Committees : Compensation

Clawbacks Are Coming. Are You Ready?


clawbacks-8-1-16.pngFive years after the passage of Section 954 of Dodd-Frank adding new provisions on clawbacks, we expect the Securities and Exchange Commission (SEC) to make some minor adjustments to its proposal and adopt a final rule before summer’s end.

The proposal, which would amend Section 10D of the Securities Exchange Act of 1934, shifts responsibility for recouping excess compensation from the SEC to the registrant, creates a non-fault standard as opposed to the Sarbanes-Oxley “misconduct” standard, extends the clawback period to three years and significantly expands the number of executives subject to its reach. Almost all issuers publicly registered with the SEC, including smaller reporting companies and current or former executive officers, are covered. Small and emerging companies, which previously were exempt under Reg SK from making detailed compensation disclosures, will shoulder a disproportionate burden.

Which Officers Are Subject to Section 10D Clawback?
Unlike Sarbanes-Oxley, which only applies to the CEO and CFO, the proposal uses the definition of executive officer from Rule 240.16a-1. It includes principal officers as well as any vice president in charge of a principal business unit, division or function and any other persons who perform similar policy-making functions for the registrant.

What Triggers a Clawback?
The law requires that the company recoup excess compensation received during the three-year period prior to the date the issuer is required to prepare an accounting restatement. Again, unlike Sarbanes-Oxley, no misconduct or error on the part of the executive need be shown. The accounting restatement is the triggering event.

What Type of Compensation Is Subject to the Rule?
The proposed rule applies to all “incentive-based compensation,” which is defined as any compensation that is granted earned or vested based wholly or in part upon the attainment of any “financial reporting measure.” A financial reporting measure is defined to mean any measure derived wholly or in part from financial information presented in the company’s financial statements, stock price or total shareholder return. This is an expansion of the language of Dodd-Frank which states that the law applies to incentive-based compensation that is based on financial information required to be reported under the securities laws. The proposed rule excludes by its terms salaries, discretionary bonus plans, time-based equity awards or other payments not based on financial reporting measures, including strategic or operational metrics.

What Is Excess Compensation?
Excess compensation is defined to be erroneously awarded compensation that the officer receives based on erroneous information in excess of what would have been received under the accounting restatement. Examples include unexercised options, exercised options with unsold underlying shares still held and exercised options with underlying shares already sold. Similarly, all excess stock appreciation rights and restricted stock units awarded must be forfeited and if already sold, any proceeds returned to the company. The clawback would also apply to bonus pools and retirement plans based on the attainment of financial metrics. What should be emphasized is the law and proposed rule leave almost no discretion to the company. Clawback is mandatory except in cases where the pursuit of recovery would be futile or counterproductive.

What Is the Tax Consequence of a Clawback?
What is particularly troublesome is the tax complications. The most common problem is likely to be that the employee will be taxed fully on the original income. When income is paid back in a different tax year, it will be treated most likely as a miscellaneous itemized deduction and its full deductibility will be subject to whether the taxpayer has sufficient deductions to equal or exceed the 2 percent threshold of adjusted gross income. A clawback could have the effect of penalizing the employee through no fault of his own beyond the amount received.

How Should a SEC Registered Bank Adjust Its Compensation Approach?
Banks which may qualify to deregister should consider it. For companies that desire to remain registered or who have no alternative, then executives should consider purchasing insurance products with their personal funds to hedge against an unexpected loss of income already earned and spent. The SEC rule does not permit the issuer to indemnify or purchase insurance for the executive to cover clawbacks. What is unfortunate is that onerous rules governing circumstances out of the control of most executives only makes performance-based incentive compensation less desirable.