You might remember back to 2015 when the SEC initially proposed rules to implement Section 954 of Dodd-Frank, the clawback provision. The SEC did not then consider adoption of the proposal in the ordinary course, instead relegating it to the long-term agenda, where it was never heard from again. Until, that is, the topic found a spot on the SEC’s short-term agenda in 2021 (see this PubCo post) with a target date for a re-proposal of April 2022. Instead of a re-proposal, however, a year ago, the SEC simply posted a notice announcing that it was re-opening the comment period and posing a number of questions for public comment.  (See this PubCo post.) One possible change suggested by the SEC’s questions was a potential expansion of the concept of “restatement” to include not only “reissuance,” or “Big R,” restatements (which involve a material error and an 8-K), but also “revision” or “little r” restatements. Then, in June of this year, DERA issued a new staff memorandum addressing in part the restatement question, which led the SEC to once again re-open the comment period.  Finally, the SEC has concluded that, after more than seven years, the proposal has marinated long enough. Time to serve it up. Accordingly, at an open meeting yesterday, the SEC adopted, by a vote of—surprise!—three to two, new rules that direct the national securities exchanges to establish listing standards requiring listed issuers to adopt and comply with a clawback policy and to provide disclosure about the policy and its implementation. The clawback policy must provide that, in the event the listed issuer is required to prepare an accounting restatement—including a “little r” restatement—the issuer must recover the incentive-based compensation that was erroneously paid to its current or former executive officers based on the misstated financial reporting measure. Commissioners Hester Peirce and Mark Uyeda dissented, contending that, among other problems, the rule was too broad and too prescriptive. According to SEC Chair Gary Gensler, the key word here is “erroneously,” that is, the rule requires recovery of compensation to which the officers were never entitled in the first place. In his statement at the meeting, Gensler indicated that he believes “that these rules will strengthen the transparency and quality of corporate financial statements, investor confidence in those statements, and the accountability of corporate executives to investors….Through today’s action and working with the exchanges, we have the opportunity to fulfill Dodd-Frank’s mandate and Congress’s intention to prevent executives from keeping compensation received based on misstated financials.”

Here are the fact sheet, the press release and the adopting release for the final rule. (I plan to post an update later with more detailed information from the adopting release.) The new rule will become effective 60 days following publication of the release in the Federal Register. Covered exchanges will be required to file proposed listing standards no later than 90 days following publication of the release in the Federal Register, and the listing standards must be effective no later than one year after publication. Each listed Issuer will be required to adopt a clawback policy no later than 60 days after the effective date of the applicable listing standards and will be required to comply with the disclosure requirements in the issuer’s proxy and information statements and annual reports filed on or after the issuer adopts its clawback policy.

The final rule. New Exchange Act Rule 10D-1 directs the exchanges to establish listing standards that require issuers to:

• “Develop and implement written policies for recovery of incentive-based compensation based on financial information required to be reported under the securities laws, applicable to the issuers’ executive officers, during the three completed fiscal years immediately preceding the date that the issuer is required to prepare an accounting restatement; and
• Disclose those compensation recovery policies in accordance with Commission rules, including providing the information in tagged data format.”

The new listing standards must apply the disclosure and clawback policy requirements to all listed issuers—i.e., no exceptions or special phase-ins for emerging growth companies or smaller reporting companies. As stated in the fact sheet, each listed issuer will “be required to adopt a compensation recovery policy, comply with that policy, and provide the required compensation recovery policy disclosures.”  An issuer that does not do so will be subject to delisting.

As noted above, in the re-opening release, the SEC asked whether the clawback policy should be applied to both “Big R” and “little r” restatements. What is the difference? “Big R” restatements “correct errors that are material to previously issued financial statements”; “little r” restatements “correct errors that are not material to 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 (commonly referred to as ‘little r’ restatements). A ‘little r’ restatement differs from a ‘Big R’ restatement primarily in the reason for the error correction (as noted above), the form and timing of reporting, and the disclosure required.”

As stated in the fact sheet, the new rule will apply the clawback policy to both “Big R” and “little r” restatements: if a listed issuer is “required to prepare an accounting restatement, including to correct an error that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period, the issuer would be required to recover from any current or former executive officers incentive-based compensation that was erroneously awarded during the three years preceding the date such a restatement was required. The recoverable amount is the amount of incentive-based compensation received in excess of the amount that otherwise would have been received had it been determined based on the restated financial measure.”

The final rules define “incentive-based compensation” as “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure.”  “Financial reporting measures” are defined as  “measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, and any measures that are derived wholly or in part from such measures. Stock price and total shareholder return are also financial reporting measures. A financial reporting measure need not be presented within the financial statements or included in a filing with the Commission.”

Clawbacks will apply to the issuer’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division, or function (such as sales, administration, or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer. Executive officers of the issuer’s parent or subs are deemed executive officers of the issuer if they perform policy making functions for the issuer. No fault or involvement with the error is required. The final rule will  require recovery of incentive-based compensation received by a person only (i) after beginning service as an executive officer and (ii) if that person served as an executive officer at any time during the recovery period. Issuers will be prohibited from insuring or indemnifying executive officers against the loss of erroneously awarded compensation.

The listing standards will include “limited impracticability exceptions” related to circumstances where:

In addition, under amendments to SEC disclosure rules, all listed issuers will be required to file their written compensation recovery policies as exhibits to their annual reports, indicate in check boxes on their annual reports whether their financial statements included in the filing reflect a correction of an error to previously issued financial statements and whether these corrections are restatements that required a clawback recovery analysis. 

A listed issuer will also be required to disclose how it has applied the policy, including:

At the open meeting.  

Chair Gary Gensler. Gensler’s statement stressed the common-sense nature of the requirements imposed by Congress in Section 954 of Dodd-Frank: “[c]orporate executives often are paid based on the performance of the companies they lead, with factors that may include revenue and business profits. If the company makes a material error in preparing the financial statements required under the securities laws, however, then an executive may receive compensation for reaching a milestone that in reality was never hit. Whether such inaccuracies are due to fraud, error, or any other factor, today’s rules would implement procedures that require issuers to recover erroneously-rewarded pay, a process known as a ‘clawback.’”  In his view, “implementing the clawback rules would benefit investors and promote accountability.”

Commissioner Hester Peirce.  In her statement, Peirce, who dissented, made clear that, while she viewed the goal of the rule to be “commendable,” she wasn’t at all pleased with “how we are doing it—expansively, inflexibly, and impractically.”  In her view, Section 954 did not rule out the use by the SEC of its exemptive authority or prohibit it from allowing exchanges and issuers some flexibility in crafting the listing standards and corporate policies. However, she said, this SEC has a “a penchant for prescription” that made a “simple” mandate more complex.  That complexity might ultimately impose costs on shareholders that exceed the benefits of the clawbacks, she cautioned.

In her view, the rule was too broad in four ways:

• First, although not required by Section 954, the rule applies in the event of “little r” restatements: “Including them unnecessarily complicates the rule and may require clawback analysis when the error did not lead to erroneous compensation during the three-year period, or require a clawback of de minimis amounts. The Commission explained in 2021, when it reopened comment on the 2015 proposal, that it was concerned about opportunistic behavior by companies when choosing between a ‘Big R’ and ‘little r’ restatement. The release does not substantiate these concerns, but if companies and their auditors are misjudging the materiality of financial statement errors, a compensation clawback rule is not the proper remedy.” She would have required clawbacks only in the event of an Item 4.02 8-K.
• Second, the definition of “executive officer” is too broad, including employees who perform a policy-making function “regardless of involvement with the events leading to the restatement.” One paper counted as many as 50,000 public company employees who may be subject to the rule. She would have either limited the definition to the company’s top five executives, applied the clawback only to employees with a “material role in the events leading to the restatement,” or left it up to the exchanges or compensation committees to define the term.
• Third, the SEC should have exempted EGCs and/or SRCs from the rule or tailored it for those groups, provided them with a more extended compliance period or delayed the implementation of their XBRL tagging requirement. The SEC also could have permitted the exchanges to “make reasonable accommodations for FPIs subject to different clawback regulation.”
• Fourth, the definition of “incentive-based compensation” should have been limited to accounting-based metrics instead of also including compensation based on stock price and total shareholder return. While, in her view “Section 954 requires clawing back compensation that is ‘based on financial information required to be reported under the securities laws,’ stock price and TSR are market-driven metrics of how the stock performs that reflect[] ‘many factors beyond its reported financial information.’ Although ‘affected by accounting-related information,’ stock price and TSR are not ‘accounting-based metrics,’ which the release acknowledges.”

Peirce also contended that the rule was unduly prescriptive, relegating the exchanges to merely ministerial roles and limiting the ability of boards to tailor their policies or make their own determinations about whether the effort to recover compensation was worthwhile, discretion that is “normally afforded to boards [and] bounded by directors’ fiduciary obligation under state laws to exercise their authority properly.” For example, she found the three impracticability standards not workable and would have preferred a simple de minimis threshold. Instead of the prescriptive disclosure mandate imposed by the rule, she would “have required website disclosure of policies and procedures and provided for streamlined, fully anonymized disclosure about amounts recouped, owed, and forgone.”

In imposing these prescriptive requirements, she contended, the SEC was upsetting the apple cart by requiring companies to revamp the policies that they already may have in place. In her view, most of the SEC’s prescriptive rules increased “the complexity and cost of the rule as compared to the statutory baseline,” which also ultimately increased the cost for shareholders.  The SEC, she believed, should have instead crafted its rulemaking to “ensure that clawback policies would yield a net benefit for shareholders.” For example, the rules may result in high recoupment costs for recovery of de minimis amounts or smaller amounts from lower level executives or as a consequence of TSR-related clawbacks. Finally, she contended that the rule will increase litigation risk as a result of the use, as a trigger date, of “the date that the issuer’s board . . . concludes, or reasonably should have concluded, that the issuer is required to prepare an accounting restatement,” as well as the requirement that companies recover the money “reasonably promptly.”

[Based on my notes.] At the meeting, Peirce asked a series of questions, including how the mandated policy differs from those already in place?  Corp Fin Director Renee Jones, said that, while the SEC has limited knowledge of the range of issuer policies, one difference she saw was that many existing policies tie recovery to misconduct or have de minimis exceptions. Some did apply to any error and were not limited to “Big R” restatements. Peirce also asked why EGCs and SRCs did not receive exemptions or special treatment? Jones responded that covering all listed issuers was consistent with the Congressional goal.  Peirce further inquired whether an executive failure to repay would require disclosure in perpetuity?  Jones responded that, if recovery were determined to be impracticable under the exceptions and disclosed, no additional disclosure would be required.  Peirce also asked if the staff expected a lower incidence of clawbacks for “little r” restatements? Acting Chief Accountant Paul Munter advised that, in determining whether a restatement is necessary, the company must consider both quantitative and qualitative factors. One qualitative factor is the extent to which the error affects executive comp, which would make the likelihood of “Big R” restatements more likely. (See this PubCo post regarding a  statement by Munter discussing materiality assessments in connection with restatements.) Finally, Peirce asked about the preemption of conflicting state rules. Dan Berkovitz from the Office of General Counsel responded that, it would depend on the details of the state law, but generally, if state law would be an obstacle to federal law by, for example, impeding recovery, if could be preempted.

Commissioner Caroline Crenshaw. Crenshaw viewed the new rulemaking as “straightforward and long awaited.” In her statement, she observed that the “principle is simple: if an executive was paid too much based upon incorrect accounting, then the executive should not get to keep that money. In such an event, the portion of compensation attributable to that incorrect accounting would be recovered, or ‘clawed back,’ by the issuer.”  In her view, inclusion of “little r” restatements made sense:  “‘little r’ restatements accounted for 76% of all restatements in 2020; and scoping such restatements into the rule is consistent with the relevant legal precedent, statutory language and mandate, accounting literature, provisions of U.S GAAP and IFRS, and staff guidance regarding accounting errors and materiality determinations. Both the scope and the design of the rule were carefully calibrated to incentivize higher quality financial reporting and to hold executives and issuers alike accountable by returning erroneously awarded incentive based compensation.”

Commissioner Mark Uyeda.   Uyeda, who dissented, noted that he had first started working on implementation of Section 954 a number of years ago as a member of the staff. He voiced several objections to the rule.  First, he pointed out that, when the proposal was re-opened for comment, the SEC took a shortcut and did not follow the usual practice of issuing a re-proposal with an updated economic analysis. Instead, the SEC just re-opened the comment period—even though a full business cycle had elapsed—asking the public whether there had been changes since the 2015 date of the original economic analysis that would affect the economic impact of the rules. “In effect,” he said, the SEC “outsourced its responsibility to conduct an appropriate economic analysis to commenters—and then it only gave them 30 days to do so,” referring here to his prior remarks critical of abbreviated comment periods (see the SideBar below). In his view, the supplemental data provided by DERA in June 2022 did not suffice. He noted with approval that the rule adopted yesterday employed an updated cost burden calculation, including updated estimated legal costs of $600 per hour, a 50% increase from the $400 estimate that had been in use for 16 years.

Uyeda also agreed with Peirce that the rule was overly broad.  He viewed the inclusion of “little r” restatements as a “dramatic shift” in the interpretation of Section 954, one that was not even mentioned in the 2015 proposal and seemed inconsistent with argument, from the cited Audit Analytics study, that “little r” restatements “are less severe” and “‘are not generally viewed as a sign of poor reporting.’ By broadening the scope of the 2015 proposal to include ‘little r’ restatements, the final rules appear to conflict with the statutory directive and even some of the underlying data.”  He also criticized a component of the “checkbox” disclosure as unconnected to the clawback issue and expressed concern that the definition of “executive officer” would capture too many employees. Finally, he suggested that the new rule might actually lead companies to restructure their compensation arrangements by providing less incentive pay subject to clawback and more discretionary bonuses, weakening alignment between executives and shareholders.  “According to some media reports,” he said, “parallel trends may already be occurring as corporations remove performance goals and replace options with shares.”

Commissioner Jaime Lizárraga.  In his statement, Lizárraga asserted that the rule was about “fundamental fairness and integrity”: “this is money that the executive was not entitled to, and would not have received, if the financial statements had been prepared accurately….Congress’ intent was for shareholders to avoid costly litigation to recoup unearned executive compensation, preserving funds that, from a shareholder’s perspective, could be put to more productive uses.”  As a staffer, he was a witness to the 2008 global financial crisis and attributed that crisis to “the stark misalignment of incentives that led executives to take excessive, catastrophic risks.” This failure of the guardrails was especially harmful for long-term investors saving for retirement, he said, who were “more likely to bear the costs of reckless actions by executives that temporarily increase share prices in the short-term but that lead to accounting restatements in the longer-run. To decrease the risk of these disruptions, Congress directed the Commission to adopt today’s rule.” The rule will ensure that executives will be incentivized to produce high quality, accurate financial statements, on which investors rely to make informed investment decisions.  Although there has been an increase in the adoption of voluntary clawback policies, they were quite varied; by “providing for standardized criteria, the rule gives investors greater assurances that all issuers face similar incentives to produce quality financial statements.”  He also contended that the rule will prevent the abuse of the potential “little r” loophole by folding both “Big R” and “little r” restatements into the rule. According to Lizárraga, “[e]mpirical evidence suggests that managers may try to use the discretion built into accounting standards to re-classify ‘Big R’ restatements to ‘little r’ restatements. These types of restatements have made up an increasingly high share of all financial restatements in recent years.” The SEC’s approach should help address that concern.

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