SEC adopts final rules on compensation clawbacks in the event of financial restatements—“Big R” and “little r” [UPDATED]

[This post revises and updates my earlier post primarily to reflect in greater detail the contents of the adopting release. For a discussion of the comments and criticisms of the SEC Commissioners at the open meeting at which the rules were adopted, see my earlier post.]

At an open meeting last week, the SEC adopted, by a vote of—surprise—3 to 2, rules to implement Section 954 of Dodd-Frank, the clawback provision. Clawback rules were initially proposed by the SEC back in 2015, but were relegated to the long-term agenda, until they suddenly reemerged on the SEC’s short-term agenda in 2021 (see this PubCo post) with a target date for a re-proposal of April 2022. Instead of a re-proposal, however, a year ago, the SEC simply posted a notice announcing that it was re-opening the comment period and posing a number of questions for public comment.  (See this PubCo post.) One possible change suggested by the SEC’s questions was a potential expansion of the concept of “restatement” to include not only “reissuance,” or “Big R,” restatements (which involve a material error and an 8-K), but also “revision” or “little r” restatements. Then, in June of this year, DERA issued a new staff memorandum addressing in part the restatement question, which led the SEC to once again re-open the comment period.  Finally, the SEC concluded that, after more than seven years, the proposal had marinated long enough. Time to serve it up.  The new rules direct the national securities exchanges to establish listing standards requiring listed issuers to adopt and comply with a clawback policy and to provide disclosure about the policy and its implementation. The clawback policy must provide that, in the event the listed issuer is required to prepare an accounting restatement—including a “little r” restatement—the issuer must recover the incentive-based compensation that was erroneously paid to its current or former executive officers based on the misstated financial reporting measure. Commissioners Hester Peirce and Mark Uyeda dissented, contending that, among other problems, the rule was too broad and too prescriptive. According to SEC Chair Gary Gensler, the key word here is “erroneously,” that is, the rule requires recovery of compensation to which the officers were never entitled in the first place. In his statement at the meeting, Gensler indicated that he believes “that these rules will strengthen the transparency and quality of corporate financial statements, investor confidence in those statements, and the accountability of corporate executives to investors….Through today’s action and working with the exchanges, we have the opportunity to fulfill Dodd-Frank’s mandate and Congress’s intention to prevent executives from keeping compensation received based on misstated financials.”

Here are the fact sheet, the press release and the adopting release for the final rule.

SEC perspective 

The SEC viewed the impetus behind the Section 954 mandate as a straightforward one: “executive officers of exchange-listed issuers should not be entitled to retain incentive-based compensation that was erroneously awarded on the basis of materially misreported financial information that requires an accounting restatement.”  With that in mind, the SEC took the position, in crafting the rules, that “discretion to implement and execute these mandated recovery policies generally should be limited” and that the “mandated recovery policies were intended to apply broadly.”  For example, the reference to “incentive-based compensation” was interpreted to cover “any incentive-based compensation that may be impacted by financial reporting.” Similarly, the absence of any limitation on the term “executive officers” implied to the SEC that “Congress intended the scope of the statute to reach more broadly to include all of an issuer’s executive officers. While this scope may result in recovery from officers who did not play a direct role in an accounting error or who did not help to set a ‘tone at the top’ that affects financial reporting accuracy, we understand that effect to be consistent with the statutory purpose of recovering compensation erroneously paid to executive officers regardless of whether the executive officer directly contributed to the error.”

Final Rule 10D-1

New Exchange Act Rule 10D-1 directs the exchanges to establish listing standards that require issuers to:

As stated in the fact sheet, each listed issuer will “be required to adopt a compensation recovery policy, comply with that policy, and provide the required compensation recovery policy disclosures.”  An issuer that does not do so will be subject to delisting.

Subject issuers and securities

Exchange Act Section 10D does not distinguish among issuers or securities, and, generally, neither does the SEC in these rules. (The SEC does exempt certain security futures products and standardized options, as well as the securities of certain registered investment companies.)  The SEC declined to include any  exceptions or special phase-ins for emerging growth companies, smaller reporting companies, controlled companies or foreign private issuers, nor did the SEC grant the exchanges discretion to decide whether certain categories of securities should be exempted from the listing standards. In making that determination, the SEC considered whether providing exemptions would be consistent with the statutory purpose of Section 10D, whether clawback recovery would encourage the preparation of reliable financial information for those issuers, and the incidence of restatements by different categories of issuers.  For example, the SEC took into account studies showing that “foreign companies present a similar risk of restatement as other companies and that U.S. issuers who are non-accelerated filers accounted for approximately 53% of restatements.” The SEC also noted that the statute did not call for exemptions for smaller companies and alluded to studies showing increased likelihood of smaller issuers and EGCs reporting an accounting error and material weaknesses in internal control over financial reporting. Viewing the recovery of unearned compensation “as appropriate for smaller listed issuers as it is for larger issuers,” the SEC elected not to exempt EGCs or SRCs. Instead of an exemption for certain categories of issuers, the SEC decided to provide an “impracticability accommodation.”

Restatements

Restatements covered. The Senate report on Section 10D described the bill as requiring recovery for restatement “as a result of material noncompliance with accounting rules.”  Originally, the proposal captured only “Big R” restatements, but when the SEC reopened the comment period, as noted above, it asked whether it should reinterpret the phrase “an accounting restatement due to material noncompliance” to include all required restatements, including “little r” restatements. What is the difference? “Big R” restatements “correct errors that are material to previously issued financial statements”; “little r” restatements “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 (commonly referred to as ‘little r’ restatements). A ‘little r’ restatement differs from a ‘Big R’ restatement primarily in the reason for the error correction (as noted above), the form and timing of reporting, and the disclosure required.” Comments in response were mixed, but some commenters expressed concern that the proportion of “little r” restatements was rising and that some issuers would not make “appropriate materiality determinations for errors identified” to avoid recovery under their compensation recovery policies.

The final rules apply the clawback policy to both “Big R” and “little r” restatements.   Under the final rule, compensation recovery policies will be triggered if the issuer is “required to prepare an accounting restatement that corrects an error in previously issued financial statements that is material to the previously issued financial statements, or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period.” As analyzed by the SEC, both types of restatements are “caused by material misstatements that either already exist or would exist in the current period.” In addition, “both types of restatements address material noncompliance of the issuer with financial reporting requirements.” By contrast, the SEC confirmed, restatements do not include corrections of errors that are “recorded instead in the current period financial statement—commonly referred to as an out-of-period adjustment—when the error is immaterial to the previously issued financial statements, and the correction of the error is also immaterial to the current period.” Determining whether an error is material will require evaluation of quantitative and qualitative factors, the SEC noted, including whether the misstatement has the effect of increasing management’s compensation by satisfying requirements for the award of bonuses or other forms of incentive compensation.

The SEC also identified a number of changes to financial statements that are not corrections or errors and would not trigger clawbacks, including

Date Issuer Required to Prepare Restatement.   Section 10D requires recovery of erroneously awarded compensation “during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement.”  But when is that? Should the trigger date include, as originally proposed, the date the board concluded, or reasonably should have concluded, that the issuer’s financial statements contained a material error? Views of commenters were mixed, with some arguing that the language would “create a more objective standard and appropriately limit board discretion,” while others expressed concern about uncertainty or ambiguity of that determination. The SEC concluded that the proposed rule would provide “reasonable certainty for issuers, shareholders, and exchanges while minimizing incentives for issuers to delay their restatement conclusions.” Accordingly, the final rules adopt the language substantially as proposed: the

The SEC notes that, “while not dispositive, one factor that an issuer would have to consider carefully would be any notice that it may receive from its independent auditor that previously issued financial statements contain a material error.” In addition, the SEC noted, an issuer’s obligation to recover erroneously awarded compensation is not dependent on if or when it files the restated financial statements with the SEC.

Application of Recovery Policy

Executive officers covered.   Under Section 10D, the clawback covers “any current or former executive officer of the issuer who received incentive-based compensation” during the three-year look back period. The adopting release notes that Congress “did not limit the scope of recovery to those officers who may be ‘at fault’ for accounting errors that led to a restatement, nor to those who are directly responsible for the preparation of the financial statements”; rather, the purpose of the statute is “to recover erroneously awarded incentive-based compensation, reducing a potential form of unjust enrichment, in which executive officers would gain from accounting errors at the expense of shareholders.”  In determining the scope of the definition, the SEC concluded that the rule should not be limited to “only officers with a direct role in financial reporting”; rather, to “incentivize high-quality financial reporting,” officers with “an important role in financial reporting” should be subject to the recovery policy, as well as officers with significant policy-making functions.

Under the final rules, clawbacks will apply to the issuer’s “president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division, or function (such as sales, administration, or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer.” Only significant policy-making functions are covered. Executive officers of the issuer’s parent or subs are deemed executive officers of the issuer if they perform policy-making functions for the issuer. Notably, no fault or involvement with the error is required.

Clawbacks will also cover former executive officers; however, the SEC agreed with commenters that recovery should not be required for compensation received prior to the period when they became executive officers. As a result, the final rule will require recovery of incentive-based compensation received by a person only (i) after beginning service as an executive officer and (ii) if that person served as an executive officer at any time during the recovery period. The SEC notes, however, that awards granted before an individual becomes an executive officer “will be subject to the recovery policy, so long as the incentive-based compensation was received by the individual at any time during the performance period after beginning service as an executive officer.” Issuers will be prohibited from insuring or indemnifying executive officers against the loss of erroneously awarded compensation or reimbursing executives for premiums paid for insurance against this loss.

Incentive-based compensation.   Under the statute, the clawback policy would apply to “incentive-based compensation (including stock options awarded as compensation)” that is received, based on the erroneous data, in “excess of what would have been paid to the executive officer under the accounting restatement.” The proposal had defined the term largely in a principles-based manner, and the SEC determined to adopt the rule largely as proposed to capture new types of compensation that may be developed. As adopted, the rule defines “incentive-based compensation” to be “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure.” As proposed, “financial reporting measures” are defined in the final rules as “measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, and any measures derived wholly or in part from such measures,” including “non-GAAP financial measures” and “other measures, metrics and ratios that are not non-GAAP measures, like same store sales,” where sales are subject to an accounting restatement.

Notably, also included are stock price and TSR, as proposed. Commenters observed that, the use of these metrics may be challenging because the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement. As a result, it could be extremely challenging to estimate how much any change in the stock price or TSR is attributable to a restatement—and not, for example, to changes in the economy or even in Ukraine.  In response to commenters who expressed concerns that calculating recoverable compensation with respect to stock price and TSR could require technical expertise and specialized knowledge and may involve substantial exercise of judgment, the final rule will permit issuers to use reasonable estimates when determining the impact of a restatement on stock price and TSR. In a change from the proposal, issuers will be required to disclose “the estimates that were used in determining the erroneously awarded compensation attributable to an accounting restatement and an explanation of the methodology used to estimate the effect on stock price or TSR, if the financial reporting measure related to a stock price or TSR metric, to better explain how the issuer established its estimates.” The adopting release includes a long, non-exclusive list of measures that would come within the definition of financial reporting measures. None of these measures must be included in financial statements or even in SEC filings. The SEC believes that the expansive definition is appropriate because the statute refers to compensation “based on” financial information and “based on” the erroneous accounting data.

In addition, under the final rule, recoverable incentive-based compensation includes options and other similar equity awards, including restricted stock, RSUs, performance share units, stock options, and SARs (as well as proceeds from sale of these shares), the grant or vesting of which is based wholly or in part upon the attainment of financial reporting measures. Also included are non-equity incentive plan awards, bonuses from bonus pools and cash awards based wholly or in part on satisfying a financial reporting measure performance goal. Incentive-based compensation does not include salaries (except for salary increases based on attainment of a financial reporting measure performance goal), discretionary bonuses (not from pools the size of which is determined by meeting financial reporting measures), bonuses or non-equity awards based on achievement of subjective standards or strategic or operational goals (e.g., excellent leadership, completion of a merger or increase in market share) and equity awards that are only time-vested or vest based on achievement of nonfinancial reporting measures.

“Receipt” of compensation and time period.  The statute would apply clawbacks to compensation received “during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement.” But how is the three-year look-back calculated? When is an executive deemed to have received compensation? Under the final rules, as proposed, compensation will be deemed received in the fiscal period during which the specified financial reporting measure is attained, even if the payment or grant occurs after the end of that period. The compensation must be received while the issuer has a listed class of securities. The date of receipt of the compensation depends upon the terms of the award, but generally awards are considered received when they are earned, awarded or vested based on achievement of the financial goal rather than when they are paid, even if the right to payment is only contingent at that time.

Under the final rule, the look-back period will be the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement.

Recovery process.  Section 10D provides for recovery of compensation “in excess of what would have been paid to the executive officer under the accounting restatement.” How is that calculated? What if the compensation is based on stock price or TSR? The final rule provides that the erroneously awarded compensation is “the amount of incentive-based compensation received by the executive officer or former executive officer that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement, computed without regard to taxes paid.” For example, for cash awards paid from bonus pools, “the erroneously awarded compensation is the pro rata portion of any deficiency that results from the aggregate bonus pool that is reduced based on applying the restated financial reporting measure.” The SEC notes that the recovery, in that instance, should be pro rata based on the size of the original award rather than discretionary. In addition, where the compensation is based on TSR or stock price, “where the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement, the amount must be based on a reasonable estimate of the effect of the accounting restatement on the applicable measure and the issuer must maintain documentation of the determination of that reasonable estimate and provide it to the exchange.”  Issuers will have flexibility to use the method that is most appropriate under the circumstances.

If the issuer has already recouped funds under SOX 304, the SEC believes that “it would be appropriate for the amount the executive officer has already reimbursed the issuer to be credited to the required recovery under the issuer’s Rule 10D-1 recovery policy.” Note that, because the incentive-based compensation must be paid back to the company on a pre-tax basis and the executive officer may have already paid income and employment taxes on the amount being recovered, the executive would need to independently seek recoupment from the applicable taxing authority.

Board discretion.  The statute makes recovery mandatory and does not allow much exercise of discretion. In the proposal, the SEC provided for only two impracticability exceptions, and, with one addition, the SEC has adopted the rule substantially as proposed. Although comments submitted advocated that the SEC allow additional board discretion, the SEC interpreted the statute to reflect a congressional conclusion “that issuers likely would not voluntarily pursue recovery to the extent mandated by Section 10D,” allowing for only narrow exceptions. Accordingly, the final rule includes the following  impracticability exceptions, as proposed: “where (1) the direct cost of recovery would exceed the amount of recovery, and (2) the recovery would violate home country law and additional conditions are met.” To minimize any incentive countries may have to change their laws in response to this rule, the home country law must have been adopted prior to the date of publication in the Federal Register of Rule 10D-1. For the exception based on the expense of enforcement, the issuer must make a reasonable attempt to recover the compensation, must document the attempt and provide that documentation to the exchange.  Only direct costs paid to a third party to assist in enforcing recovery, such as reasonable legal expenses and consulting fees, may be considered for this purpose.  For the exception based on violation of home country law, the issuer must obtain and provide to the exchange an opinion of home country counsel, acceptable to the exchange, that recovery would result in a violation. The SEC declined to provide a similar exception related to conflicting state law, largely because it was not aware of any clear state prohibitions and because it was likely that state law would be preempted by federal law to the extent that it presented an obstacle to fulfilling state law objectives.

The final rules also add a new exception where “recovery would likely cause an otherwise tax-qualified retirement plan, under which benefits are broadly available to employees of the registrant, to fail to meet the requirements” of  applicable law. Compensation contributed to plans limited only to executive officers, SERPs or other nonqualified plans and related benefits would still be subject to recovery. 

The determination of impracticability must be made by the issuer’s independent comp committee or by a majority of the independent directors serving on the board, subject to review by the listing exchange.

In the proposal, the SEC concluded that issuers should have discretion to determine how to accomplish recovery, given that the appropriate means of recovery may vary by issuer and by type of compensation arrangement. For example, the SEC suggests, issuers may be able to cancel unrelated unvested compensation awards or future compensation obligations.  The final rules are consistent with the proposal, but provide that issuers must pursue recovery of excess incentive-based compensation “reasonably promptly,” which could include, for example, “establishing a deferred payment plan that allows the executive officer to repay owed erroneous compensation as soon as possible without unreasonable economic hardship to the executive officer, depending on the particular facts and circumstances.”

Disclosure of Issuer Policy on Incentive-Based Compensation

The statute requires the listing standards to call for disclosure of the policy of the issuer on incentive-based compensation. Issuers may be delisted if they fail to disclose, fail to adopt recovery policies or  fail to comply with the terms of their policies. In the final rules, the SEC is adopting the proposed disclosure requirements along with some additional requirements, including the following:

• File the recovery policy as an exhibit to its Form 10-K (Item 601(b)(97) of Reg S-K and corresponding requirements for FPIs);
• Disclose (and tag using inline XBRL) the information required by new Item 402(w) of Reg S-K (discussed below) as a separate item in proxy or information statements that call for Item 402 disclosure and in the Form 10-K (however, the information will not be deemed to be incorporated by reference into any filing under the Securities Act, except to the extent that the issuer specifically incorporates it by reference);
• Disclose the effect of any recovered amount in the Summary Compensation Table, including reducing the amount reported in the applicable  and “total” columns, and adding an identifying footnote (Item 402 of Reg S-K); and 
• Require the same Item 402(w) information for FPIs and listed funds;
• Add cover page check-boxes (tagged in Inline XBRL) for Forms 10-K, 20-F and 40-F to indicate separately (a) whether the financial statements of the issuer included in the filing reflect correction of errors to previously issued financial statements, and (b) whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the issuer’s executive officers during the relevant recovery period.

Disclosure under Item 402(w) will be applicable if the issuer was required, at any time during or after its last completed fiscal year, to prepare an accounting restatement that required recovery of erroneously awarded compensation under the issuer’s recovery policy or there was an outstanding balance as of the end of the last completed fiscal year of erroneously awarded compensation to be recovered from the application of that policy to a prior restatement. Item 402(w) will require the following disclosure:

Item 402(w) will also require that, if an impracticability exception is used, the issuer disclose, for each current and former named executive officer and for all other current and former executive officers as a group, the amount of recovery forgone and a brief description of the reason recovery was not pursued in each case, including which aspect of the exception made the recovery impracticable and additional context, such as, to the extent applicable, the types of direct expenses paid to a third party, the provision of conflicting foreign law or how the policy would cause the plan to fail to meet the applicable tax requirements. In addition, the issuer must disclose, for each current and former named executive officer, the amount of erroneously awarded compensation still owed that had been outstanding for 180 days or longer since the date the issuer determined the amount owed. Finally, Item 402(w) will require, if the issuer was required to prepare an accounting restatement, at any time during or after its last completed fiscal year, but concluded that a clawback was not required under its policy, the issuer must explain why it reached this conclusion under its recovery policy.

The SEC is also amending Item 404(a) of Reg S-K to provide that an issuer that complies with its Item 402(w) disclosure requirements need not disclose any incentive-based compensation recovery pursuant to Item 404(a).

Timing and Transition

The new rule will become effective 60 days following publication of the release in the Federal Register. Covered exchanges will be required to file proposed listing standards no later than 90 days following publication of the release in the Federal Register, and the listing standards must be effective no later than one year after publication. Each listed Issuer will be required to adopt a clawback policy no later than 60 days after the effective date of the applicable listing standards and will be required to comply with the disclosure requirements in the issuer’s proxy and information statements and annual reports filed on or after the issuer adopts its clawback policy.

The final rules provide that each listed issuer is required to comply with the recovery policy for all incentive-based compensation received by current or former executive officers on or after the effective date of the applicable listing standard (as opposed to the effective date of Rule 10D-1). In addition, each listed issuer is required to provide the disclosures required by the rule and Item 402(w) in applicable SEC filings required on or after the date on which the exchanges’ listing standards become effective. Note, however, that incentive-based compensation under a contract or arrangement that existed prior to the effective date of Rule 10D-1 but was not received until after the effective date of the applicable listing standards would still be subject to recovery under the final rules.