Effective on October 2, 2023, restatements of companies’ financial statements will trigger mandatory clawbacks of executives’ incentive-based compensation payments. This article seeks to provide a step-by-step summary of how a company would claw back erroneously paid incentive compensation.
The process is detail-intensive but is scalable to meet every organization’s unique circumstances. Our suggestion is to start is with:
After that, there are four essential steps every organization needs to follow, which fall under the assumption that the compensation committee is responsible for administering and enforcing the clawback.
Soon after restatement, the compensation committee should convene a special meeting to decide how the process will work and who will help assemble the needed data. There are several agenda items to include in that meeting.
Management should be prepared to provide a summary of the potential impact of the restatement on all elements of incentive compensation.
Identify who from management will provide the financial data, compensation plans, meeting minutes and any other relevant information to the team charged with performing the calculations.
Fundamentally, the compensation committee must consider conflict-of-interest questions when management helps determine clawback values. This risk diminishes when clawback amounts are smaller – the calculation is simpler and there are fewer assumptions or judgment calls needed to complete the calculation.
However, when more money is at stake, it is more likely that both shareholders and officers will question the results and ask about the source of funds, state legal authority and individual taxation. Additionally, the calculations become more complicated, and that makes the objections more plausible.
For these reasons, the committee will hire its own legal counsel and compensation experts to form the clawback team. You also may want to preserve the attorney-client privilege in communications among the committee, the clawback team and executive officers as much as possible.
The clawback team’s deliverables will include:
A timeline for completion of each deliverable also should be established.
After the committee determines the amounts subject to clawback, it must understand who has the legal authority within the company to carry out the recovery and ensure it is completed with a preset time frame.
To calculate the clawback, the clawback team needs to execute the fundamental steps outlined in its listing exchange’s manual. The process and dependencies established in Step 1 will help govern how the data and information changes hands. That process and those dependencies also will identify who is involved in the following list of to-dos for the three fiscal years completed immediately preceding the restatement (i.e., the lookback period):
While identifying executive officers during the lookback period is mostly straightforward, determining incentive compensation grants and calculating how much must be clawed back are more complicated.
Complications can arise when reviewing the documentation about how compensation levels were determined, and pay was settled for each compensation element received during the lookback period. The first issue to address is identifying elements of compensation that aren’t obviously incentive compensation but still might be affected by the restatement (e.g., salary increases based on prior-year financial results, compensation deferred into a nonqualified plan based on a prior-year bonus).
The second issue involves looking at pay that is clearly incentive compensation (e.g., annual bonus) and figuring out which portion might be attributable to non-financial performance, whether based on a specific non-financial metric or at the committee’s discretion. Making this determination requires a review of plan documents, grant agreements and so on, plus reading committee reports and minutes to eliminate compensation not based on financial reporting measures. When there isn’t enough documentation, the committee likely will err on the side of including that compensation in the clawback amount.
Most of this work is straightforward math; however, in some cases powerful statistical tools may be required to calculate the value of erroneously paid incentive compensation. This work becomes complicated when incentive pay previously received was calculated based on stock price or total shareholder return performance that is affected by a restated financial metric.
The regulations outline the SEC’s understanding that trying to determine what stock prices would have been if the restated financials had been presented accurately for prior fiscal years isn’t a simple quantification exercise. Determining “what could have been” requires companies to make a reasonable estimate using a statistical tool like an event study, which is often used in accounting, finance and economics.
An event study estimates the expected impact of specific actions or activities (an event) over a specific time (the event window) on stock price returns. There are two types of event studies:
While multi-firm event studies are more common in academic work, single-firm event studies have been recognized in securities fraud litigation in the Delaware Chancery as a preferred method for determining the impact of a particular event on share price.
The mechanics may be complicated to execute, but they’re relatively straightforward to explain. An event study starts by looking at the correlation between share price movements of a company and a peer group over a period significantly before the restatement. This establishes a baseline of how the company share price moves relative to its peer group. This is what economists call normal conditions based on this pre-event period.
Next, look at the company’s shareholder returns and those of peer-group firms from just before to just after the restatement (the event period). The goal is to determine the abnormal impact on share prices due to the restatement, which is the difference between the actual shareholder returns during the restatement’s event period and the expected returns under normal conditions compared with the peer group.
It is important to note that not all stock plans or total shareholder return-based plans will require an event study for every restatement. The clawback team may need to conduct a lot of homework before the company knows one way or the other. There are several factors that will influence this determination (see Figure 1).
| Reasonable estimates may suffice | Event study needed | |
|---|---|---|
| Inflection points in plan | Fewer hurdles and greater distance to next lowest hurdle | More hurdles and shorter distance to next lowest hurdle |
| Stock movement at restatement | Tepid movement when announced | Large share price change when announced |
| Market volatility | Lower volatility at original filing and restatement date | Higher volatility at original filing and restatement date |
| Proportion of pay affected | Lower percentage of incentive compensation | Lower percentage of incentive compensation |
| Magnitude of restatement | Lower value restated | Higher value restated |
| Cause of restatement | Change in accounting convention/audit firm | Systemic failure causing reputational harm |
Some clawback policies are written narrowly so that the committee must send a demand letter to the officer for repayment. The committee would seek other funding sources only if the officer delays in responding. Other policies are so broad that the committee has the sole discretion to determine of the funds are received via direct repayment or recoupment from compensation still held by the company.
We recommend that the committee decide the clawback funding source after a discussion with the officer about their preferences. The executive’s ability to repay the money directly rather than holding back other pay (and the tax considerations of doing so) is the primary focus. Not only does this promote good will, it also expedites the committee’s ability to act reasonably promptly.
These informal discussions are just that, as every policy we’ve seen makes clear that the committee has the sole discretion to determine the fund source. When a clawback applies to a former officer, unless funds remain held by the company, the committee might skip this step and simply issue a demand letter for the funds owed.
To prepare for this discussion, the committee needs to understand the extent to which an executive holds company shares, either on an after-tax basis or based on those still held by the company. This information should be readily available so the committee can determine whether the officer holds sufficient shares to satisfy the clawback while factoring in any company share-ownership requirements or if previously paid shares are still available to satisfy the clawback.
The committee also should understand the financial value available from alternative sources. Counsel must advise whether these would be permissible sources under state and federal law (including the tax code):
Regardless of whether the committee talks with the officer, the goal is to permit the committee to determine the best source of funds so it can act reasonably promptly while balancing other considerations (e.g., maintaining a positive relationship with the executive, incentive effects on current and future short- and long-term incentive grants). The committee can then present a potential source of funds determination to the officer along with the clawback calculations.
At the end of this step, the committee needs to authorize the appropriate company official to effectuate the clawback. This may be required if a demand letter is sent mandating how the payment is to be made if an alternative source of funds is identified.
The first three steps involve the clawback team documenting the process, decisions and calculations in a formal written report that includes:
This report – step 4 – should be preserved both to advise future restatement-related clawback actions and serve as a backup if the clawback action becomes the subject of shareholder lawsuits. The report also is:
These changes also influence changes to the Item 402(v) pay versus performance disclosures, both as the compensation actually paid and any previously disclosed performance metrics the restatement changes.
Identifying how your company’s clawback policy will work is no easy feat. However, maintaining a level head, having the right processes in place and collaborating with the right partners – both internally and externally – will get you from restatement to recoupment in this first year of mandatory disclosures.
