The U.S. Securities and Exchange Commission (SEC) announced on June 8 that it has again reopened the comment period for its proposed rule on recovery of erroneously awarded compensation under section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) for an additional 30 days that will close on July 14. On the same day as the announcement, the SEC also released an internal memo from the Division of Economic and Risk Analysis (DERA) that provides a summary of what issues might be included in an economic analysis under any final regulations, if and when they are adopted. Beyond that, however, the SEC provided no explicit indications of what additional information they are seeking in this announcement.
We blogged previously on what we view as the issues the SEC is struggling to resolve in its final regulations, and those observations still hold as the comment period is reopened. From more recent comment letters, and the DERA report, we are able to glean some insights on what issues the SEC still has to resolve, discussed below.
The SEC noted last October it was considering expanding the rule 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 DERA report found that although “little r” restatements may account for roughly three times as many restatements as “Big R” restatements, based on 2019 – 2021 data, the proportion of “little r” restatements that trigger clawbacks would be far lower because they result in smaller stock price reactions. There would be benefits if the rule is expanded, according to the DERA, in that compensation recoveries would provide additional corporate funds for other productive uses and could encourage even higher-quality financial reporting by companies. Additionally, companies would be less likely to create incentives to avoid “Big R” restatements when future “little r” restatements also would trigger clawbacks.
The cost of compliance is cited as a reason why the SEC might decide not to include “little r” restatements where recoveries might be less beneficial when share price impacts are minimal. The DERA also noted that data clearly reflects that smaller reporting companies disproportionately report “little r” restatements, so their administrative burden would be heightened compared with larger companies.
For performance-based equity grants that use share price or generally accepted accounting provision (GAAP) measures, calculation of the compensation subject to clawback after a restatement would be complicated but fairly straightforward. Things get even more complicated in determining the impact of a restatement on non-GAAP performance metrics used under a performance-based compensation plan; however, each of these calculations can likely be managed by in-house company resources.
Relative total shareholder return (TSR) plans would require companies to tackle an exponential degree of complication when determining the impact of a restatement. Not only would a company need to do an event study of the stock price impact of the restatement on the company itself, it would also need to do the same study for every company in its comparator group because share prices of peers are impacted by any financial restatement of a company within that peer group.
Our view is that the SEC understands these complications but may consider that it doesn’t have the regulatory authority to exempt relative TSR plans from coverage under the rules.
The SEC determination to require more disclosure when a clawback is invoked, per its contemplated rules when it last reopened the comment period, will create challenges for companies that their SEC counsel will need to balance. We surmise the SEC would prefer to permit companies more discretion in how they apply their judgment in making the cost/benefit determination of whether to claw back, and how those calculations are made, rather than providing black letter rules as to how calculations must be made; however, it appears that the price of flexibility may be that the SEC then would require companies to show their work in calculating the clawback amounts in proxy and other filings.
On the other hand, the more companies must disclose how they made those decisions, including potentially showing the calculations, the more likely it is that the plaintiffs’ bar would be provided sufficient information in company filings that would enable the plaintiffs to withstand a company’s motion to dismiss if they sue to challenge those calculations as not being in the best interests of shareholders. As a result, this puts a lot more pressure on companies to take a more aggressive view when calculating amounts to be clawed back from executives to withstand these legal claims that not all money owed to the company was recouped.
We are not yet to the end of the road on Dodd-Frank clawbacks, as the SEC still seems to be pondering some important considerations on how the rules will be crafted; however, we have seen no indication that the currently constituted SEC will decide it can ignore Congress’s statutory remit to finalize these regulations. It is still possible the SEC is closer to issuing final regulations than it appears, so companies should not conclude regulations won’t be finalized until 2023. Keep in mind, once the regulations are finalized, it becomes the obligation of the various listing exchanges to adopt rules to implement the SEC guidance, which likely adds another six months until clawback policies must be adopted by companies.
