Enforcement of Dodd-Frank Clawback Policies Under Foreign Law
The SEC adopted Rule 10D-1 in October 2022, directing national securities exchanges to establish listing standards that prohibit the listing of any security of a company that does not adopt and implement a written policy requiring the recovery, or “clawback,” of certain erroneously paid incentive-based executive compensation. The NYSE and Nasdaq proposed clawback listing standards closely tracking Rule 10D-1 in February 2023, which they amended in June 2023 to provide for the October 2, 2023 effective date. Listed companies have 60 days after the effective date of the clawback listing standards, until Friday, December 1, 2023, to adopt and implement a compliant clawback policy. For more information on Rule 10D-1 and the related listing standards, see our Legal Update, “Compensation Clawback Listing Standards Requirement: US Securities and Exchange Commission adopts Final Rules,” dated November 3, 2022 and our Legal Update, “SEC Approves Dodd-Frank Clawback Listing Standards with October 2, 2023 Effective Date,” dated June 13, 2023.
Rule 10D-1 generally requires a clawback of erroneously awarded compensation in the event of a restatement, which generally includes an accounting restatement of a listed company’s financial statements due to material noncompliance with any financial reporting requirement under the federal securities laws, including any required accounting restatement to correct an error in previously issued financial statements that is material to the previously issued financial statements, or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period. The amount of “erroneously awarded compensation” generally means the amount of incentive-based compensation (compensation that is granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure) received by a covered executive that exceeds the amount of incentive-based compensation on that otherwise would have been received had it been determined based on the restated financial statements.
Rule 10D-1 mandates recovery of erroneously awarded compensation, except to the extent that pursuit of recovery would be impracticable. The SEC did not provide a board of directors with much latitude to exercise discretion.
Background
Rule 10D-1 allows for only three narrow exceptions to the mandatory recovery requirement where recovery is considered impractical: (1) the direct cost of recovery would exceed the amount of recovery, (2) the recovery would violate home country law and additional conditions are met, and (3) potential disqualification of tax-qualified retirement plans. This Legal Update discusses the application of the first two exceptions for countries that are incorporated or have executives working in foreign jurisdictions where the enforcement of the policy will require application of local law in such foreign country.
First, listed companies do not have to recover excess incentive-based compensation if the direct expense of recouping the compensation would exceed the amount recoverable (the “Direct Expense Exception”). However, to rely on this exception, the company must first make a reasonable attempt to recover the requisite compensation and document the recovery efforts. To be deemed to be impracticable, the direct costs paid to a third party to assist in enforcing recovery, such as legal expenses and consulting fees, must exceed the erroneously awarded compensation amounts.
Second, a company does not need to seek recovery of excess incentive-based compensation if recovery of such compensation would violate home country law that was adopted prior to November 28, 2022 (the “Home Country Exception”). Further, in order to rely on this exception, the company must first obtain an opinion of home country counsel, acceptable to the applicable exchange, that recovery would result in such a violation.
The Home Country Exception is limited to the laws of the country of incorporation of the issuer and is not intended to be an exception based on the location of the country in which the executive works. As such, this exception is limited to companies incorporated in a foreign country with a law in existence as of November 28, 2022 that prohibits enforcement in such country (the SEC noted in the preamble to the regulations that no commentators had noted the existence of any such law). The date was adopted to prohibit countries from passing a law after the publication of the regulations to make such country more attractive as a place of incorporation that would prohibit enforcement.
For companies that have executives working in foreign countries where enforcement may fall under the local laws of that country, the company must be able to enforce the clawback requirements or rely on the Direct Expense Exception.
For each of these exceptions, the determination would have to be made by a committee of independent directors responsible for executive compensation decisions, such as a compensation committee, or in the absence of such a committee, by a majority of the independent directors. In addition, as discussed below, the company would need to disclose why it did not pursue the recovery. The determination is subject to review by the applicable exchange.
Manner of Enforcement
While the rules clearly require enforcement of the clawback policy unless an exception applies, the rules do not specify how the policy must be enforced. Rule 10D-1 does allow companies to exercise discretion in how to accomplish recovery, recognizing that the means of recovery may vary by the type of compensation arrangement, as well as by company, provided that the recovery of excess incentive-based compensation must be pursued “reasonably promptly.”
To increase the likelihood of enforceability, companies must consider the methods of recoupment to be added to any such policy. While any such policy would certainly permit the company to demand repayment of erroneously paid incentive compensation subject to the clawback or even to sue to require repayment, should companies consider adding additional methods of recoupment such as offsetting by reducing any future payments of previously granted incentive compensation by the required amount of repayment or reducing future payments of base salary by such amount until repaid or reducing the balance of any amounts in deferred compensation plans by the required amount to be repaid? While the reduction of future compensation by the required repayment amount may seem harsh to the executive, such an approach of reducing future compensation may actually be preferred by the executive as an easier way of making such payment rather than liquidating assets to make a repayment (particularly when the repayment must be done using after-tax proceeds to repay the gross amount of the overpayment).
The offset of future compensation or nonqualified deferred compensation needs to be carefully considered in the United States as the tax treatment of such reduction may not be clear and companies must be careful to not trigger any violation of Section 409A of the Code.
The following section discusses the application of the clawback rules, whether offsets can be permitted against future compensation and whether any actions can be taken by a company now in order to increase the likelihood of enforceability in the following countries:
Foreign Laws on Clawback Policies
1. Is a policy requiring the recovery of certain erroneously paid incentive-based executive compensation enforceable under local law?
A policy requiring the recovery of certain erroneously paid incentive-based executive compensation is enforceable under Brazilian law, as there is no local law that prohibits its enforceability. However, local corporate and labour laws should be observed during the execution of the recovery, as well as the provisions set forth in the agreement that rule the relationship between the parties.
2. If recovery of certain erroneously paid incentive-based executive compensation is required, can the Company deduct such amounts from future compensation otherwise payable to the executive under local law?
Brazilian Law No. 10,820, of 2003, regulates compensation deductions in the context of employment relationships, and must be observed for the purposes of deductions that result from erroneously paid compensation. In light of this law, erroneously paid compensation may be deemed as payment in advance and upon the employee’s express authorization and recognition of the error, the employer may deduct only up to 30% of the employee’s monthly salary.
The Brazilian Labour Code does not authorize unjustified salary deductions. Thus, in order to proceed with the relevant deduction, the employer is required to provide proof of the error, communicate it to the employee, and, provided that they agree with it, deduct the differences from future compensation as if it was paid as payment in advance.
3. Are there any provisions that a Company can add to such policy to increase the likelihood of enforcement under local law?
There are no specific provisions that a company can include in such a policy to increase the likelihood of its enforcement in Brazil, but it should set forth internal procedures to be adopted in order to guarantee compliance with the law in the context of the execution of the deductions (i.e. communications with the employee, collection of authorization etc.).
This section was prepared with the assistance of Meng Bo Law Office, a PRC law firm based in Shanghai, with which Mayer Brown has a close working relationship.
1. Is a policy requiring the recovery of certain erroneously paid incentive-based executive compensation enforceable under local law?
There is no local law that prohibits the enforceability of a policy requiring the recovery of certain erroneously paid incentive-based executive compensation.
It appears that the erroneously paid incentive-based compensation could fall within the concept of "unjust enrichment" under PRC law. Pursuant to Article 985 of the Civil Code of the People's Republic of China, where a person is unjustly enriched without a legal basis, the person who thus suffers a loss is entitled to request the enriched person to return the benefit.
The clawback policy requiring the recovery of certain erroneously paid incentive-based executive compensation is likely to be enforceable under PRC law, in particular, if such policy is explicitly incorporated into the executive’s labour contract.
2. If recovery of certain erroneously paid incentive-based executive compensation is required, can the Company deduct such amounts from future compensation otherwise payable to the executive under local law?
There is no local law that prohibits the company (as the employer) from deducting erroneously paid incentive-based executive compensation from future compensation payable to the executive (as the employee).
As a general position under PRC law, an employer can deduct an amount from the future remuneration/wages (including bonus) payable to the employee, provided that:
(i) such deduction mechanism is (i) agreed upon by the parties in their labour contract, or (ii) set forth in the employer’s internal rules and regulations duly formulated and known to the employee; and
(ii) after the deduction, the remaining amount of the remuneration/wages shall not be lower than the local minimum wage.
The company can therefore deduct certain erroneously paid incentive-based executive compensation from future compensation otherwise payable to the executive, provided that (i) the executive’s labour agreement or the company’s internal rules and regulations explicitly allows this, and (ii) after such deduction, the remuneration/wages payable to the employee remain no lower than the local minimum wage.
3. Are there any provisions that a Company can add to such policy to increase the likelihood of enforcement under local law?
It is strongly suggested that each executive sign a written acknowledgement so that the clawback policy (including the recovery methods) is explicitly incorporated into the labour contract of such executive. It will increase the likelihood of future enforcement of such policy under PRC law.
1. Is a policy requiring the recovery of certain erroneously paid incentive-based executive compensation enforceable under local law?
In theory, there is no reason why a policy requiring the recovery of certain erroneously paid incentive-based executive compensation would not be enforceable under French law.
In terms of enforceability, this would depend on (i) the source of law which provides for the incentive-based compensation and (ii) whether the recovery terms and conditions breach the employee’s fundamental rights (notably the freedom to work) or the principle of prohibition of the pecuniary sanctions.
2. If recovery of certain erroneously paid incentive-based executive compensation is required, can the Company deduct such amounts from future compensation otherwise payable to the executive under local law?
Yes, but there are some rules limiting the deduction on salaries. For example, depending on the amounts at stake, the recovery could be undertaken in several instalments.
3. Are there any provisions that a Company can add to such policy to increase the likelihood of enforcement under local law?
Yes. The employer can provide the policy in French and (or, at least) insert acknowledgment of receipt and understanding. The employer should be mindful of not linking the recovery to disciplinary matters and ensure that the terms and conditions remain compatible with the employee’s fundamental right to work (e.g. no recovery could be required to an executive on compensation linked to their individual performance because of their departure).
1. Is a policy requiring the recovery of certain erroneously paid incentive-based executive compensation enforceable under local law?
Yes, in principle such a policy will be enforceable. However, it will be necessary to clearly define the conditions under which the company wants to exercise the recovery right, including a definition of what “erroneously awarded” means. Payouts/awards need to be marked as subject to later review/correction.
2. If recovery of certain erroneously paid incentive-based executive compensation is required, can the Company deduct such amounts from future compensation otherwise payable to the executive under local law?
Yes, a deduction from future compensation is possible. There are certain limitations that need to be observed. There is, for example, a certain amount (the so-called “garnishment exemption amount”) that is determined and regularly updated by the German legislator, which is protected against garnishment. Also, the company may be able to recover only the net amount of the overpayment from the executive; overpaid taxes and social security contributions may have to be reclaimed from the respective authorities.
3. Are there any provisions that a Company can add to such policy to increase the likelihood of enforcement under local law?
Yes, the policy should state that the payment/award remains subject to review, adjustment and potentially clawback if it is determined later that the incentive compensation was calculated based on financial statements that were required to be restated due to material noncompliance with financial reporting requirements.
1. Is a policy requiring the recovery of certain erroneously paid incentive-based executive compensation enforceable under local law?
An employer may, by way of contract, reserve its rights to recover any erroneously paid incentive-based executive compensation.
The Hong Kong Monetary Authority (HKMA) and Hong Kong Insurance Authority (HKIA) have issued guidelines requiring the banking and insurance industries to put in place a "clawback" arrangement to ensure that the remuneration systems are consistent with and promote effective risk management:
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- Pursuant to Section 2.3.7 of the Guidelines on a Sound Remuneration System issued by HKMA, the remuneration policy of the authorised institutions under the Banking Ordinance (i.e., a bank, a restricted licence bank or a deposit-taking company) should allow remuneration to be adjusted before and after it is awarded to the employee, such as applying “clawback”, when it is later established that any performance measurement was based on data which have been manifestly misstated or based on erroneous assumptions.
- HKIA’s Guideline on Corporate Governance of Authorized Insurers requires the insurers authorised by the HKIA to include “clawback” provision for the unvested portion of the deferred remunerations if the financial performance of the authorized insurer, or the circumstances under which the performance is measured, has been proven not genuine.
The above guidelines are not binding on the employees. To enable the employers to recover the erroneous payment, the clawback arrangement must be given contractual force and accepted by the employee.
There is no legal or regulatory requirement outside the banking and insurance industries to put in place a "clawback" arrangement. That said, it is not uncommon for employers in Hong Kong to impose such arrangement as part of their terms of the award of any discretionary incentive.
2. If recovery of certain erroneously paid incentive-based executive compensation is required, can the Company deduct such amounts from future compensation otherwise payable to the executive under local law?
Deduction from the wages or any other sum due to the employee is strictly prohibited unless it falls within one of the permitted deductions under Section 32 of the Employment Ordinance.
Assuming the erroneously paid incentive-based executive compensation can be treated as overpayment of “wages” then pursuant to Section 32(2)(e) of the Employment Ordinance, an employer may recover the payment by making deductions from the wages to be paid (subject to a cap of 1/4th of the wages payable to the employee in respect of that wage period).
3. Are there any provisions that a Company can add to such policy to increase the likelihood of enforcement under local law?
The clawback arrangement should form part of the terms of the award which the employees have agreed to. Particular attention should be paid to the drafting of the clawback triggers as any ambiguity may be interpreted in favour of the employee. Employers may list out specific circumstances in which the clawback may apply while retaining the discretion to decide when the incentive was erroneously paid.
Employers may also consider including a “malus” provision which enables the employer to reduce and/or cancel any unpaid or unvested incentive compensation if there is any erroneously paid incentive as a term of the award of the incentive. Again, the employees’ agreement to the malus arrangement is required.
This section was contributed by PK Wong & Nair, now in a Joint Law Venture with Mayer Brown.
1. Is a policy requiring the recovery of certain erroneously paid incentive-based executive compensation enforceable under local law?
At the outset, there is no local law that prohibits the enforceability of a policy requiring the recovery of certain erroneously paid incentive-based executive compensation.
Notably, the term “incentive-based compensation” only refers to compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure. It does not include time-or service-based awards. It also does not include salaries, bonuses paid discretionarily, or bonuses paid upon satisfaction of subjective standards.
The Monetary Authority of Singapore (“MAS”) has published “Guidelines on Corporate Governance for Designated Financial Holding Companies, Banks, Direct Insurers, Reinsurers and Captive Insurers which are Incorporated in Singapore” (dated 9 November 2021). Paragraph 7.9 provides that “to effectively accommodate the potentially longer-term nature of risks, including conduct risk, remuneration polices for key management personnel and other material risk takers contain mechanisms and provisions to facilitate ex-post adjustments to variable remuneration after it is awarded or paid. Ex-post remuneration adjustment tools include malus and clawback arrangements”. However, the term “remuneration” here is used to refer to performance-related remuneration, which takes into account non-financial factors of the company. While this guideline is silent on incentive-based executive compensation, it does suggest Singapore’s positive stance towards the existence of such clawback policies.
In addition, s 27(f) of the Employment Act (Authorised Deductions) provides that deductions may be made from the salary of an employee for the recovery of any advance, loan or unearned employment benefit, or for the adjustment of any overpayment of salary. Similar to MAS’s guidelines, this provision is silent on incentive-based executive compensation because “incentive-based compensation” does not include salary. Nevertheless, it still suggests Singapore’s positive stance towards clawback policies.
Therefore, the enforceability of such a policy is likely to depend on the contract between the employer and employee (executive). If such a policy exists in the employment contract between the employer and executive, it may be enforceable through judicial means, as long as the term does not constitute an illegal penalty clause.
2. If recovery of certain erroneously paid incentive-based executive compensation is required, can the Company deduct such amounts from future compensation otherwise payable to the executive under local law?
There is no local law which prohibits the company from deducting erroneously paid incentive-based executive compensation from future compensation payable to the executive. However, section 27(1)(f) of the Employment Act 1968 in Singapore entitles an employer to deduct the full amount of an unearned employment benefit from an employee’s salary. Erroneously paid incentive-based compensation could fall within the interpretation of an ‘unearned employment benefit’ since the compensation would not have been paid if not for the error made in the company’s financial statements, where the necessary financial reporting measure granting the compensation has not been attained.
3. Are there any provisions that a Company can add to such policy to increase the likelihood of enforcement under local law?
Since the enforceability of such a policy is likely to depend on the contract between the employer and the employee, employers must be careful in drafting the policy such that it would not be invalidated as an illegal penalty clause. The Singapore Court of Appeal in Denka Advantech Pte Ltd v Seraya Energy Pte Ltd [2020] SGCA 119 held that the rule against penalties will only apply where liquidated damages are required upon a breach of contract. Where the rule applies, the Court would deem the clause an illegal penalty if the payable liquidated sum exceeds the greatest conceivable loss that may flow from the breach.
Thus, a Company should first avoid drafting the clawback provision in the form of a liquidated damages clause in the case of a breach of contract. Additionally, clawback adjustment mechanisms should be drafted to ensure that the amount recoverable is proportionate to the error made by the executive.
1. Is a policy requiring the recovery of certain erroneously paid incentive-based executive compensation enforceable under local law?
There is no local law that prohibits the enforceability of a policy requiring the recovery of certain erroneously paid incentive-based executive compensation. However, the enforceability of such a policy is likely to depend on the agreement between the employer and employee. Please note that the UAE legal and judicial systems tend to be fairly protective of employees’ rights.
Generally, a policy requiring the recovery of certain erroneously paid incentive-based executive compensation may be covered under Article (25) of the UAE Labour Law No. 33 of 2021. Article (25) provides that an amount may be deducted or withheld from the employee's salary for the redemption of the amounts paid to the employee in excess of their entitlements, provided that the amount deducted does not exceed 20% of the employee's salary.
Furthermore, Article (25) of the UAE Labour Law provides the following in relation to cases of deduction or withholding from an employee's salary:
1. No amount may be deducted or withheld from the employee's salary except in certain cases (e.g. the redemption of loans granted to the employee; contributions relating to bonuses, retirement pensions and insurances; employee contributions to the Savings Fund; deductions relating to employee violations; debts due pursuant to judgments; and amounts necessary to rectify damage caused by the employee as a result of their mistake or violation of the employer’s instruction). Various limits and conditions apply to such deductions.
2. If there are many reasons for deduction or withholding from the wage, in all cases the percentage of deduction and/or withholding may not exceed 50% of the salary.
Furthermore, Article (51) of the UAE Labour Law provides that the employer may deduct from the employee's end of service benefits any amounts payable under the law or a judgment, in accordance with the conditions and procedures specified in the Implementing Regulations of the UAE Labour Law.
2. If recovery of certain erroneously paid incentive-based executive compensation is required, can the Company deduct such amounts from future compensation otherwise payable to the executive under local law?
There is no provision under local law that expressly prohibits companies from deducting erroneously paid incentive-based executive compensation from future compensation payable to the executive. In any case, the employer must consider Articles (25) and (51) of the UAE Labour Law – as provided in the response to question 1 above – prior to making any deductions to employee's compensation.
3. Are there any provisions that a Company can add to such policy to increase the likelihood of enforcement under local law?
Since the enforceability of such a policy is likely to depend on the agreement between the employer and the employee and on the conditions summarized in our response to question 1 above, employers must be careful when drafting the policy such that it would not be deemed an illegal penalty clause.
As such, it is preferable for policies to include references to Article (25) of the UAE Labour Law when describing cases where an employer has a right to deduct amounts from an employee's compensation. It should also be noted that any deductions would not be in the form of penalties and would be made in accordance with the UAE Labour Law.
1. Is a policy requiring the recovery of certain erroneously paid incentive-based executive compensation enforceable under local law?
Yes. Employers in the financial services sector have been under a regulatory obligation for many years to apply clawback provisions to variable remuneration for certain employees and that practice has since extended to the broader corporate sector. While there is no legal or regulatory requirement outside of financial services, the United Kingdom’s Corporate Governance Code strongly encourages listed companies to apply clawback policies and they have become commonplace for listed and larger non-listed companies.
On its own, however, a policy will not be enough. It must be given contractual force and accepted by the employee rather than being imposed unilaterally. Often therefore, the policy provisions will be incorporated into the terms of the relevant compensation award agreement between the employee and the employer or the relevant group entity providing the award.
2. If recovery of certain erroneously paid incentive-based executive compensation is required, can the Company deduct such amounts from future compensation otherwise payable to the executive under local law?
Yes, provided the employee has given their prior written agreement, otherwise making deductions from an employee's pay is unlawful in the United Kingdom. The employee will commonly be asked to agree in writing to repay any sums due to be repaid to the employer (or other relevant group company) out of other remuneration due to be paid to them, whether fixed or variable. Again, the safest place to include the deductions language will be in the terms of the award agreement itself, which should be counter-signed by the employee.
As an alternative to requiring clawback from vested and paid compensation, a common practice is to provide that clawback can be achieved through the forfeiture of other unvested awards. Known as 'cross-clawback', this has the advantage of avoiding the practical difficulties inherent in trying to claw back monies that have been paid, received and taxed.
3. Are there any provisions that a Company can add to such policy to increase the likelihood of enforcement under local law?
Above all else, the drafting of clawback policies should be clear as any ambiguity will be construed in favour of the employee. In particular, the drafting of the clawback triggers needs careful thought. If drafted too narrowly, it will not catch the various scenarios that the employer is intending to cover. If drafted too broadly, there will be scope for challenge by an employee that the company is acting unreasonably and possibly inconsistently in its interpretation of what should trigger the clawback.
As noted above, in addition to careful drafting of the clawback policy itself, making sure that the policy is effectively incorporated into the relevant plan rules and the terms of the individual award agreement will also be key to ensure enforceability.
