The Securities and Exchange Commission on Oct. 26, 2022, voted 3 to 2 to finalize so-called clawback rules that direct national stock exchanges to require listed companies to implement policies intended to recoup bonuses paid to executives if the company is found to have misstated its financial results.
The rule, mandated by Section 954 of Dodd-Frank, is intended to discourage executives from taking questionable actions that temporarily boost share prices but ultimately result in a correction of financial statements. Sec. 954 of PL111-203
The commission has decided to interpret Dodd-Frank expansively to include both “Big R” and “little r” restatements as triggers for a compensation recovery analysis.
“Big R” restatements correct errors that resulted in a material misstatement in previously issued financial statements. “Little r” restatements correct errors that would only result in a material misstatement if the errors were left uncorrected in the current report or if the error correction was recognized in the current period. The period in question is during the three completed fiscal years immediately preceding the date that the company is required to prepare an accounting restatement.
“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.”
Two conservative commissioners—Hester Peirce and Mark Uyeda—voted against the rules because of the inclusion of “little r” restatements in the new requirements, among other reasons.
Section 954 left it up to the SEC to decide whether both restatements should trigger a clawback analysis, but Peirce said that including “little r” restatements “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 final rule is different from the SEC’s proposal in 2015—that did not include both types of restatements. The commission in 2021 and again in June 2022 reopened the comment periods of the 2015 proposal. In reopening the reproposal, the commission contemplated the inclusion of “little r” restatements because of concerns about opportunistic behavior by companies that would deliberately choose do “little r” instead of “Big r” restatement to avoid clawbacks.
“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,” Peirce said. “A better approach—and one that would be easier to apply—would have required clawbacks only when a company has to “prepare a financial restatement to correct a material error of the type required to be reported under Item 4.02(a) of Form 8-K.” Item 4.02 is non-reliance on previously issued financial statements or a related audit report or completed interim review. And it points to the Financial Accounting Standard Board’s ASC 250, Accounting Changes and Error Corrections.
During a media briefing following the meeting, Gensler defended the SEC’s decision to include “little r” restatements.
There has “been a significant use of restatements in the current year. It’s grown to nearly three quarters of the restatements when I think in 2013—is the release said—it was maybe one in 33 or 35 percent,” Gensler said in response to a question by Thomson Reuters. “And there were some questions in 2015 related to this, but we felt in ‘21, that we should get public input on this. And as we voted today, it’s an important piece. Again, if the financials are inaccurate, why should executives be getting paid incentive comp on financials that were inaccurate? It’s a misalignment and whether it’s material to historic financials or these so-called little rs have to do with that, it’s still material, but it’s material to the current financials on an ongoing basis. It’s still relevant and I feel comfortable supporting both.”
SEC officials also noted that under today’s U.S. GAAP requirement, both restatements are required.
In the meantime, the SEC does not expect many of the little r restatements will result in actual clawback. However, Acting Chief Accountant Paul Munter, during the commission’s open meeting, noted that the company is required to consider all relevant facts and circumstances, including both the quantitative and qualitative factors around the error in assessing materiality of the error.
“And one important qualitative factor is, of course, to what degree does an error affect executive compensation?” Munter explained. “So, the issuer would need to take into consideration the impact of an error on executive compensation in making a determination as to whether the error should be appropriately corrected through a little r or a Big r. And so when there’s a significant impact on executive compensation, the likelihood that it would be a big R is increased.”
Final Clawback Rules
The final rules are in Release No. 33-11126, Listing Standards for Recovery of Erroneously Awarded Compensation.
The rule changes will become effective 60 days following publication in the Federal Register. Exchanges must file proposed listing standards no later than 90 days following the release’s publication in the register. And the final listing standards must be effective no later than one year following publication. Companies then will have to adopt a recovery policy no later than 60 days following the effective date of new listing standards in proxy and information statements and the company’s annual report.
Executives subject to the requirements are “executive officers” as defined in the rule. And they are a company’s president, principal financial officer, principal accounting officer, any vice president in charge of a principal business unit, division or function, any other officer who performs a policy-making function or any other person who performs similar policy-making functions.
The rules also apply to emerging growth companies, smaller reporting companies and foreign private issuers.
In particular, the SEC’s new rules direct national exchanges and associations to establish listing standards that require a company to implement a policy to recover erroneously awarded incentive-based compensation received by its current or former executive officers in the event of a restatement because of material non-compliance with any financial reporting requirements.
These policies must be disclosed. All listed companies must file their written recovery policies as exhibits to their annual reports. And they must indicate by check boxes on their annual reports whether the financial statements included in the filings reflect correction of an error to previously issued financial statements and whether any of those error corrections are restatements that required a recovery analysis. Companies then must disclose any actions they have taken under such recovery policies.
Clawback rules already exist under Section 304 of the Sarbanes-Oxley Act of 2002. But it applies only to the chief executive officer and chief financial officer and requires misconduct for clawbacks to be triggered.
Practical Implications Uncertain at this Juncture
The Dodd-Frank clawback rule was a long time coming, said Dave Brown, a partner with Alston & Bird LLP.
“And the wait is even longer given the exchanges still need to propose and adopt standards regarding clawback policies. It remains to be seen what the practical implications will be given that the standard is based on ‘material noncompliance,’” Brown said. “Most, if not all, mid and large cap companies already have some form of clawback policy and provide disclosure regarding such policy. Companies should prepare to review their existing policies in light of the eventual listing standards. They should also understand that if there is an issue of material noncompliance there will be much more disclosure about any clawbacks.”
This article originally appeared in the October 27, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.
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