Changes made by the SEC to clawback regulations may impact the nonqualified deferred compensation (NQDC) plans of select companies.

Updated U.S. Securities and Exchange Commission (SEC) requirements addressing the recovery of erroneously awarded incentive compensation became effective in December 2022. Commonly referred to as “Dodd-Frank clawback policies,” these regulations require covered companies to promptly recover any erroneously awarded incentive compensation received by certain current or former executive officers.

Examining the components of this requirement makes it easier to understand what this regulation means and who may be impacted by it.

What is the definition of clawback?

A clawback is a provision in a contract between an employer and an employee that allows the employer to require repayment of previously paid compensation. People are often most familiar with a corporate clawback being executed either because of misconduct by the executive or poor job performance. However, the revised regulations address only clawbacks of incentive compensation based on financial metrics later determined to be in error, whether or not the clawbacks are related to misconduct or performance.

Which companies are subject to Dodd-Frank clawback policies?

The SEC defines “covered companies” as companies listed on the Nasdaq or the NYSE*, companies classified as foreign private issuers (FPIs), and companies with publicly listed debt. FPIs can be loosely described as companies that may be incorporated outside the US but whose stock ownership, executive leadership, or primary business is more than fifty percent US-based.

Which employees may face a clawback of incentive compensation?

The current or former employees whose incentive compensation may be clawed back by a covered company are:

• The company’s president
• The principal financial officer
• The principal accounting officer or controller
• Any vice president in charge of a principal business unit, division, or function such as sales administration or finance.

What types of incentive compensation may be clawed back?

An erroneous incentive payment could be made through salary, rewards, or bonuses.

• The compensation could be a non-equity incentive plan award or a cash award received for satisfying an established financial performance goal. It could also be a bonus paid from a bonus pool, in which a financial performance goal determines the size of the pool.
• Incentive compensation can be awarded in the form of restricted stock units (RSUs), stock options, stock appreciation rights (SARs), and performance stock units (PSUs) that are granted or that vest based on satisfying a financial performance goal. The covered compensation could also be in the form of proceeds from the sale of shares through an incentive plan that was granted or vested based on satisfying the financial performance goal.

The requirement to claw back the compensation applies whether financial reporting is the sole metric for awarding the incentive compensation or is only partially used.

What is a qualifying financial performance goal?

Examples of financial reporting measures or financial performance goals that may impact the amount of incentive compensation granted, earned, or vested by certain executive officers include:

• Stock price
• Total Shareholder Return Value (TSR)
• Revenues
• Net income
• Operating income
• Earnings before interest, taxes, depreciation, and amortization (EBITDA)
• Operating income, etc.

Lastly, how do companies determine that awarded incentive compensation is “erroneous”?

If a covered company issues either a “Big R” or a “Little r” financial restatement based on Generally Accepted Accounting Principles (GAAP), it may be subject to the SEC’s clawback policy for erroneously awarded incentive compensation:

• “Big R” Restatement: correcting an error in previously issued financial statements that is material to those financial statements.
• “Little r” Restatement: correcting an error that would result in material misstatement if the error was corrected in the current period or left uncorrected in the current period.

When a triggering event occurs, the company must review its incentive compensation award to executives at the time of the event and for three years before the event.

What Covered Companies and Their Executives Need to Know

Under the clawback rule, covered companies must develop and implement a clawback policy that provides for the recovery of incentive compensation erroneously awarded to current or former executives. Covered companies must also disclose their clawback policies according to federal securities laws. Failure to comply with these rules can result in the exchange delisting the company.

Clawback policies should be in place and effective now, and they should address whether and how a nonqualified deferred compensation plan, which is subject to Section 409A of the Internal Revenue Code, can be effectively used as a repayment source.

For example, if the erroneously paid compensation was deferred into a nonqualified deferred compensation plan, it may be possible to effectively repay such amounts from the same plan. However, if the erroneously paid compensation is repaid by forfeiting amounts from other nonqualified deferred compensation, then such repayment could be interpreted as an impermissible distribution under Section 409A.

Executives should know that their company cannot indemnify them from the requirement to repay. Under a clawback policy, executives are obligated to repay erroneously awarded incentive compensation even if they did not cause a restatement and had no role or responsibility for financial reporting. They will be required to pay back all the erroneous compensation paid to them, even if such amounts were already subject to personal income taxes. Executive officers can also seek third-party insurance to fund potential recovery obligations as long as the company does not pay for or reimburse the insurance premiums.

You can learn more about how companies and their executives can prepare for clawbacks by reading Dodd-Frank Clawback Policies on NQDC. Want to read more about executive benefits strategies? Check out this article: Split Dollar Life Insurance as a Deferred Comp Tool for Not-for-Profit Organizations

*Nasdaq - National Association of Securities Dealers Automated Quotations
NYSE – New York Stock Exchange.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.

Daniel Mercer is affiliated with Valmark Securities, Inc. Securities offered through Valmark Securities, Inc. member FINRA, SIPC. Investment Advisory Services are offered through Valmark Advisers Inc., a SEC Registered Investment Advisor. 130 Springside Drive, Suite 300, Akron, OH 44333. 800-765-5201. OneDigital is a separate entity from Valmark Securities, Inc. and Valmark Advisers, Inc.

Some of the Financial Professionals associated with OneDigital are registered representatives of and offer securities through Valmark Securities, Inc. a registered broker-dealer, Member FINRA / SIPC. Additionally, some OneDigital Financial Professionals are also Investment Adviser Representatives and offer advisory services through Valmark Advisers, Inc., an SEC registered investment advisor. To help public members determine the specific registrations associated with our Financial Professionals, we recommend reviewing the Broker Check Link that provides insight to the securities registration and company affiliation of our Financial Professionals. Please note that while the individual Financial Professionals can be associated with multiple financial services organizations, the products and services of those independently owned and operated entities can be separate and segregate. OneDigital is a separate entity from Valmark Securities, Inc. and Valmark Advisers, Inc.

Eric Loi is not affiliated with Valmark Securities, Inc., or Valmark Advisers, Inc.