On October 14, President Gensler announced that the Securities and Exchange Commission (SEC) would reopen the comment period for the controversial compensation clawback rule it had originally proposed in 2015 in response to the requirements of the Dodd-Frank Wall Street Act of 2010 on consumer reform and protection (the “proposed recovery rule”). The proposed clawback rule would direct stock exchanges to require listed companies to implement a policy of clawing back the incentive compensation paid to executives when a company needs to restate its financial statements in a wide range of circumstances, including cases where the financial statements were found to simply contain errors due to human or other error. In re-examining the proposed payback rule, President Gensler cited recent regulatory and market developments, noting: “I believe we have an opportunity to enhance the transparency and quality of companies’ financial statements as well as the accountability of company managers to their investors.”
The proposed clawback rule, however, would require companies to claw back incentive compensation awarded to current and former executives for up to three years before a restatement occurs, with non-compliant companies to be delisted from the stock exchanges. However, such recoveries would only be necessary to go back to the calendar year in which the final rule came into effect. For example, if the final rule comes into effect in calendar year 2022, an issuer would be required to recover incentive compensation based on erroneous financial results ending on December 31, 2022. This compliance date would apply regardless of the moment when the shares of the stock exchange issuer proposes its corresponding listing rules.
Significantly, the proposed recovery rule would define an accounting restatement as the process of a company revising previously published financial statements to reflect the correction of errors that materially affect those statements, without delineating the types of errors that could be material to Investors. This approach is important because it would not capture the types of revisions in which companies correct minor errors, correcting the problem in their subsequent financial statements.1 Note, however, that the SEC’s request for additional comment asked respondents to comment on whether the current definition of restatements requires broadening.
For reference, the proposed recovery rule currently includes the following key elements:
- the recovery of incentive compensation is triggered when a company is required to prepare an accounting restatement due to a material non-compliance with financial reporting requirements under US federal securities laws;
- applicable to any company listed on a stock exchange or national securities association and to all current or former officers (i.e. all “Section 16” officers, including the chief accountant) of that company , and more broadly to any other person who carries out the policy – to do functions for this company;
- three-year look-back period from the restatement date;
- recovery on a “no-fault” basis, leading to recoveries regardless of whether fault has occurred or whether senior management was not responsible for inaccurate financial statements;
- compensation granted, earned or vested on the basis, in whole or in part, of the achievement of any financial reporting metric, including share price and total shareholder return, subject to a recovery, with the recoverable amount based on what would have been paid in the absence of a restatement;
- potential delisting for failure to adopt, disclose or enforce a clawback policy;
- the prohibition against indemnifying or paying premiums for an insurance policy to cover losses suffered under the salvage policy; and
- certain required information, including: (1) public filing of the policy with the SEC; and (2) disclosure of subject events or actions taken as a result of the clawback policy.
In reopening the comment period, the SEC requested that particular attention be paid to certain topics, including:
- whether the SEC should expand the types of accounting restatements that would trigger the application of the proposed recovery rule by interpreting “restatement” under the Dodd-Frank Act to include not only (1) those restatements to correct errors that are material to previously published financial statements statements that were part of the proposed recovery rule, but also (2) additional restatements necessary to correct errors that would result in material misstatement if the errors were not corrected in the current report or if the correction of errors was observed in the current period;
- whether the recovery is to be triggered on (1) the date on which the board of directors, a committee of the board of directors or an authorized officer (if action by the board of directors is not required) concludes, or would have reasonably should have concluded, that the Company’s previously published financial statements contain a material error; or (2) the date a court or regulator orders a company to restate its previously published financial statements to correct a material error (the SEC specifically asking commentators to comment on whether the standard “would reasonably have had to conclude ”is too vague); and
- whether to add checkboxes to Form 10-K that indicate (1) whether previously published financial statements include an error correction; and (2) whether these corrections are restatements that triggered a recovery analysis, as well as other information that could be useful to investors on the restatements in general and the decision to recover or not the compensation.
The comment period was open from October 21 to November 22, and to date the SEC has not announced whether it will extend the comment period or review comments received to date before issuing a final rule. If and when a final rule is adopted, exchanges will also need to publish their own proposed listing rules to enforce the policy, which in turn will need to be reviewed and approved by the SEC, a process that often takes months.
To prepare for the possibility of the new rule coming into effect, boards of directors of public companies should be made aware of the proposed clawback rule and its potential impact on existing incentive compensation plans. Companies should also consider how they will need to modify their existing recovery policies (or adopt new ones) to sufficiently meet the requirements of the recovery rule, if and when it is adopted.