow, return on invested capital, return on assets, earnings per share, sales per square foot or same-store sales, and any of such financial reporting measures relative to a peer group.

All “executive officers” (as defined under Section 16) of a listed company that issues a restatement will be subject to recovery, and recovery must be collected “reasonably promptly” unless an exception applies. The final rule also provides that any person identified as an executive officer in the issuer’s proxy statement or annual report who is not also a Section 16 officer will be presumed to be an executive officer subject to clawbacks.

Importantly, the new rule applies to all restatements without differentiating between so-called big-R and little-r restatements. The big-R variety are generally those prompting a disclosure under Item 4.02(a) of Form 8-K to correct errors that are material to previously issued financial statements, whereas for little-r restatements the information can be restated when the issuer next files the financial information in question. Any restatement – big-R or little-r – prompts an analysis and potentially a recovery, which in turn triggers disclosure.

If a restatement prompts a recovery under the new rule, the results and progress toward paying such recovery must be disclosed under a new subjection (w) to Item 402 (Executive Compensation). Such disclosures will be incorporated into the existing summary compensation table and other disclosures under Item 402.
<h5>Updates to Executive Compensation Disclosures</h5>
The final rule also adds a new disclosure requirement regarding the recovery of compensation as subsection (w) to Item 402 of Regulation S-K, which is required in annual reports, information statements and proxy statements. Disclosures under the new subsection (w) must appear with the other executive compensation disclosures under Item 402, using the same format.

This new subsection will impact the existing summary compensation table by adding columns and footnotes showing how previously disclosed compensation is impacted by recovery under Rule 10D-1. Although these disclosures may be made for executive officers as a group, named executive officers must be called out individually.

When recovery is pursued, issuers must make a disclosure for each restatement. Such disclosures must state the date on which the preparation of a restatement became necessary, as well as the aggregate dollar amount of the erroneously awarded compensation that is attributable to the restatement. An analysis showing how the aggregate amount was calculated must also be provided. When recovery is pursued, disclosures must show the recoverable amount, how much has been recovered and how much has not yet been recovered. If recovery is not pursued, that fact must be disclosed with a brief statement about why, along with the amount of the forgone recovery. All executive officers who have not paid their recovery for 180 days or more must be listed by name even if they are not named executive officers.
<h5>Exceptions</h5>
The new rule exempts specific securities and issuers and provides three enumerated exceptions based on impracticability, but there are also other notable reasons that the rule will not apply to certain companies.

Importantly, compensation recovery policies do not apply to pay that is not incentive-based compensation. For example, compensatory options that vest exclusively over time and are not tied to financial reporting measures are not impacted. Other compensation that is not dependent on financial reporting measures (e.g., discretionary bonuses and milestone compensation based on strategic or operational measures) is also excluded. The lookback period is also limited to three years before the date on which a restatement becomes required, plus any applicable transition periods due to a change in fiscal year. Because of this, older restatements will not be covered unless an exchange addresses this in listing standards or an issuer voluntarily recovers such compensation.

<em>Specific Exemptions</em>

The rule provides an exemption for security futures products and standardized options issued by clearing houses. It also exempts unit investment trusts and any investment company that does not pay incentive-based compensation to its executive officers.

<em>Impracticability Exceptions</em>

A majority of an issuer’s independent directors may determine that recovering affected compensation would be impracticable where (1) third-party enforcement costs would exceed the amount of recovery, (2) recovery violates home country law or (3) recovery would likely cause a retirement plan to lose its tax-qualified status. The first two impracticability exceptions must be substantiated in documentation submitted to an exchange consisting of either documented collection efforts and costs or a legal opinion based on home country law, respectively. The third exception does not include a requirement to provide documentation to an exchange, though the reasons for claiming this exception will need to eventually be disclosed in accordance with S-K 402(w), as described above.
<h5>What’s Next?</h5>
Compliance dates for Rule 10D-1 and related rules are keyed to the Release’s Nov. 28, 2022 publication to the <a href="https://www.federalregister.gov/documents/2022/11/28/2022-23757/listing-standards-for-recovery-of-erroneously-awarded-compensation">Federal Register</a>:
<ul>
 	<li>Amendments in the Release become effective Jan. 27, 2023.</li>
 	<li>Exchanges must submit listing standards to the SEC by Feb. 27, 2023.</li>
 	<li>Listing standards must become effective by Nov. 28, 2023.</li>
 	<li>Listed companies must submit clawback policies to exchanges by 60 days after listing standards become effective (i.e. between April 27, 2023 and Jan. 27, 2024, depending on how quickly listing standards become effective).</li>
</ul>
Since listing standards become effective between 90 days and one year after publication of the final rule, companies should be prepared to submit their compensation recovery policy as soon as the first half of 2023.

Issuers should also review existing award agreements for incentive-based compensation to confirm that their terms account for Rule 10D-1, amending as necessary to protect the company’s clawback rights. Issuers might also consider (1) tracking incentive-based compensation separately from other compensation to minimize the scope of clawback risk and (2) shifting away from incentive-based compensation. In light of other recent SEC disclosure requirements and tax code provisions <a href="https://www.bakerlaw.com/alerts/sec-adopts-dodd-frank-act-pay-versus-performance-rules">applicable to performance-based compensation</a>, there may be additional reasons to use more time-based, discretionary and milestone-based compensation. Issuers must be mindful, however, that executive compensation programs that are not performance based may be inconsistent with the expectations of many institutional investors.

Please feel free to contact any of our experienced professionals if you need assistance with complying with these requirements or have questions about this alert.

<em>Authorship credit: Matthew Sferrazza, Stefan P. Smith and Janet A. Spreen</em>
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<a title="" href="#_ftnref1" name="_ftn1">[1]</a> A “national securities exchange” is an exchange registered as such under Section 6 of the Exchange Act [15 U.S.C. 78f]. There are currently eighteen exchanges registered under Section 6(a) of the Exchange Act: NASDAQ OMX BX, NASDAQ OMX PHLX, The NASDAQ Stock Market, National Stock Exchange, New York Stock Exchange (NYSE), NYSE Arca, NYSE MKT, BATS Exchange, BATS Y-Exchange, BOX Options Exchange, C2 Options Exchange, Chicago Board Options Exchange, Chicago Stock Exchange, EDGA Exchange, EDGX Exchange, International Securities Exchange (ISE), ISE Gemini and Miami International Securities Exchange.
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SEC Adopts Final Rule Requiring Recovery of Incentive-Based Compensation Awarded in Error

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