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Global rules on foreign direct investment (FDI)
Cross-border acquisitions and investments increasingly trigger foreign direct investment (FDI) screening requirements.
United States | Publication | oktober 2022
On Wednesday of last week, the SEC announced a new regulation requiring publicly traded companies to establish policies to claw back executive compensation in certain instances.1 This new rule expands executive compensation clawbacks dramatically: under the rule, companies must now enforce a clawback almost any time it restates its financials, regardless of whether the restatement was caused by fraud, mistake or any other error. The rule also requires each listed company to disclose its policy and all clawbacks that occur as a result of the policy. A company's level of transparency and compliance with the new rule will likely influence the course of any future enforcement action triggered by restatements of corporate financials.
As noted above, the SEC's new rule, codified as Rule 10D-1, marks a broad expansion of corporate clawback policy. Section 304 of the Sarbanes Oxley Act already requires that a CEO and CFO disgorge excess profits when an accounting restatement is issued as a result of misconduct.2 Further, only the SEC has enforcement power against the CEO and CFO under Section 304, and a corporation cannot enforce the provision against the executive. As discussed below, Rule 10D-1 enlarges the clawback concept to capture all executive officers for any type of restatement, even restatements arising from honest errors. The rule requires companies to implement a look-back window to encompass any incentive-based compensation3 awarded for three years before the restatement at issue. Companies that do not properly adopt and follow clawback policies compliant with Rule 10D-1 risk criminal penalties, civil penalties and de-listing from the exchange on which they trade.
This new rule dovetails with the DOJ's efforts to target individual actors who may be viewed as responsible for corporate wrongdoing. Last month, in a speech focused on corporate accountability, Deputy Attorney General Lisa Monaco made it clear that the Department of Justice is prioritizing enforcement actions against individuals who they believe profit from corporate crime.4 Additionally, according to Monaco, companies that do not enforce clawback policies risk harsher penalties.
Rule 10D-1 directs national securities exchanges (such as the New York Stock Exchange and NASDAQ) to incorporate into their listing standards clawback policies that comply with the rule. The rule also requires the corporation to file its recovery policy as an exhibit to the corporation's annual Form 10-K.
Rule 10D-1 states that a corporation's policy must be triggered any time a material accounting error is discovered in the preceding three years' financial statements. The rule requires that the company's policies cover both restatements that correct errors that are material to the previously issued financial statements and restatements that correct errors that are not material to previously issued financial statements, but which would result in a material misstatement if the errors were left uncorrected in the current report, or if the error correction was recognized in the current period (these are commonly known as big "R" and little "r" restatements, respectively). This means that an executive compensation clawback is likely triggered even if an issuer is not required under the rules to file an Item 4.02 Form 8-K in connection with its restatement but, rather, merely makes the correction the next time it files its year-end financial statements. Immaterial errors or out-of-period adjustments, however, do not require a clawback under the rule.
The SEC intentionally left the universe of executives subject to clawbacks under Rule 10D-1 vague in order to give corporations flexibility in crafting their clawback policies. However, the SEC has expressed its view that Dodd-Frank intended for the definition of covered executives to be broad and, at a minimum, individuals identified as officers under Regulation S-K must be subject to a company's clawback policy. Additionally, Rule 10D-1 states that any "current or former executive officer of the issuer" from the previous three years is subject to the policy, regardless of their role in the accounting errors giving rise to the restatement.
The compensation subject to clawback under Rule 10D-1 includes any cash, shares or stock options awarded over the last three years that would not have been paid to the executive officer had the company filed correct financial statements ("covered compensation"). Covered compensation includes any incentive-based compensation tied to stock price because, in the SEC's analysis, a company's stock price is inherently tied to accounting information. Significantly, neither salaries nor incentive-based bonuses tied to non-financial data, such as overall business growth, hours worked, leadership, etc., are considered covered compensation.
Rule 10D-1 requires that a company's policy calculate the clawback amount as the difference in covered compensation that was received and the covered compensation that should have been received if the financial statements had been reported correctly, regardless of the type of covered compensation. The SEC noted that it may be difficult for companies to assess over-compensation based on a stock price because a company's stock price can be based on many factors, not just its financial statements. Corporations are allowed to use their own "reasonable methods" to calculate the level of over-compensation. The new rule also does not address how compensation should be clawed back when officers trade their stock or stock options for cash before the accounting error is discovered. As long as the corporation uses reasonable methods to claw back some of the erroneous compensation, the corporate clawback policy will likely comply with the requirements of Rule 10D-1.
Corporations must begin taking steps to effectuate the required clawbacks when the board of directors or management first knows, or should know, that there is a material accounting error resulting in excessive compensation. While the rule does not mandate how corporations implement those steps, it provides an exception that companies may refrain from clawing back excessive compensation if the cost of collection were to exceed the amount to be recovered. Furthermore, the rule prohibits companies from indemnifying executive officers or paying the insurance premiums for executive officers related to excessive compensation policies.
Rule 10D-1 requires companies to include their compensation clawback policy as an exhibit to their annual Form 10-K. Corporations must also include information regarding whether the clawback policy has been triggered during the reporting period. This will be indicated by a check box system on the cover page of the corporation's annual reports to indicate whether the corporation corrected an error to previously issued financial statements and whether any of those error corrections required a clawback analysis. Finally, in the event that a corporation did institute a clawback during the reporting period, the corporation must either state the amount recovered from the executive and/or update the executive compensation amount in the Form 10-K.
As of now, there is not a date certain by which corporations need to implement a compensation clawback policy. Rule 10D-1 takes effect when the rule is formally published into the Code of Federal Regulations (CFR). The exchanges will be required to publish their new listing standards no later than 90 days after the rule takes effect. Each exchange must make its new listing standards effective within a year of when the rule takes effect. Each listed corporation then has 60 days after the new listing standards take effect to establish its own policy.
Rule 10D-1 requires stock exchanges to commence delisting proceedings against corporations that fail to comply with the rule. Corporate officers that attempt to evade enforcing the policy or mischaracterize accounting adjustments will be subject to both civil and criminal penalties.
While many corporations already have clawback policies in place, they will need to re-examine those policies to comply with the new rule. It remains to be seen whether there will be any flexibility in how this rule is implemented and whether the scope of accounting errors requiring a clawback policy will be further narrowed. SEC Commissioner Hester Pierce has raised concerns that the rule is overly broad in the type of accounting errors it appears to encompass; she has also objected to the lack of clear guidelines to corporations regarding recovery of executive compensation. Given the ambiguities to the rule, corporations will need to create clear policies that provide proper notification to executives and that allow companies to enforce clawbacks while mitigating potential litigation risk.
Special thanks to John Heath and Zach Woods for their assistance in preparing this content.
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