The Securities and Exchange Commission (SEC) is poised to pass an executive compensation rule that would require public companies to claw back incentive-based compensation if their finances are restated within the previous three years.
The executive compensation clawback rule currently in effect for public companies is a rather narrow provision of the Sarbanes-Oxley Act of 2002. Firms are required to recover incentive-based compensation from executives only in cases of misconduct, limited to CEOs and CFOs, and only within one year.
The new rule, which was passed as part of the Dodd-Frank Act of 2010 but never implemented, would expand the executives potentially affected to any current, former, or retired company officer who meets the definition of “officer” under Section 16 of the Exchange Act.
“I think there will be significant opposition to this rule, but I also think it could prompt companies to strengthen internal accounting controls to avoid errors in the first place.”
Lene Powell, Senior Legal Analyst, Securities, Wolters Kluwer Legal & Regulatory
That includes “the issuer’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 issuer and otherwise conforms to the full scope of the Exchange Act Section 16,” according to the SEC’s proposal.
The rule has been dormant since 2015, the last time the SEC opened a comment period on it. It is one of 11 mandates of Dodd-Frank the agency never implemented. New SEC Chair Gary Gensler has publicly committed to seeing through these outstanding rules, just as he did when he was chair of the Commodity Futures Trading Commission from 2009-14.
Gensler “clearly wants to finish off these last rules related to executive compensation,” said Sean Donahue, partner in Goodwin’s Capital Markets practice, noting the pay-for-performance rule might be next up.
The SEC is currently accepting comments on the clawback rule, which could be approved by the agency in late November. The feedback period is open for 30 days from the rule’s posting in the Federal Register, which was Oct. 21.
Areas of potential pushback
Perhaps the most important—and controversial—change would be the clawback could be triggered for any kind of restatement on “a ‘no fault’ basis, without regard to whether any misconduct occurred or an executive officer’s responsibility for the misstated financial statements,” the proposed rule said.
The thinking behind this change, according to Gensler, is that even if company executives did not manipulate or falsify financial statements to hit pay incentive milestones, occasionally companies must go back and revise prior financial reporting.
“As a result, an executive may have been paid for meeting certain milestones that the company didn’t, in fact, hit,” Gensler said in a statement.
In addition, and perhaps of most interest to compliance officers, public companies would be required to draft a new executive compensation clawback policy and disclose that policy to investors. Failure to do so could lead to the company being delisted from U.S. stock exchanges. Compliance officers at stock exchanges would likely take on the added responsibility of policing which firms have clawback policies and which do not.
“I think there will be significant opposition to this rule, but I also think it could prompt companies to strengthen internal accounting controls to avoid errors in the first place,” said Lene Powell, senior legal analyst, securities with Wolters Kluwer Legal & Regulatory. “There may be more of an incentive from executives to catch any errors before they get into financial statements.”
In the intervening years since the rule was first proposed, more than 2,000 public companies have adopted an executive compensation clawback policy: from 982 companies in 2015 to 1,321 in 2018 to 2,021 in 2020, the SEC said in a footnote to its rule.
“The corporate world has moved on to develop its own best practices regarding clawbacks since the Dodd-Frank Act,” said Michael Melbinger, recently retired chair of Winston & Strawn’s Executive Compensation practice and a longtime adjunct law professor at Northwestern.
Melbinger said the SEC appears to be seeking guidance and a greater definition on what kinds of financial restatements should trigger the clawback rule. “The shift toward so-called small ‘r’ financial restatements and away from capital ‘R’ restatements has been observed and noted by many,” he said.
In the proposed rule, the SEC said it “proposed to define an ‘accounting restatement’ for this purpose 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.’”
The SEC added the clawback rule would not be triggered in instances “where an issuer’s previously issued financial statements are required to be restated in order 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.”
The existing executive compensation clawback rule in Sarbanes-Oxley is enforced infrequently, Donahue said, although there was a recent case.
In February, the SEC took action against the former CEO and CFO of WageWorks, ordering them to pay back more than $2 million in combined compensation for manipulating financial statements in order to hit certain financial targets that resulted in incentive-based pay.
“My main takeaway is that the SEC is focused on executive compensation, and that they want to strengthen the rules around it,” Donahue said.