The approval of recent proposed rules by the U.S. Securities and Exchange Commission (“SEC”) will force companies to recoup executive bonus pay in the event of significant accounting errors or misstatements.
The SEC voted 3-2 on October 26, 2022 to finalize the “clawback rules,” implementing Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 over a decade after its enactment. The clawback rules will require the national securities exchanges to adopt listing standards compelling issuers to implement policies for the recovery of incentive-based compensation awarded to current and former executive officers based on erroneous or false financial results. The policies must provide for a three year look back period.
“I believe 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,” said SEC Chair Gary Gensler. “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.”
The SEC first proposed compensation recovery rules back in 2015 under former President Barack Obama. The clawback rules did not receive further attention under former President Donald Trump and then-SEC Chair Jay Clayton. However, upon President Biden’s naming Gensler as SEC chair, the comment period was reopened on a proposal for similar rules in both October 2021 and June 2022. The rules were adopted by the SEC with all Democrats approving and all Republicans dissenting. GOP lawmakers took issue with certain elements of the final rules, criticizing as overly broad the breadth of listed potential triggering restatements and the definition of “executive officer.”
In practice, the rules will be triggered in the event of a restatement due to material non-compliance with any financial reporting requirements. The rules are more expansive than those first proposed in 2015, which would have only applied if a company identified significant accounting errors requiring a restatement of previously issued financial results. These restatements are often referred to as “Big R” restatements. The final rules, on the other hand, require companies to recover not just for Big R restatements, but also in the event of an error that would be considered a material misstatement “if the error were left uncorrected in the current report or the error correction was recognized in the current period” (“little r” restatements).
Prior to the approval of these new rules, it had become widespread practice for corporate boards to include provisions requiring these clawbacks in compensation agreements. Still, these rules will surpass the requirements of previously voluntary measures, which generally impose a higher bar for triggering repayment to the company.
A set of existing clawback rules under Section 304 of the Sarbanes-Oxley Act of 2002—which were similar, but narrower than the new SEC rules——already required the repayment of incentive-based compensation in the event of an accounting restatement. However, those already existing clawback rules only apply to the chief executive officer and chief financial officer positions and are triggered in the event of a restatement resulting from misconduct. The new Dodd-Frank rules just approved by the SEC apply to a much broader group of executive positions, including the president, principal financial officer, principal accounting officer (or, if none, the controller), 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.
Under the new rules, companies will be required to file their recoupment policies as an exhibit to their annual reports. The filed policy must include a number of detailed disclosures, including:
- The date the company was required to prepare an accounting restatement and the total amount of erroneously awarded compensation;
- Any outstanding amounts that remain due from any current or former named executive officer for 180 days or more; and
- Details regarding any reliance on certain impracticability exceptions under the rules, which identifies situations where recovery is excused because it is impractical to obtain it.
Issuers that do not adopt these policies and comply with the requirements of the rules will be subject to delisting.
The final rules will become effective 60 days following publication of the adopting release in the Federal Register, with a one-year deadline for the listing standards to become effective following publication.