During its October 14, 2021 meeting, the Securities and Exchange Commission (SEC) reopened the comment period on proposed rules for listing standards for recovering compensation that must be returned under Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The proposed rules themselves were released back on July 14, 2015. This second round of comments were due by November 22, and the SEC is expected to issue final regulations soon.
Even if the SEC finalizes its regulations 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, as required under Dodd-Frank Section 954; therefore, it is unlikely that companies will be required to adopt compliant clawback policies before sometime in 2022.
Even though there are still unresolved issues as to how compliant policies must be crafted, there are immediate actions companies can consider as they anticipate steps toward implementation. Those are discussed below.
Background
Under Dodd-Frank Section 954, if a company is required to prepare an accounting restatement to correct a material error, incentive-based compensation that was paid to current and former executive officers during the three years prior to the restatement must be recouped on a “no fault” basis if it exceeds the amount that would have been received had the initial company financial reporting been accurate.
The proposed regulations would require clawback policies to be filed as an exhibit to the company’s annual report. If the clawback policy is invoked, a company’s annual report and proxy must include details 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.
SEC comment period
During the reopened comment period, the SEC sought general information on current company clawback provisions, including details about what triggers a clawback, who is covered, what compensation is covered and how effective existing company polices appear to be.
The SEC also sought to understand whether companies have reduced the share of bonus plans and long-term incentives in the executive pay mix since the advent of voluntary clawbacks. This request appears to be part of the SEC’s due diligence 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 is too broad in covering all executive officers.
More specifically, the SEC requested comments on the following issues:
- Expanded focus on 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 discouraging companies to issue prior period restatements. The SEC is contemplating broadening this rule in two ways:
- The rule would apply to restatements to correct errors that are material to a previously issued financial statement, as already proposed.
- The rule 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 sought comments on how and whether an expanded standard would be workable, as it would appear to cover a lot more circumstances than the original proposal. It also asked 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, listed above, companies are not currently required to label historical Form 10-K financials as “restated.” Additionally, 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 sought comments on whether and how such restatements must be reported.
- Changed timing for the three-year lookback. The SEC proposed rule, as drafted, 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, not the date that the material error was actually identified. The SEC sought comments as to whether 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 (TSR). The proposed regulations simply would require companies to make a “reasonable estimate” of the values to be clawed back and provide documentation to the relevant listing exchange. The SEC sought comments on whether those calculations should be disclosed to shareholders and how much detail should be presented.
- Use of GAAP or IFRS definitions. The SEC also sought comments on whether it should independently define the terms “accounting restatement” and “material noncompliance,” or revert to existing definitions.
Steps to prepare
Companies should consider taking the following steps to prepare for the eventual adoption of required Dodd-Frank clawbacks:
- Determine how they might integrate their existing clawbacks, especially those focused on misdeeds, with the “no-fault” concept under Dodd-Frank.
- Decide if 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 lookback is appropriate for non-Dodd-Frank clawbacks.
- Create a written process for determining if a Dodd-Frank clawback provision has been triggered and decide how to include that process in existing documentation and in board/committee charters.
- Consider seeking expert guidance to determine a “reasonable estimate” of the amount to be recouped when equity or total shareholder return (TSR)-based incentive compensation is involved. Boards will also likely want to consult with experts to help them determine whether a clawback is worth pursuing weighed against the expenses necessary to recover the compensation.
