It’s time to dig back into your mental archives for 2015. That’s when the SEC, by a vote of three to two, initially proposed rules to implement Section 954 of Dodd-Frank, the clawback provision. But the proposal was relegated to the SEC’s long-term agenda and never heard from again. Until, that is, the topic found a spot on the SEC’s short-term agenda this spring (see this PubCo post) with a target date for a re-proposal of April 2022. The SEC had scheduled an open meeting for Wednesday to consider re-opening the comment period, but instead cancelled the meeting and, on Thursday, simply posted a notice. Here is the original 2015 Proposing Release and here is the new fact sheet. SEC Chair Gary Gensler said that, with re-opening of the comment period, he believed “we have an opportunity to strengthen the transparency and quality of corporate financial statements as well as the accountability of corporate executives to their investors.” The questions posed by the SEC in the notice (discussed below) give us some insight into where the SEC may be headed with the proposal. It’s worth noting that one possible change suggested by the questions is a potential expansion of the concept of “restatement” to include not only “reissuance” restatements (which involve a material error and an 8-K), but also “revision” restatements (or some version thereof). The public comment period will remain open for 30 days following publication of the release in the Federal Register.
As you may recall, Section 954 required the SEC to direct the national securities exchanges to adopt listing standards obliging each listed company to adopt, disclose and enforce a policy for recouping executive compensation that was paid on the basis of erroneous financial information, the theory being that it was compensation to which the executives were never really entitled in the first place. Under the 2015 proposal, new Rule 10D-1 would require exchange-listed companies to adopt and implement clawback policies under which they must recover from current and former executive officers the amount of erroneously awarded “incentive-based compensation” received during the three years preceding the date of an accounting restatement that resulted from the company’s material noncompliance with any financial reporting requirement under the securities laws. The “amount erroneously awarded” means the amount that exceeds the amount the executive would have received had the compensation instead been determined based on the restated amount.
Summary of the Proposed Rules
Persons subject to clawback. The proposed rule applies to a person who was an “executive officer” at any time during the performance period for the incentive-based compensation subject to recovery. Under the proposal, the definition of executive officer is the same as the definition of “officer” for Section 16 purposes and includes the company’s president, principal financial officer, principal accounting officer (or controller, if there is no principal accounting officer), any vice-president in charge of a principal business unit, division or function (such as sales or finance) and any other officer or other person who performs a significant policy-making function for the company.
Generally, Section 954 goes further than the clawback provision of SOX 304. Section 954 applies to any current or former executive, while SOX provides a reimbursement remedy only against CEOs and CFOs. In addition, no culpability on the part of the company or the executive is necessary to trigger a clawback under Section 954, while SOX requires that the company’s material noncompliance be the result of issuer misconduct. SOX 304, however, does not limit the clawback to amounts paid in excess, although it covers only a 12-month period (compared to the three-year period of the proposed rules).
Companies subject to the proposed rule. The proposed rule generally applies to all exchange-listed companies, including foreign private issuers, emerging growth companies and smaller reporting companies, categories of companies that have enjoyed exemptions from certain disclosure and say-on-pay requirements.
The SEC’s decision to make the proposed rule applicable to EGCs and SRCs was not without controversy. At the time the proposal was issued, the two dissenting SEC Commissioners, Daniel Gallagher and Michael Piwowar, both objected to the inclusion of any but the biggest companies under the rule’s ambit. Commissioner Gallagher preferred to limit application of the provision to larger companies that could more easily bear the costs and then, if the rule worked effectively and efficiently, ease in SRCs and EGCs. Commissioner Piwowar preferred to make compliance voluntary for these smaller companies. While the Dodd-Frank provision applies on its face to all listed companies, the SEC has the power to exclude specific categories of companies to the extent that doing so would be necessary or appropriate in the public interest and consistent with the protection of investors. However, in this case, the SEC took into account the provision’s legislative history, which indicated that it was designed “so that shareholders do not have to embark on costly legal expenses to recoup their losses or so that executives must return monies that should belong to the shareholders.” Consequently, the SEC declined to exempt EGCs, SRCs, foreign private issuers or controlled companies, arguing that “the objective of recovering excess incentive-based compensation is as relevant for these categories of listed issuers as for any other listed issuer.” Will this issue continue to be a point of contention as the proposal is considered again?
Compensation covered. The proposal applies to “incentive-based compensation,” defined as any compensation that is granted, earned or vested based in whole or in part on the attainment of a financial reporting measure. Cash examples include bonuses earned by achieving, in whole or in part, a target based on a financial reporting measure and cash bonuses from a “bonus pool” the size of which is determined based on attainment of a goal that is a financial reporting measure (even if the size of particular awards is discretionary). Equity examples include stock options, restricted stock, restricted stock units and stock appreciation rights (including the proceeds of sale of the shares underlying any of these awards), provided the awards are earned, granted or vested by attainment, in whole or in part, of goals based on financial reporting measures.
The SEC’s proposal defines “financial reporting measures” as those measures based on accounting principles used in preparing the company’s financial statements, any measures derived in whole or in part from that information (including reportable segments of the company’s business and non-GAAP financial measures, such as EBITDA or same-store sales), stock price and total shareholder return (TSR). These measures may appear outside the financial statements, such as in MD&A.
With respect to stock price and TSR, the proposed rule permits companies to calculate the amount to be recovered by using a reasonable estimate of the effect of the restatement. The company is required to create and maintain documentation regarding the calculation of the reasonable estimate and to provide that documentation to the exchange on which it is listed. To the extent a bonus pool is recalculated, all relevant bonuses paid pursuant to the pool are subject to pro rata reduction.
“Incentive-based compensation” does not include compensation that is discretionary (such as salary), based on subjective goals or strategic or operational metrics (such as completion of a merger or opening a specified number of new stores) as opposed to financial reporting measures, or equity compensation (including stock options) that is subject only to time-based vesting. (How would ESG-based performance metrics factor in?)
All calculations must be performed on a pre-tax basis “to ensure that the company recovers the full amount of incentive-based compensation that was erroneously awarded.” The SEC also commented in the proposal that recovery on a pre-tax basis would permit the company to avoid the burden and administrative costs associated with calculating recoverable amounts based on the particular tax circumstances of individual executive officers.
Three-year lookback. Under the proposed rule, there is a three-year look-back period for recovery of incentive-based compensation. Compensation would be subject to recovery if it was “received” during the three completed fiscal years immediately preceding the date that a restatement is “required” to correct a material error.
The date that the company is required to prepare an accounting restatement for purposes of the proposed rule is the earlier of (1) the date that the board of directors (or committee or group of officers, as applicable) concludes, or reasonably should have concluded, that the company’s previously issued financial statements contain a material error; or (2) the date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.
The date on which the compensation is considered to be “received” for purposes of the proposed rule is the date on which the target financial reporting measure is attained, even if, for example, the shares underlying an award have not yet been issued or the executive must still work for an additional period of time in order to receive payment.
Amount subject to recovery. Companies are required under the proposal to recover the “excess” compensation even in the absence of fault or misconduct on the part of company and even when the executive officer had no responsibility for the erroneous financial statements. In addition, companies may not reimburse executive officers for any recovered amount either directly or via indemnification or payments for insurance premiums.
Narrow company discretion. Under the proposed rule, companies have the discretion to forego recovery of compensation only in two narrowly prescribed circumstances.
First, companies may exercise discretion not to recover compensation where it would be impracticable to do so because the cost of recovery would be in excess of the amount to be recovered. The SEC noted in the proposal that “[o]nly direct costs involving financial expenditures, such as reasonable legal expenses, would be considered for this purpose. Indirect costs relating to concerns such as reputation or the effect on hiring new executive officers would not be taken into account.” To justify its conclusion that recovery is impracticable, the company would first need to make a reasonable attempt to recover the compensation, document its attempts and provide that documentation to the exchange on which it is listed. As discussed below, the company will also need to disclose the reason for its determination.
Second, the company may determine that recovery is impracticable because it would violate home country laws, provided that the laws predate the clawback proposal. In that instance, the company would first need to obtain from home country counsel an opinion that recovery would be unlawful, which opinion must be “not unacceptable” to the exchange.
In either case, the determination that recovery is impracticable must be made by the comp committee (or the majority of independent directors, if there is no comp committee).
Filing and disclosure. The proposal requires each listed company to file its clawback policy as an exhibit to its annual report on Form 10-K. Additionally, in amendments proposed to Reg S-K, if during the last completed fiscal year, either the company completed a restatement that required recovery of incentive-based compensation, or there was an outstanding balance of excess incentive-based compensation as a result of application of the clawback policy to a prior restatement, the company must disclose, in any annual report, proxy or information statement in which executive compensation disclosure is required:
- the date on which the company was required to prepare each restatement, the aggregate dollar value of excess incentive-based compensation attributable to the restatement and the aggregate amount of such compensation that remained outstanding at the end of the company’s last completed fiscal year;
- where the financial reporting measure related to stock price or TSR, the estimates used to determine the excess incentive-based compensation attributable to the restatement;
- the name of each person subject to recovery from whom the company determined to not pursue recovery, the amount at issue, and a description of the reason the company made the decision to not pursue recovery; and
- the name of, and amount due from, each individual from whom, at the end of the last fiscal year, excess incentive-based compensation was outstanding for 180 days or longer following the date the company determined the amount that the person owed.
In the event that a listed company recovers any amounts under its clawback policy, the company would need to reflect that recovery in its Summary Compensation Table in future filings by reducing the compensation reported in the applicable column, as well as the “total” column for the year in question, and identify the reduction in footnotes to the table. The disclosure must also be provided in interactive data format using XBRL. The interactive data must be filed as an exhibit to the definitive proxy statement and the 10-K.
Consequences of noncompliance. The proposed rule provides that a company will be subject to delisting if it does not adopt, disclose and comply with a compliant policy. The proposal does not specify when the recovery must be completed; rather, the exchange on which the company is listed would be responsible for determining whether the company was making a good faith effort to pursue recovery in compliance with its own policy.
Requests for public comment
The SEC requested comment on a number of specific areas, which seem to be a pretty good indication of where it may be going on this proposal. Below are some of the question areas identified:
Restatements. What should count as an accounting restatement for purposes of the rule? Essentially, the proposal considered restatements to be only “reissuance” restatements, but what about “revision” restatements? As proposed, an “accounting restatement” was defined as “the result of the process of revising previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements.” Typically, in these cases, the company must restate to correct a material error and file an 8-K Item 4.02 to warn investors that previously filed financial statements should no longer be relied upon. However, the SEC notes, the proposed definition would not require a recovery where the restatement was required “to correct errors that were not material to those previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period.” (Although the SEC does not refer to them as such, restatements of this type are sometimes referred to as “revision restatements”). Since 2015, the SEC notes, concerns have been raised about whether companies are making appropriate materiality determinations for errors identified—perhaps because they are attempting to avoid application of clawbacks. In addition, commenters suggested that the clawback provisions also be made applicable in the event of revision restatements. The SEC believes that expanding the proposal to cover both types of restatements would be appropriate to trigger recoveries and asks for comment about that possibility. Are there circumstances where it would be too burdensome? How could they be addressed? Would it make sense to allow more discretion to the comp committee in that case?
The WSJ reports that “[s]o-called ‘little r’ revisions last year represented 75.7% of all restatements by U.S.-based public companies, up from 34.8% in 2005, according to data provider Audit Analytics. Major restatements, meanwhile, have become less common, comprising 24.3% of all restatements in 2020, down from 65.2% 15 years earlier, data show.”
A study reported in 2015, “Why Do Restatements Decrease in a Clawback Environment? An Investigation into Financial Reporting Executives’ Decision-Making during the Restatement Process,” demonstrated that clawbacks may have unintended consequences. The study, conducted by an academic at Miami University of Ohio and published in The Accounting Review, showed that financial executives who receive substantial incentive-based pay were more likely to resist their auditors’ recommendations to restate financial statements if their companies had clawback policies. The implication was that, to the extent that additional clawback policies are mandated under SEC rules, we may see a further reduction in restatements, but perhaps not entirely for the right reasons. Of course, that may depend to some extent on whether the SEC adopts a broader view of “accounting restatement.”
Earlier studies found a reduction in the level of restatements for companies that had voluntarily adopted clawback policies, largely attributed to the deterrent effect of clawbacks. Commonly, clawbacks were thought to reduce restatements because they led financial executives to be more diligent in their efforts to prevent errors and fraud. This 2015 study looked at the effect of clawbacks on restatements after the misstatements had been discovered: as reported in CFO.com, according to the study’s author, by looking at the “’back end,…what we may be seeing is that the executives are fighting restatements’ in order to avoid clawbacks of their pay.’” (See this PubCo post.)
Lookback period triggers. Under the proposal, one prong of the trigger for the three-year lookback period the date the issuer’s board committee or authorized officer concludes, or “reasonably should have concluded,” that the issuer’s previously issued financial statements contain a material error. The SEC asks whether it should remove the “reasonably should have concluded” standard in light of concerns that the standard adds uncertainty to the determination. The SEC notes that, for material errors, the date would likely be included in the 8-K and, for other errors, evidence of the conclusion that a restatement is required is generally included in the issuer’s materiality analysis.
Definitions. Should the SEC provide definitions or rely on common understandings, existing guidance and literature for terms such as “accounting restatement,” “material noncompliance” and when incentive compensation is “received”?
Checkboxes. Because revisions are not usually labeled as “restated,” to provide more transparency, the SEC asks for thoughts on “whether to add check boxes to the cover page of the Form 10-K that indicate separately (a) whether the previously issued financial statements included in the filing include an error correction, and (b) whether any such corrections are restatements that triggered a clawback analysis during the fiscal year.”
Cost estimates. The SEC noted that, in recent years, there has been an increase in voluntary adoption of clawback policies. The SEC asks for estimates or data that would help to refine its understanding of costs and benefits of existing clawback policies and policies that might be developed under the proposal, including under the new potential interpretation of “an accounting restatement due to material noncompliance”? What are characteristics of voluntary policies and compensation subject to the policies? Have the policies led to a decrease in incentive-based compensation or an increase in compensation tied to non-financial performance metrics?
Leveraging prior analyses. The SEC asks about the extent to which companies’ examination of whether any misstatement of previously issued financial statements had the effect of increasing management’s compensation—typically performed as part of the materiality analysis related to errors—can be leveraged in connection with determining the need for and the amount of any clawback? What would be the impact of expanding the scope of “accounting restatements”? Would that change “capture situations where issuers may have shifted from restating previously issued financial statements to avoid triggering compensation clawback policies, or would there be situations where the revised scope becomes overinclusive?” Is the rule appropriately tailored?
Recoverable amount. For incentive-based compensation based on stock price or TSR, the “amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in the accounting restatement.” Under the proposal, the company would be required to provide documentation of the calculation to the exchange. Should the SEC require that the calculation be disclosed?
XBRL. Under the proposal, the new compensation recovery disclosures would be required to be block-text tagged using XBRL. Why not detail tag specific data points within the new compensation recovery disclosure using Inline XBRL instead?
New developments. Finally, the SEC asks if there are any other developments that should be taken into account? Should there be changes in the methodologies and estimates used to analyze the economic effects?
The SEC concludes that comments will be especially helpful if they are accompanied by supporting data and analysis of the issues addressed in those comments, particularly quantitative data on costs and benefits and, for any alternatives suggested, supporting data and analyses