On June 8, the U.S. Securities and Exchange Commission (SEC) announced that it has once again reopened the comment period for its proposed rule on recovery of compensation paid based on erroneous financial data under section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).1 The comment period for these clawback provisions has been reopened for an additional 30 days and is set to close on July 14.
Also on June 8, the SEC 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.
Following is an overview of the issues the SEC is seeking to resolve during the reopened comment period.
Last October, the SEC noted it was considering expanding the rule to cover restatements to correct errors that are not material to 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. Commenters have raised concerns to the SEC about the latter issue.
In response, the SEC asked its DERA to look at what the data would show about the impact of the expanded coverage of the rule. 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 reaction that might not trigger a need to recover any compensation. According to the DERA, benefits to expanding the rule include 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 reflect 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 that is subject to clawback after a restatement would be fairly straightforward. More complicated calculations would be required when determining the impact of a restatement on non-GAAP performance metrics used under a performance-based compensation plan.
For relative total shareholder return plans, companies would face even greater burdens 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.
When the SEC previously reopened the comment period in October 2021, the rules it was considering would require more disclosure when a clawback is invoked. While it appears that the SEC would now prefer to give companies more flexibility in how they make cost/benefit calculations to determine whether to claw back, companies could be required to show their work in calculating the clawback amounts in proxy and other filings. Decisions about how much or how little information to disclose in SEC filings always introduce tricky legal questions to be negotiated by appropriate counsel.
Although it is not known when final regulations will be issued, companies should continue to monitor this issue and prepare for compliance. Once the regulations are finalized, the various listing exchanges must adopt rules to implement the SEC guidance, which would likely add another six months before companies would be required to adopt clawback policies.
1 For background and information on previous comment periods, see “SEC finalizing Dodd-Frank clawback policy,” Insider, December 2021.
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