The Securities and Exchange Commission enacted a rule today that will require public companies to adopt and disclose executive compensation clawback policies, echoing the Justice Department’s effort to make companies exercise clawbacks more often when their executives commit misconduct.
The rule directs U.S. stock exchanges to update their listing standards so that listed companies are required to “develop and implement a policy providing for the recovery of erroneously awarded incentive-based compensation” received by current or former executive officers. That policy must then be filed as an exhibit in the company’s annual report, and the report must include disclosures about “any actions an issuer has taken pursuant to such recovery policy.”
The clawback rule was originally required by the Dodd-Frank Act of 2010, and the SEC first proposed such a rule in 2015. That effort then went into a regulatory deep freeze during the Trump Administration, until current chairman Gary Gensler revived the effort last year.
“If a company makes a material error in preparing the financial statements required under the securities laws… then an executive may receive compensation for reaching a milestone that in reality was never hit,” Gensler said in a prepared statement before the SEC’s vote to adopt. “Whether such inaccuracies are due to fraud, error, or any other factor, today’s rules would implement procedures that require issuers to recover erroneously rewarded pay.”
Precisely what is a company supposed to clawback, and under what circumstances? Let’s quote directly from the SEC statement:
If an issuer is required to prepare an accounting restatement… the issuer must recover from any current or former executive officers incentive-based compensation that was erroneously awarded during the three years preceding the date such a restatement was required. The recoverable amount is the amount of incentive-based compensation received in excess of the amount that otherwise would have been received had it been determined based on the restated financial measure.
Let’s state that again more simply. If your company has to issue a restatement, then you must claw back incentive-based pay that was mistakenly paid to any current or former executive officers during the three years preceding the restatement. The amount to be recovered is any extra pay the executive received, above the appropriate amount that should have been paid based on the restated results.
So companies have a sweeping new policy to enact, and extensive financial calculations to perform if a restatement ever comes your way.
Clawback Policies Everywhere!
Compliance officers will wonder how the SEC’s rule intersects with the Justice Department’s policy, announced earlier this fall, that prosecutors will consider clawback policies when evaluating a company’s culture of compliance.
Clearly the two efforts are quite similar, but I wouldn’t say that the SEC adopted this rule specifically to support the Justice Department’s efforts. Rather, both agencies are working toward the same goal of forcing companies to hold themselves accountable for executive misconduct.
After all, the message isn’t just that companies should have clawback policies; many already do. The message is that you will need to exercise those policies whenever you find scenarios that led to executives getting compensation they didn’t deserve.
For example, when Monaco announced the Justice Department’s new policies last month, she expressly said prosecutors “will evaluate what companies say and what they do, including whether, after learning of misconduct, a company actually claws back compensation or otherwise imposes financial penalties.” Likewise, the SEC’s rule says issuers must recover compensation in the event of a restatement.
To a certain extent, the Justice Department’s policies are broader than the SEC rule. For example, they can apply just as well to private companies while the SEC only oversees public companies. The Justice Department’s policies can also apply to misconduct that doesn’t result in a restatement, such as antitrust violations.
But really, the main point is that companies are running out of ways to avoid clawbacks. You’ll need to have them, and you’ll need to exercise them. If not, public companies will face delisting and every company will face more unpleasant outcomes with the Justice Department. So a corporate commitment to hold wrongdoers accountable will be paramount, regardless of how difficult that might be.
Then Again, Not So Simple
Republican commissioner Hester Peirce issued a long statement opposing the clawback rule. That’s to be expected from a Republican commissioner under a Democratic-led commission. Still, her objections do raise good questions about how the clawback rule would work in practice.
Most notably, Peirce said the rule applies to too many employees. As currently written, she said, “affected employees would include anyone who performs a policy-making function for the issuer regardless of involvement with the events leading to the restatement.” It would be better to restrict the clawback rule to a company’s top five executives, or to those employees with a material role in the events leading to the restatement.
I’d go even further, and note that most workers don’t have any employment contracts at all, let alone contracts that include clawback clauses. So how do we extend the reach of clawback clauses to them?
For example, I could easily imagine an assistant controller or deputy sales manager in a position to commit fraud, but not have a formal employment contract. So do we start including clawback clauses in the employee manual? (You know, the one everybody just skims before signing the back page and returning it to HR.) Conversely, what’s the point of restricting the clawback rule to named executive officers only, when so many frauds are perpetrated further down the org chart?
Monaco’s policy on clawbacks is no clearer, by the way. It only talks about wanting clawbacks exercised against “current or former employees, executives, or directors whose direct or supervisory actions or omissions contributed to criminal conduct.” Noble idea, problematic in execution.
Peirce also complained that the rule will force companies to make extensive disclosures, including:
- the amount of erroneously awarded compensation attributable to an accounting restatement;
- an analysis of how the erroneously awarded compensation was calculated;
- the estimates used to determine the amount of erroneously awarded compensation, linked to stock price or total shareholder return, plus an explanation of the methodology used for such estimates;
- amounts recovered, amounts still owed, and amounts forgone.
Those calculations will put your HR, legal, and accounting functions through the wringer. Some giant corporations already have full-time “compensation compliance” personnel; these demands seem like a full employment act for those people. Companies will need to think through the processes and workflows necessary to get all this right, since compiling those disclosures will cut across numerous business functions.