During its October 14, 2021 meeting, the Securities and Exchange Commission (SEC) reopened the comment period on proposed rules for listing standards for the recovery of erroneously awarded compensation under Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). The proposed rules themselves were released back on July 14, 2015, and the SEC had received public comments already on many of the outstanding issues before it reopened the comment period. The second round of comments were due by November 22, so the clock is ticking for the SEC to issue final regulations.
Because Dodd-Frank Section 954 would require national listing exchanges to adopt standards for issuers to adopt a compensation recovery policy, this means that even if the SEC finalizes its regulation before the end of 2021, it will still take time for the listing exchanges to create their implementation guidelines and then submit them to the SEC for approval. This likely would mean that companies will not be required to adopt compliant clawback policies until sometime during 2022, at the earliest.
The request for comments does provide companies some immediate steps to consider as they anticipate having to adopt these more stringent clawback provisions. We detail these steps later in the article.
Where things stand now
Dodd-Frank Section 954 requires incentive-based compensation that is paid during the prior three years before a company is required to prepare an accounting restatement to be recouped from current and former executive officers on a “no fault” basis if it exceeds the amount that would have been received had the company financials been stated accurately. Without recounting every issue here, important issues covered by proposed regulations are defined as follows:
- “Executive officers” are Section 16 officers, defined under SEC rules as a company’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 policymaking functions for the issuer.
- “Incentive-based compensation” is any compensation that is granted, earned or vested based wholly or in part on the attainment of a financial reporting measure, and further defining “financial reporting measure” as a measure that is determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measure derived wholly or in part from such financial information, and stock price and total shareholder return. This does not include time-based equity (including stock options), compensation issued at the board’s discretion, awards based on subjective standards (e.g, completion of a task or event) and awards issued based on operational measures not based on financials (e.g., same store sales, customer satisfaction).
- Compensation “received” for determining the three-year period during which compensation would be subject to clawback would be the fiscal period when the performance measure is achieved. This would mean that a performance grant whose goals are achieved that is still subject to a service condition that delays vesting would be counted in the year the performance condition is attained.
The proposed regulations would not provide specific methodologies for determining the amount to be recouped but rather would allow companies to use “reasonable estimates” to determine those amounts with scant guidance as to how those estimates must be determined.
Disclosure-wise, the proposed regulations would require clawback policies to be filed as an exhibit to the company’s annual report, and if the policy is invoked, details would be required in the annual report and proxy about whose compensation is being clawed back, the reason if a clawback is not pursued and the aggregate dollars recouped or still to be recouped.
The SEC is seeking comments on some unsettled issues
The SEC is seeking general information on the current state of company clawback provisions, including details about the triggers, who is covered, what compensation is covered and how companies perceive the effectiveness of these policies. It also wants to understand if, since the advent of voluntary clawbacks, the mix of executive pay has changed due to the potential that pay can be recouped. It appears this request is part of the SEC’s due diligence in assembling data to determine the economic impact of requiring companies to adopt clawbacks, although the SEC is also interested in whether the proposed regulations’ “no-fault” approach was too broad in covering all executive officers, so there is some hope of a more tailored final regulation.
More specifically, the SEC requests comments on the following issues:
- Expand focus to errors that become material in a later reporting period: The SEC is concerned that the proposed regulations, if finalized, would create incentives for companies to conclude that prior financial statement errors do not rise to the level of “an accounting restatement due to material noncompliance,” thereby creating a disincentive for companies to issue prior period restatements. The SEC is contemplating broadening this rule:
- First, it would apply to restatements to correct errors that are material to a previously issued financial statement, as already proposed.
- Second, it would be expanded to cover restatements to correct errors that are 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 SEC is seeking comments on how and whether this standard would be workable, as it would appear to cover a lot more circumstances than the original proposal. It is also asking for comments on whether restatements in the second category should be treated differently by perhaps giving boards more flexibility on how and whether to invoke a clawback.
- Expanded disclosure requirements: The SEC notes that for the second category of restatements, there are no current requirements that companies must label historical Form 10-K financials as “restated.” Additionally, it notes that most companies do not file an Item 4.02 Form 8-K filing for these errors because they are not material to the previously issued financial statements. The SEC is seeking comments on whether and how such restatements must be reported.
- Timing for the three-year lookback: The SEC proposed rule, as drafted, would require a clawback to be invoked within three years of the date that the board or management concludes that the previously issued financial statement contains a material error but also, if beyond that period, to determine if the board or management “reasonably should have concluded” within three years that a prior financial statement contained a material error. This rule would mean that, in some situations, a clawback could need to be invoked for a three-year period that is based on when the error should have been identified, which may be much earlier than the date that the material error is actually identified. The SEC is reopening comments to revisit this standard and to consider if another method of measuring the three years would be preferable.
- Determining the amount to be clawed back: The SEC recognizes there are many questions about how to determine the value to be clawed back in situations where incentive-based compensation is based on stock price or total shareholder return. The proposed regulations simply would require companies to make a “reasonable estimate” of the values to be clawed back and to provide such documentation to the relevant listing exchange. The SEC seeks comments on whether those calculations should be disclosed to shareholders and how much detail should be presented. It does not seem the SEC is ready to provide any more guidance on how to perform the calculations, such as providing “safe harbor” methodologies, although that can change as the SEC considers comments.
- Use GAAP or IFRS definitions: The SEC is also seeking comments on whether it should independently define the terms “accounting restatement” and “material noncompliance,” or revert to existing definitions. These definitions might be those under U.S. GAAP and IFRS guidance on how accounting errors are corrected in previously issued financial statements, or under existing federal securities laws and SEC rules require presenting information that is not misleading.
What should companies do now?
Even though required adoption of Dodd-Frank clawbacks is unlikely to happen before the middle of 2022, it is not too early start thinking about the issues that will confront companies when the time comes:
- Pivoting from an existing clawback policy: Current clawback policies differ widely dependent on industry, with most companies focused on financial restatements that were caused by some act of commission (e.g., fraud, willful misconduct). Certain industries have moved to broaden those triggers to violation of codes of conduct, executive misbehavior or actions causing reputational harm, while a handful of companies already have “no-fault” policies for financial restatements. We would not expect companies with broader provisions to eliminate those provisions. The trick will be determining how to harmonize those very specific misdeed-based clawbacks with the “no-fault” concept under Dodd-Frank.
Companies will need to decide if these different clawback triggers will apply to the same elements of compensation, the same group of officers (or a broader group) and the use of discretion for the board to invoke as well as whether a three-year look-back is appropriate.
- How the process works at the board level:There will need to be a well-defined process by which the compensation committee is apprised of errors that causes the need for a restatement, which information already will have been vetted by the audit committee for its advice and consent. This likely differs from current practice where clawbacks triggered by deliberate acts are likely investigated by the full board, or by a special committee, often through a third party. In essence, the process moves from being a case requiring the utmost scrutiny to one that becomes more ministerial in determining if a Dodd-Frank clawback provision has been triggered. This will require companies to craft a written process for doing so, and to decide how to embody that process in existing documentation and how to depict these actions in board/committee charters.
In addition, even though the determination of whether a restatement happened and who will be covered will be largely factual, determining a “reasonable estimate” of the amount to be recouped would appear to be something the board would seek experts to help determine and document on its behalf when equity or total shareholder return (TSR)-based incentive compensation is involved. It is likely boards would also consult with experts to help determine whether the expenses paid to recover the compensation would exceed the amount of the compensation to be recovered so that the board would conclude the clawback is not worth pursuing.
Potential influence on typical executive compensation designs
When the SEC sought input on how existing clawback policies have influenced compensation plan design, it didn’t ask how required Dodd-Frank clawbacks might change the landscape of executive compensation plan design. Certainly, executives will be sensitive to the fact that “no-fault” clawbacks loom over their financially based incentive compensation, and boards will hear about it from them. Yet, the advent of these broader clawbacks seems unlikely to have a major influence on the overall focus on incentive-based compensation for corporate executives. The world of executive compensation for many public companies is fairly well settled based on the influence of major shareholders and proxy advisors who like what they like concerning pay mix.
While it would be easy to speculate that the share of bonus plans and long-term incentives based on financial metrics in the total pay mix could be reduced, the risk of doing so would be that the connection of pay to performance would erode. Keep in mind, the pesky disclosure that was mandated by Section 953(a) of the Dodd-Frank Act, which would require proxy disclosure of the relationship between executive compensation actually paid and the financial performance of the company, is on the SEC’s agenda to be finalized as soon as during 2022. As a result, any actions taken to recalibrate pay so that it is not as responsive to TSR will be apparent over the years as that connection performance is reduced.
Another issue that eventually will confront compensation committees is what to do after a clawback of compensation from a group of executives who had no connection to the cause of a financial restatement. Will compensation committees feel obliged to increase pay levels in subsequent years to offset those losses?
Many compensation-related regulations have, over the years, had the unintended result of changing how pay is delivered and/or increasing executive pay levels. It will be interesting to see if Dodd-Frank clawbacks, when required, will have a similar impact.
