Recently, the U.S. Securities and Exchange Commission (SEC or the Commission) proposed a controversial new rule under the Dodd-Frank Act that instructs companies to establish policies that require “executive officers” to repay incentive-based compensation that was paid to them based on erroneous accounting figures.1 The Commission proposed the new rule pursuant to Section 954 of the Dodd-Frank Act, and the rule is the last of the executive compensation rules to be proposed.
The proposed rule, Rule 10D-1, requires listed companies to develop policies that will allow the company to “clawback” incentive-based compensation due to material accounting errors. While executive officers will not have to pay back the full amount of compensation received, the officers will have to pay back those amounts they would not have received were it not for the accounting errors. For compensation based on stock price or total shareholder return, companies could use a reasonable estimate of the effect of the restatement on the applicable measure to determine the amount to be recovered. The company must also issue a restatement correcting the error. The proposed rule requires executives to repay amounts received in the three fiscal years prior to the date a company is required to issue the restatement, which is the period set by Section 954 of the Dodd-Frank Act. Companies must disclose their recovery policies as well as actions taken under the policies as an exhibit to their Exchange Act annual reports. The proposal allows for companies to use their discretion to choose not to recover clawbacks in two circumstances: (1) if the direct expense of enforcing recovery would exceed the amount to be recovered, or (2) for foreign private issuers, in circumstances where recovery would violate home country law.
The rule proposal was a controversial one, and support for the rule among SEC Commissioners was split down party lines. One of the most controversial aspects of the proposal is the “no-fault” provision, which requires executive officers to repay incentive-based compensation even when the officers were not at fault for the errors or if there was no misconduct. In addition, executives cannot be indemnified for any premiums paid on an insurance policy that would insure amounts that must be recovered. Proponents of the no-fault provision, such as SEC Chair Mary Jo White, believe that the rule “is an important one” because it prohibits executive officers from “retain[ing] 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.”2 One criticism of the proposal, such as that stated by dissenting Commissioner Daniel M. Gallagher, is that the rule places a strict liability standard on executives where Congress did not mandate one in the Dodd-Frank Act.3 A second point of controversy is the definition of “executive officers.” The proposal purports to base its definition of executive officers on the definition of officer in Section 16 of the Exchange Act, and includes “the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs policy-making functions for the company.”4 Critics, such as Commissioner Gallagher, believe that this definition is broader than the requirements of the statute. According to Commissioner Gallagher and other critics, the rule’s no-fault standard, coupled with the broad definition of who the rule applies to, “creates the potential for substantial injustice” because “the rule sweeps far more broadly than the group of individuals ultimately responsible for the financial reporting of the entire issuer.”5 A third area of contention within the proposal is how to measure clawbacks for compensation based on share price metrics such as total shareholder return. Commissioner Gallagher describes the process as a difficult one that will likely cause “post-facto second-guessing.”6 Similarly, in instances where companies restate erroneous financial results for a quarter or two or for one fiscal year, the three-year clawback provision required by Section 954 of the Dodd-Frank Act suggests, at best, a Congressional estimate of the impact of the accounting errors on shareholders upon the announcement of the restatement without any empirical evidence of long-term harm. The three-year clawback provision is especially problematic where, due to an otherwise well-managed company, share prices return to pre-announcement levels within one or two quarters. The comment period on the rule proposal will last 60 days after the proposal’s publication in the Federal Register.