November 2, 2022 | Amanda Khatri
Estimated reading time: 5 minutes
New SEC clawback rule: erroneously awarded executive compensation to be reversed
On 26 October, the Securities and Exchange Commission (SEC) adopted rules that require listed issuers, also known as public companies, to have frameworks in place that will repossess incorrectly granted incentive-based compensation from current and former executives. This clawback rule applies even if the public company executive wasn’t responsible for the mistake.
This new SEC regulation implements a requirement of the Dodd-Frank Act and was inactive until SEC Chair, Gary Gensler, became regulator last year. Since Gensler’s arrival, the SEC has also passed the pay versus performance rule.
What are the new clawback requirements?
This long-awaited rule has been on the cards for over a decade. Under the rule, public companies that list securities are required to create and implement clawback policies that will demand back any “erroneously awarded incentive-based compensation.”
“Erroneously awarded” compensation refers to any compensation that is granted, earned or vested based wholly or in part upon the attainment of an incorrectly reported financial measure. In the instance of incorrect compensation, the public firm must recover the compensation from current and former executives. Listed companies must also disclose their policy information and compliance with the clawback regulation.
The rule applies to most public companies as well as “emerging growth companies,” “smaller reporting companies,” and “foreign private issuers.” Under the regulation, compensation examples that could be clawed back include “options and other equity awards.”
In Section 16 of the Exchange Act, the executive officer could be related to the following job titles:
- Principal financial officer
- Principal accounting officer or controller
- Vice President in charge of a principal business unit
- Officers who are in charge of policy-making or perform policy-making functions for the firm.
“I believe 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,” said SEC Chair Gary Gensler. “Through today’s action and working with the exchanges, we have the opportunity to fulfil Dodd-Frank’s mandate and Congress’s intention to prevent executives from keeping compensation received based on misstated financials.”
Key clawback rule takeaways
- Public companies have one year and 60 days after the rule has been published in the Federal Register to implement the changes. After being published, the regulation will be effective after 60 days.
- Companies are required to oversee a clawback analysis for “little r” accounting restatements. This is the most obvious difference from the SEC’s original proposal in 2015. It requires issuers to adopt a compensation recovery policy in the instance that:
“Big R” restatements, which correct errors that are material to previously issued financial statements.
“Little r” restatements, which correct errors that are not material to previously issued financial statements, but that would result in a material misstatement if the error were recognized or left uncorrected in the current period.
- The new regulation depicts incentive-based compensation as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.” This is so that the SEC can include new compensation and measures of performance.
- The maximum time allowed to retrieve the compensation has not been outlined, firms are required to recover the entire amount “reasonably promptly.”
- Each public company must report yearly the actions it has taken to comply with the regulation, including where a compensation error has been made and how clawback policies have been applied in these instances.
According to the SEC fact sheet, if the rule is not adopted and the clawback policy is not met, the public company will be delisted from the U.S stock exchanges.
To read the full set of rules, please click here.
SEC Commissioner, Hester Pierce opposes new rule
In a statement, SEC Commissioner, Hester Peirce argues that the clawback rule’s scope is far too broad and is not “limited to “Big R” restatements, which restate historical financial statements to correct errors that were material to those previously issued financial statements.” The rule applies to too many company employees and doesn’t properly define what an executive officer is.
The definition of “incentive-based compensation” is also too broad and there aren’t tangible metrics to identify this type of compensation.
We are entering an age in which financial services are becoming far more transparent. With tougher enforcement actions against wrongdoers and firms, it is not just a company that is getting into trouble, individuals are also being held to account for their errors in judgement.
The Financial Industry Regulatory Authority’s (FINRA) increased penalties for individuals, the US Department of Justice’s Deputy Attorney General, Lisa Monaco, honing in on accountability for corporate crime and the UK’s Consumer Duty to increase transparency and consumer trust are just some examples of this shifting regulatory landscape to becoming more transparent. This shift aims to fight corporate crime and maintain an innovative market whilst inciting consumers and investors to make informed financial choices.
Clawing back compensation from executives that were incorrectly handed out sets a clear standard of practice. It demonstrates that the SEC is depicting incorrect compensation handouts as wrong and anyone who has been involved in this will be held accountable. It ensures that all is right in the financial world and bad actors are pushed out and held accountable.
Public firms that do not disclose the clawback policies in place or do not comply will also be held accountable and there will be the repercussion of being delisted.
We advise US public companies to re-evaluate and understand the new clawback regulations, how they will affect current compensation policies and how they will need to be altered to ensure they align with the SEC’s new rules.
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