Compensation Disclosure

The Securities and Exchange Commission (“SEC”) released a proposed rule on July 14, 2015 that will require publicly traded companies to create and enforce a clawback policy (called a “recovery policy” by the SEC) to recover incentive-based compensation (“IBC”) paid to executives for specific metrics for which the company has to issue revised financial statements because those metrics were overstated. While the rule is discussed in more length in a previous post, this blog post discusses two tax issues that companies and executives should be aware of when creating a clawback policy. The first issue arises if a company’s recovery policy were to provide for clawback from nonqualified deferred compensation before it becomes payable, which could result in a significant tax penalty on an affected executive under Section 409A of the Internal Revenue Code. The second issue arises when an executive has already paid taxes on the IBC, as the rule requires the clawback be equal to the bonus amount pre-tax, not the amount that the executive netted from the bonus.

Section 409A generally does not allow the payment of deferred compensation at times other than upon certain events specified in the statute (separation from service, disability, or death) or on a fixed date. Acceleration of payment is generally prohibited. Under the existing Section 409A guidance, the ability of a company to clawback IBC from deferred compensation that is not yet payable generally would violate the anti-acceleration rule of Section 409A, potentially triggering severe tax consequences for affected executives. Companies should draft their recovery policies so that clawback will come from sources other than deferred compensation subject to the anti-acceleration rule of Section 409A.

The second issue arises when the executive has already paid taxes on IBC, but the amount to be recovered is on a pre-tax basis.   The executive generally should be able to claim the clawback repayment as a miscellaneous itemized deduction in the year of the repayment. However, there will be instances where the tax benefit from this deduction will not completely offset the amount of additional taxes incurred in the year the IBC was received (e.g., when the executive’s tax rate is different in the year of receipt of the IBC than the year the clawback takes place and due to limitations on miscellaneous itemized deductions). While Section 1341 generally provides relief in the situation where the deduction in the year of repayment does not fully compensate a taxpayer for the additional taxes previously paid on such repaid amount, tax practitioners are skeptical that Section 1341 will always be available to executives in these situations. This issue likely will not affect how companies draft their policies; rather, it will inform how executives make financial and tax decisions, particularly given that executives will generally have to make the clawback repayment of (and therefore will generally be “out of pocket” for) the full pre-tax amount of the bonus before realizing any tax benefits from the repayment.

On July 1, 2015, the Securities Exchange Commission (“SEC”) took action to fulfill the final executive compensation rulemaking mandate of Section 954 of the Dodd-Frank Act. The SEC proposed a rule that directs national securities exchanges and associations to establish listing standards that would require companies to develop and implement executive compensation clawback policies. Under the proposed rule, if a company is required to prepare an accounting restatement due to a material noncompliance with any financial reporting requirement, executive officers—defined in the proposed rule to include the same “officers” subject to Section 16 short-swing trading disclosures under SEC Rule 16a-1(f)—must relinquish the compensation they received in excess of what would have been received based on the restated financial results. Proposed Rule 10D-1 would apply to incentive-based compensation that current and former executives received for any of the three completed fiscal years preceding the date the company is required to prepare a covered restatement.

The driving principle behind the rule is that “executive officers should not be permitted to retain incentive-based compensation that they should not have received in the first instance, but did receive because of material errors in their companies’ publicly reported financial statements,” as SEC Chair Mary Jo White stated. Executives will be prevented from keeping “erroneously awarded” compensation without any regard to fault, misconduct, or an executive’s responsibility for the financial statements that prompted the accounting restatement, which is not required by the Dodd-Frank Act. Ms. White and other supporters hope the rule will “result in increased accountability and greater focus on the quality of financial reporting, which will benefit investors and the market.” SEC Commissioner Luis A. Aguilar commented that the proposed rule rests on the perceived foundational idea that “Americans believe you should earn your money” and that “if you did not earn your compensation, you should not keep it.”

Not all incentive-based compensation will fall under the proposed rule’s scrutiny and be subject to recovery. As proposed, the rule defines 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.” Financial reporting measures may include three pieces of information: accounting-related metrics used to prepare a company’s financial statements, stock price, or total shareholder return. For example, compensation that could be subject to a clawback policy includes stock options, non-equity incentive plans, bonuses paid from a bonus pool, and other compensation that was earned or granted based wholly or in part on satisfying a performance goal tied to a financial reporting measure. Excluded from the proposed rule’s contemplated umbrella of incentive-based compensation are salaries, discretionary and time-vested awards that don’t depend on financial reporting metrics, and incentive compensation awarded based on the occurrence of a non-financial event, such as consummating a merger, opening a certain number of stores, or obtaining regulatory approval of a product. However, the clawback requirement would apply to all incentive-based compensation that is “received” for any portion of the covered three-year period – which would include compensation paid out after the end of such period based on the achievement of any specified financial reporting measure during the period in question.

Proposed Rule 10D-1 would also require all listed companies—except certain registered investment companies to whom the rule would not apply—to file their clawback policy as an exhibit to their annual reports and disclose actions they’ve taken pursuant to their policy. Significantly, this means that companies which happen to list only debt securities—and previously have not been required to identify which of their executives are “officers” for purposes of equity-based Section 16 compliance—will need to do so to comply with this new rule. Additionally, companies will have to disclose, in any proxy statement that requires executive compensation disclosure, whether during the most recent fiscal year the company completed an accounting restatement that required recovery of erroneously paid excess compensation, and whether there was an outstanding unrecovered balance of excess incentive-based compensation from the application of the company’s clawback policy to a prior restatement. Companies that fail to adopt any compensation recovery policy, fail to disclose such policy in accordance with the rule, or fail to comply with their clawback policy could face delisting.

One of the distinctive characteristics of the proposed rule is that boards of directors will be able to exercise discretion not to recover any excess incentive-based compensation only if: (1) recovery would violate the home-country laws of a foreign private company; or (2) the expense of enforcing recovery would be expected to exceed the amount of incentive-based compensation that would be recovered. Commenters noted in response to a preliminary SEC proposal that boards should have this discretion because the costs of recovering excess incentive-based compensation may outweigh the benefits of obtaining it. The proposed rule recognizes this fact, but also notes that allowing boards to exercise too much discretion could undermine the entire purpose of the rule—to bar an executive officer from retaining incentive-based compensation that he or she did not earn.

On the other hand, some commenters argue that allowing a board to forego the costs of recovering erroneous compensation based on the impracticality of pursuing the compensation would align with investors’ interests. But as SEC Commissioner Piwowar noted, the breadth of the proposal—requiring companies to pursue a clawback unless it would be “impracticable” to do so—may end up unnecessarily committing more shareholder resources to clawbacks. Under the proposed rule, the only criteria that would factor into a determination of “impracticability” are those related to whether the recovery would be cost effective. Thus, before a company can conclude the costs of recovering excess incentive-based compensation impractically outweigh the benefits, they may need to first make a reasonable attempt to recover the incentive-based compensation, and then determine it would not be cost-effective. By engaging in this process, companies may still end up expending more shareholder resources than the excess compensation would justify.

Concerning the exercise of Board discretion, the SEC is seeking comment on a variety of topics, including: (1) whether this discretionary provision will hinder effectuation of the rule’s purpose; (2) whether the provision grants companies a substantial loophole to avoid compliance; (3) whether the standard for exercising discretion not to recover should be limited to situations in which it is impracticable; and (4) whether other circumstances exist in which companies should be allowed not to pursue recovery.

Opponents of Proposed Rule 10D-1 argue the rule as proposed could have the unintended effect of increasing the overall compensation of executive officers. In opposing the rule, SEC Commissioner Michael Piwowar pointed to the fact that the rule will breed uncertainty in executive compensation. Due to the threat that some of their compensation may ultimately be subject to a “clawback” triggered by a financial restatement even in the absence of any misconduct, executives are likely to demand higher salaries or insist that a smaller portion of their compensation come from incentive-based awards. These consequences could potentially defeat the purpose of the increased emphasis on pay-for-performance in designing executive compensation.

The method for calculating certain types of compensation subject to recovery constitutes another source of uncertainty. Unlike incentive-based compensation that bears a clear relationship to the financial reporting measure that triggered the payment, erroneously-awarded compensation that is based on stock price or total shareholder return cannot be recalculated with mathematical precision from the new information in an accounting restatement. In recognition of this difficulty, the rule proposes to allow companies to use a reasonable estimate of the effect of the accounting restatement on the stock price or total shareholder return on which the erroneous compensation was based. Companies would have to document their methodology in determining such a reasonable estimate and provide the information to their national securities exchange. We expect a number of comments to question whether this is feasible or would require too many assumptions, or result in additional, unnecessary expense to shareholders as companies engage third party experts to provide support for their estimates.

Others who have spoken out against the proposed rule criticize its scope. Tom Quaadman, the Vice President of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness has called the plan “extremely prescriptive” in that it includes more executive officials than the statute contemplated. The rule has expanded on the Sarbanes-Oxley Act’s clawback provisions, which only apply to CEOs and CFOs, by applying to any president, principal financial officer, principal accounting officer, vice president in charge of a principal business unit, division, or function, or any other person who performs a similar policy-making function at the company. Some have argued that the rule’s aggressive “no fault” clawback policy should apply to a smaller group of executives who are responsible for the preparation of the financial statements. Alternatively, some argue the proposed rule could apply to a larger group of executives, but the application of the rule should be limited to only those who had a hand in causing the financial misstatement.

The proposed rule also raises certain questions concerning how the clawback amount will be treated for tax purposes. For instance, while the proposed rule would allow “erroneously awarded” compensation to be recovered over time from an executive’s future salary or other incentive awards, companies should be careful to ensure that any amounts recovered through an offset against future awards of deferred compensation do not result in an impermissible acceleration of deferred compensation payments that could trigger tax penalties under Section 409A of the Internal Revenue Code. Additionally, the clawback is calculated on a pre-tax basis, but the officers would be returning the compensation with after-tax money, requiring them to seek to recover any resulting overpayment of income tax from the IRS.

Under the SEC’s clawback proposal, each exchange will have 90 days after the date the SEC adopts Rule 10D-1 in definitive form to file its proposed listing standards to implement the new rule, and its rules must become effective no later than one year following the publication date of the exchange’s proposed rules. Listed companies would be required to have a clawback policy in place that complies with such rules no later than 60 days after the date on which their exchange’s rules become effective. Accordingly, while these rules are not likely to be applicable until early 2017, listed companies of all sizes should begin now to proactively evaluate the impact they may ultimately have on existing company policies and on the design of their executive compensation programs.

Madison Benedict, a summer associate at the firm, assisted in the preparation of this post.

On September 18, 2013, the Securities and Exchange Commission (the “SEC”) issued proposed rules to implement the pay-ratio disclosure requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The proposed rules would compel public companies to disclose how the compensation of the chief executive officer compares with that of employees.

As proposed, covered companies would be required to disclose (i) the median annual total compensation of all employees (excluding the principal executive officer, referred to here as the CEO), (ii) the annual total compensation of the CEO, and (iii) the ratio of the two totals. The ratio must be expressed as a multiple of one – for example, 1 to 268 or the CEO’s “annual total compensation is 268 times that of the median of the annual total compensation” of all other employees. The information must appear in any annual report, proxy, information statement or registration statement requiring executive compensation disclosure under Item 402 of Regulation S-K. Further discussion of the specifics of the proposed rules can be found here.

The question some are asking in response to this proposal is “what information will investors truly glean from such disclosure?” Disclosures of the compensation of the CEO have long been required of public companies. Will the strategy of investors change when they see a ratio of the pay of the median employee to the CEO in writing in a proxy statement? Is it worth the cost and time that companies are going to have to expend to determine these numbers?  Why were part-time, seasonal and foreign employees included? Will the use of sampling and reasonable estimations help limit the costs and burden on companies having to make this disclosure? Will we really learn anything new at all or will this disclosure be used to embarrass CEOs?