SEC Parties Like Its 2010: Adopts Long-Awaited Executive Compensation Regulations Under Dodd-Frank

January 17, 2023


2022 saw a flurry of activity to implement rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, a statute passed in reaction to the financial crisis of 2008 but for which enacting guidance had long been absent.

Two significant rules adopted this year in the area of executive compensation are the so-called “pay vs. performance” rules (PVP Rules)[1] and rules on mandatory clawback of incentive compensation (the Clawback Rules).[2]  This memo focuses on insights and considerations that have arisen since the passage of the rules and highlights some practical takeaways for boards and management teams as we collectively work through compliance with rules that, in many cases, have created significant unanswered questions.

PVP Rules

As a refresher, the PVP Rules apply to U.S. public companies subject to SEC reporting (other than foreign private issuers (FPIs), most registered investment companies and emerging growth companies) and generally will require disclosure in proxy or information statements in which disclosure under Item 402 of Regulation S-K is required with respect to any fiscal year ending on or after December 16, 2022.

PVP Key Takeaways and Questions

  • Even if this work will be done internally, setting up a process early that can be applied consistently will be helpful in complying with the rules.  Because the PVP Rules require disclosure of valuation assumptions at later stages of the vesting cycle for equity-based awards, and these assumptions may differ from those used in determining grant-date fair value, companies may face a tension between complying with the rules and disclosing confidential or sensitive information (i.e., internal projections not otherwise required to be disclosed may be relevant for valuation assumptions but premature or competitively harmful).
  • The PVP Rules will require focus on peer group evaluation and selection and discipline, given that changing groups year-over-year will likely increase the disclosure burden under the rules.
  • The selection of a “Company Selected Measure” on which compensation is based will imply its importance to the company’s strategic objectives and compensation philosophy.  Care must be taken to ensure conformity with selecting this measure and non-compensation-related disclosure of how this metric fits within the company’s operational goals.
  • Compensation committees will need to decide the form and content of the PVP disclosures and ensure consistency between those disclosures and discussion of performance both within the compensation discussion and analysis (CD&A) in the proxy and elsewhere in the company’s public filings.  In terms of practicalities, we believe most issuers will opt for graphic disclosure (as it will be the easiest way to present the information in a clear and concise manner), will choose to present this new disclosure outside of the CD&A and will resist the temptation to add supplemental disclosure in excess of what is plainly required by the PVP Rules, unless of course there is a significant disconnect in pay-versus-performance caused by external factors not readily discernible from the minimum required disclosures.
  • While we expect companies will take time to digest the initial response from proxy advisory firms and institutional shareholders to PVP disclosures to better understand the impact of these disclosures before making any significant changes to their compensation philosophy and programs, it is never too early for compensation committees to begin to analyze their current compensation program designs, including use of financial performance measures and operational, strategic and ESG goals, and to assess whether any changes to program designs may be warranted.
  • We do not expect companies to include non-financial measures, such as operational, strategic or ESG goals, in their list of performance measures unless such non-financial measures are significant determinants of compensation, and we would caution against doing so without a compelling narrative linking the company’s achievement of such non-financial goals and the compensation paid to the named executive officers.
  • While the PVP Rules require various disclosures relating to total shareholder return (TSR) (both the company’s absolute TSR and the TSR of its peer group), the rules are ambiguous regarding use of relative TSR as the “Company Selected Measure,” even when that metric is a predominant financial measure in a company’s compensation program, and whether such company must select an alternate financial performance measure (assuming there are additional financial performance measures in the list of financial performance measures to choose from) in lieu of relative TSR, since absolute TSR is already disclosed.  While we believe relative TSR should be an appropriate “Company Selected Measure,” companies should proceed with caution until we have received clarification from the SEC.

Clawback Rules

The Clawback Rules remain at this time a bit inchoate, insofar as they require the listing exchanges to adopt clawback listing standards further enacting the Clawback Rules prior to the end of February 2023 (which listing standards must go into effect no later than November 28, 2023, with issuers required to implement policies within 60 days thereafter).  Unlike the PVP Rules, the Clawback Rules will also apply to FPIs.

Generally, the Clawback Rules require most issuers to implement “no fault” clawback policies that apply in the event of certain restatements of the issuer’s financial reporting for accounting purposes, which policies would require the issuer to pursue recovery of any erroneously paid incentive compensation that is earned, vested or granted to any of the issuer’s current or former executive officers during the three completed fiscal years prior to the date of the accounting restatement.  An issuer must also file a copy of its clawback policy as an exhibit to its annual report and disclose details regarding the incentive compensation subject to recovery and any excess amounts that remain outstanding for at least 180 days.  Issuers that do not adopt a clawback policy compliant with the Clawback Rules or who fail to enforce their policy are subject to delisting on their applicable exchange.

The Clawback Rules are simultaneously broader and narrower in scope than many existing clawback policies that have been adopted by issuers both in anticipation of the Dodd-Frank rules and investor pressure.  On the one hand, most financial restatements (including certain so-called “little r” restatements that are not inherently material) will implicate the Clawback Rules, and current and former executive officers may be subject to the Clawback Rules regardless of whether they have engaged in any misconduct.  In addition, the Clawback Rules significantly restrict the board’s use of discretion, including in areas such as: whether a clawback will be required, the amount of compensation subject to clawback, how to factor in extenuating concerns like adverse tax impact of clawback and similar considerations. On the other hand, the type of misconduct covered by the rules remains limited to deemed overpayment of incentive compensation tied to financial restatements, and does not include other misconduct that may result in financial or reputational harm to the company (e.g., policy violations, criminal conduct), which is commonly included in existing clawback policies.

Clawback Takeaways and Next Steps

  • Most public companies have already adopted clawback policies in response to shareholder feedback or the views of institutional proxy advisory firms who consider clawback policies in their proxy voting guidelines.  However, a large number of those clawback policies were influenced by the clawback provisions under Section 304 of the Sarbanes-Oxley Act, which generally require misconduct and are limited to clawback in the event of a “Big R” restatement.  As a result, we anticipate that many companies will need to revise existing clawback policies to address the broader scope of the Clawback Rules, but may choose to retain multiple policies (or a policy-within-a-policy) that will require clawback in compliance with the Clawback Rules, but will also permit clawback in other circumstances currently covered by their issuer’s policies and/or to non-executive officers, in the discretion of the issuer’s board of directors. 
  • Although we do not expect the listing exchange implementing standards to substantially differ from the Clawback Rules, in light of ongoing interpretive uncertainty in the rules, we are advising most issuers to defer adoption of changes to their existing policies until such standards (and any further guidance) are released.  That does not mean boards and compensation committees should defer all action until the listing standards are released.  Issuers should review their compensation committee charters and other applicable governance documents to ensure the compensation committee will be empowered to act on the Clawback Rules once the listing standards are adopted. In addition, careful deliberation and consideration should be given to whether existing clawback policies will be retained to the extent they are broader than the Clawback Rules require, mindful that there will likely be substantial institutional shareholder and proxy advisory firm pressure to retain these policies.  For this reason we expect many companies to adopt a segregated Dodd-Frank clawback policy that effectively tracks the minimum requirements of the statutory language and applicable listing standards, leaving any clawbacks broader in scope to separate or supplemental policies.
  • In addition to the above considerations, FPIs will have additional work to do. The individuals covered by the Clawback Rules generally track the definition of “executive officer” under Section 16 of the Exchange Act, to which FPIs are not subject. As a result, we recommend that FPIs begin the analysis of who would qualify as an executive officer for purposes of the Clawback Rules now, particularly because it is likely judgment calls will need to be made in this process. The definition of executive officer is based on a “facts and circumstances” analysis, informed by the issuer’s reporting lines and structure and focused on the degree of policy-making authority of the applicable individuals, which will vary based on their responsibilities within the organization.  It is likely that there may be some overlap between the members of the issuer’s “administrative, supervisory or management bodies”[3] required to be disclosed in an FPI’s annual report on Form 20-F, but the disclosure requirements in Form 20-F defer to home country practice rather than the functional test utilized in Section 16, which FPIs will need to consider when implementing the Clawback Rules.
  • Compliance with the Clawback Rules will require more fulsome internal controls and procedures, including documentation and decision-making processes for determinations regarding compensation (e.g., preparing materials for compensation committee meetings including significant detail regarding the role of financial/non-financial metrics considered by the committee when making compensation decisions).  Issuers will need to clearly delineate what items of compensation may be subject to the Clawback Rules and evaluate whether elements of an issuer’s compensation design may be inadvertently swept up in the incentive-based compensation covered by the Clawback Rules due to being awarded partially in recognition of prior achievement of financial reporting measures, even if the compensation itself is not subject to further achievement of financial goals.
  • Issuers should review their compensation disclosure for upcoming proxy statements with the Clawback Rules in mind, given the inherent tension between, on the one hand, demonstrating an alignment between their executives’ compensation and the issuer’s financial performance, which will remain a focus of shareholders and proxy advisory firms, and on the other, linking elements of compensation that the committee did not intended to be “incentive compensation” within the meaning of the Clawback Rules (i.e., base salary increases) but that might be deemed to be performance-based if the disclosure would suggest it is contingent or related to attainment of financial performance metrics.
  • Issuers should begin reviewing their current compensation programs and arrangements to evaluate whether and how current contracts will need to be modified to address the Clawback Rules and to assess the feasibility of recovery in the event of a clawback.  This review should include ensuring awards and contracts with executive officers include clawback language that could be revised unilaterally by the issuer to permit recovery as required under the Clawback Rules, or that at least reference any clawback policies adopted by the issuer.  In addition, for go-forward annual equity or bonus awards, issuers should consider whether to require executives to execute, as a condition to their receipt, an acknowledgement agreeing that such awards, as well as any previously awarded compensation that falls within the scope of the Clawback Rules, will be subject to the Clawback Rules (carefully specifying whether and to what extent such compensation will also be within the scope of any supplemental clawback policy issuer has in effect) and allowing for broad recovery and offset rights in favor of the issuer.  In conducting these reviews, issuers should be mindful that significant questions remain about how to reconcile potential tension between the Clawback Rules and other applicable law, including state and local laws that broadly protect “wages” against forfeiture or clawback and limitations in the tax rules for recovery of taxes paid on amounts that are ultimately clawed back.
  • The Clawback Rules generally prohibit a company from indemnifying or otherwise economically protecting executive officers from the Clawback Rules and their implications.  Affected companies may wish to review their employment and executive agreements and plans, as well as indemnification policies, to ensure that they comply with this aspect of the rules.
  • Compensations committees will want to consider the impact of the Clawback Rules on compensation design.  We expect many committees to turn to their compensation consultants and advisors to assist in modifying compensation programs with an eye toward enforcement of the Clawback Rules and potential mitigation of the reach of new clawback policies on executives’ compensation.  The desire and ability of compensation committees to make any such changes to plan design will be limited by the countervailing interests of shareholders and proxy advisory firms.  Potential areas for consideration may include:
    • Using operational, strategic or ESG measures as opposed to financial performance measures and/or moving away from a reliance on stock price or TSR as a financial performance measure given the difficulty in determining the impact of a restatement on incentive compensation earned based on achievement of stock price and TSR.
    • Moving from awards with multiple year performance periods to incentive compensation that contains a “banking” element (e.g., awards where performance is measured at one-year performance periods subject to a requirement of continued employment through the end of the aggregate number of performance periods) to limit the scope of the award that may be covered by the issuer’s clawback policy if a lookback period encompasses only a portion of the performance period.
    • Similarly, compensation plan design may evolve to assist in the recovery of compensation in the event of a restatement by requiring deferral of earned incentive compensation through the date it is no longer covered by the lookback period, longer stock ownership periods following settlement of equity awards or similar steps to extend the period of time before earned incentive compensation becomes payable to covered executives in order to facilitate recovery of such amounts in the event of a restatement.
  •  While the Clawback Rules do not empower the SEC to directly compel issuers to pursue recovery pursuant to the issuer’s clawback policy, they are also likely to result in an increase in shareholder derivative suits in connection with restatements, in particular around questions of whether a restatement was required, the calculation of erroneously awarded compensation and where the issuer determines not to pursue recovery due to its impracticability. In addition, executives subject to the rule may also pursue actions against their employers in connection with the loss of earned incentive compensation as a result of the application of the issuer’s clawback policy.  For its part, the SEC is likely to scrutinize issuers’ disclosures about compensation clawback calculations, efforts, and the timing of restatement decisions.  Boards and compensation committees should be braced for this potential devel

[1] See our September Alert Memo on these rules available here.

[2] See our November Alert Memo on these rules available here.

[3] See Form 20-F Item 6(B).