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The Final SEC Clawback Rules: Insights, Best Practices, and More
To state the obvious, the final clawback rules from the SEC can wield a dangerously heavy hammer for organizations and leaders caught unprepared. That's why we're delving into the intricacies of these new regulations, providing valuable insights that CEOs, CFOs, CAOs, and other corporate leaders should take to heart. Seriously.
In fact, we're going to discuss the most relevant and impactful areas of the new clawback rules, specifically:
- The New SEC Clawback Rule and Its Importance
- Triggers for Clawbacks Under SEC Rules
- Scope of Incentive Compensation Subject to Clawbacks
- Executive Officers Subject to Clawback Policies
- Lookback Period for Clawbacks
- Disclosure Requirements for Clawback Events
- Accounting Considerations and Enforcement Challenges for Clawbacks
Sounds like a hoot, right? We thought so, too. So, on that note, let's dive right in.
The New SEC Clawback Rule and Its Importance
The Securities and Exchange Commission (SEC) built on the compensation recovery provisions of the Dodd-Frank Act by implementing its new clawback rules, posing significant possible changes for companies and their executive compensation policies. These long-awaited final rules now require issuers to adopt and comply with their national exchange’s updated listing standards on executive compensation clawbacks. So, to put it mildly, companies need to get their compensation policies compliant and in check. Pronto.
Compensation Recovery Provisions under Dodd-Frank and SOX
Before diving in head first, let’s start with a bit of history. Thanks to the many corporate scandals involving misstated and misleading annual reports and financial statements in the last couple of decades, Congress and regulators have enacted sweeping laws like the Dodd-Frank Act and the Sarbanes-Oxley Act (SOX). These pieces of legislation have aimed to enhance transparency in financial reporting by requiring companies to implement more robust internal controls over their accounting practices.
In the case of Dodd-Frank, its Section 954 required listed companies to establish a compliant clawback policy for recovering erroneously awarded incentive-based compensation from named executive officers.
Going back even further, Section 304 of SOX contained a recovery provision triggered when an accounting restatement results from an issuer's misconduct. Granted, this new Exchange Act Rule 10d-1 from the SEC is different in critical ways, but, as history demonstrates, the spirit behind it isn't a recent phenomenon.
Compliance with Written Policy on Executive Compensation Clawbacks
To ensure compliance with these new regulations, public companies must now develop comprehensive written clawback policies. These policies should outline their approach to identifying instances where they need to recover incentive-based compensations due to material noncompliance with federal securities laws. Going forward, companies should also conduct regular reviews of existing clawback policies, updating them to account for any changes in regulatory requirements or best practices within their industry.
In a broader sense, this increased focus on establishing transparent processes around executive pay recoupment highlights how crucial it is for CFOs and other finance leaders to understand these new rules. By taking proactive steps and implementing them effectively within their organizations, they can help protect shareholder interests while minimizing potential legal and reputational risks associated with noncompliance.
Triggers for Clawbacks Under SEC Rules
The new SEC clawback rules require companies to identify clawback triggers and make a reasonable attempt at recovering erroneously awarded incentive-based compensation (IBC) "reasonably promptly" within a three-year lookback period. As for triggers, that’s where ASC 250 and "Big R" and "Little r" restatement filings enter the fray – more on them in just a bit – both of which can trigger clawbacks that hit executive officers squarely in the pocketbook, even if they weren’t responsible or aware of the misconduct or events leading to restatements.
No-Fault Basis for Triggering Clawbacks
Building on that last point, the SEC has adopted a no-fault approach to enforcing clawback policies, mainly to protect investors and maintain market integrity. Therefore, even if an executive officer was not directly involved in any wrongdoing or didn’t know about the misstated financial reporting measures, they may still be subject to clawback.
The rationale for the SEC's no-fault approach to enforcing clawback policies is straightforward – it encourages executive accountability over a company's financial reporting, thereby promoting better oversight and increased transparency.
Big R vs. Little r Restatement filings
The clawback trigger applies equally to both Big R and little r restatements. Looking at each a bit closer:
- Big R Restatements: These are significant corrections companies make due to material noncompliance with federal securities laws. They typically involve substantial errors in previously issued financial statements that require immediate attention from regulators like the SEC.
- Little r Restatements: Conversely, these represent smaller error corrections and adjustments that do not necessarily indicate material noncompliance. They may result from minor errors or misinterpretations of accounting standards and usually do not warrant regulatory intervention.
Since both types of restatements can trigger a clawback event, companies have increased scrutiny to ensure accurate financial reporting and maintain robust internal controls. However, this poses an even bigger question – once a clawback is triggered, what does a company do from there? That leads us to the scope of IBC subject to clawbacks, how recovery policies and processes apply, and what a recovery analysis must include when evaluating executive officers' performance.
The SEC's new clawback rules require companies to recover erroneously awarded incentive-based compensation received within a three-year lookback period, regardless of whether executives were involved in any wrongdoing in the prior periods. As a result, both Big R and little r restatements can trigger a clawback event, highlighting the importance of accurate financial reporting and robust internal controls.
Scope of Incentive Compensation Subject to Clawbacks
The new SEC rule directs national securities exchanges to recover incentive-based compensation received and based on misstated financial measures. Besides the requirements on the stock exchanges, this significant shift in the regulatory landscape also requires listed issuers – with very limited exceptions – to carefully review these requirements and take proactive steps toward compliance. Aside from the usual suspects, note the final rule also applies to:
- Emerging growth companies (EGCs)
- Smaller reporting companies (SRCs)
- Foreign private issuers (FPIs)
- Controlled companies
Further, a wide range of non-GAAP measures and performance metrics derived from the financial statements could potentially trigger clawback events, including:
- Total shareholder return (TSR)
- Share price
- Return on equity (ROE)
- Revenue growth
When a company uses a stock price or TSR as the financial reporting measures to determine a payout, it can use reasonable estimates to understand how their restated financial statements would impact those financial measures.
Types of IBC
We covered the scope of IBC subject to clawbacks in the SEC ruling so now let’s focus on the types. The rule defines IBC as "any compensation that is granted, earned or vested based wholly or in part on the attainment of any financial reporting measure." That said, the form of compensation can take many forms – cash-based incentive awards, bonuses paid from a bonus pool, stock options, RSUs, SARs, and proceeds from the sale of shares, to name a few.
Also, note that compensation not based on a financial reporting measure is not subject to the recovery policy. For example, this would include awards with vesting conditions tied to operational goals or based exclusively on employee service.
Material Noncompliance with Reporting Requirements
Clawback policies apply to executive officers who have received IBC during a period of material noncompliance with financial reporting requirements. Again, this includes instances where the company must prepare an accounting restatement due to material misstatements and errors in its previously issued financial statements.
When determining whether there has been material noncompliance, companies should consider factors such as:
- The magnitude and nature of the error
- The impact on key performance indicators or metrics used for calculating ICB
- Whether the error was intentional or resulted from negligence
Key Considerations When Implementing Clawback Policies
As a best practice, companies should take into account several important considerations when implementing compliant clawback policies:
- Review existing agreements: Examine current employment contracts, award agreements, and indemnification agreements with executive officers to ensure they align with the new SEC rule and national exchange listing standards. If necessary, update these documents accordingly.
- Align policy language: Create clear and consistent language across all company documents referencing clawbacks – like proxy statements – specifying what types of events trigger recoupment actions.
- Evaluate communication strategies: Prioritize transparency by proactively communicating your company's approach towards enforcing clawback provisions, both internally – with employees– and externally with shareholders and other stakeholders.
In addition, note that boards have no discretion regarding pursuit of recovery, with three limited scenarios where such pursuit isn’t required:
- Direct expense paid to a third party to assist in enforcing the policy that would exceed the amount to be recovered, applicable only after making a reasonable attempt to recover;
- Recovery would violate home country law that existed before the publication of the new rule in the Federal Register, in which an issuer must obtain a legal opinion in support of this condition;
- Recovery would likely cause certain tax-qualified retirement plans to not meet the relevant legal requirements.
Executive Officers Subject to Clawback Policies
To ensure full compliance with the new regulations, companies should also reevaluate their process of identifying executive officers who may be subject to recoupment under these provisions. As part of this effort, organizations need to:
- Analyze current policies and procedures for defining "executive officer"
- Review applicable definitions under Exchange Act Rule 16A-1(f), better known as Section 16
- Assess the impact of these changes on existing clawback policies and make necessary adjustments
Identifying Affected Executives
Section 16 defines an "executive officer" as a person, both current or former, occupying such roles as president, principal financial officer, principal accounting officer or controller, and any vice president in charge of a major business unit or function. Thus, as a rule of thumb, companies should:
- Review existing roles: Companies should review their current organizational structure and job descriptions to determine if they align with the definition provided by Section 16
- Create a list: Once a company has identified all relevant positions, it should create a comprehensive list of individuals occupying those roles during each fiscal year within the lookback period
- Maintain records: An enterprise should keep detailed records on changes in executive leadership over time so that it can quickly identify affected individuals in policy-making functions, just in case a clawback event occurs
To comply with SEC clawback rules, companies must identify executive officers subject to potential recoupment due to material noncompliance with reporting requirements under federal securities laws. This involves reviewing existing roles, creating a list of affected individuals and maintaining records. Companies should also consider factors such as the magnitude and nature of errors when determining whether there has been material noncompliance and align policy language across all company documents that reference clawbacks while prioritizing transparency in communication strategies.
Lookback Period for Clawbacks
The new SEC clawback rules require companies to recover erroneously awarded incentive compensation within a three-year lookback period. By using this period as a standard timeframe for all listed companies, the new clawback rules ensure consistency of enforcement and applicability across industries and organizations.
For example, if a calendar year-end company identifies an accounting restatement in December 2024, the lookback period would include fiscal years 2021 to 2023. This holds true even if those restated financial statements are not filed until the subsequent year.
To put a finer point on it, a business bases the year in which incentive-based compensation is considered awarded or received on when the award’s financial reporting measure is attained, not on when the award is granted or paid.
Applicability of the Lookback Period
The three-year lookback period applies regardless of whether an executive officer was responsible for or aware of any misconduct leading to restatements. As long as there has been material noncompliance in financial reporting – thus, triggering a need for restatement – affected executives may be subject to clawbacks within this specified timeframe, making it necessary to:
- Determine if any past errors warrant recoupment: Review historical financial statements and identify instances where inaccuracies led to overpayment of incentive-based compensation
- Evaluate current policies and procedures: Assess existing internal controls related to financial reporting and ensure they adequately address risks associated with erroneous awards that may trigger clawbacks
- Establish a process for identifying and recovering excess compensation: Develop a systematic approach to recoup erroneously awarded incentives, including communication with affected executives, calculation of the recoverable amount, and documentation of recovery efforts
To maintain compliance with SEC rules and avoid potential penalties or enforcement actions, a company must remain vigilant in monitoring financial reporting practices and proactively addressing any issues that may lead to restatements requiring clawback action. By understanding the lookback period's applicability and taking steps to ensure accurate financial reporting, you can help protect your organization from costly clawback situations.
The new SEC clawback rules require companies to recover erroneously awarded incentive compensation within a three-year lookback period. This applies regardless of whether or not an executive officer was responsible for the misconduct leading to restatements. Accordingly, companies should establish a process for identifying and recovering excess compensation while ensuring accurate financial reporting.
New Policy and Disclosure Requirements for Clawbacks
As part of the new SEC clawback rules, listed companies must adopt their compliant clawback policy within 60 days of the effective date of listing rules, not to mention some essential disclosure requirements. And, yes, those are as important as they sound, so let’s discuss some key policy, reporting, and disclosure elements within the new clawback rules.
Filing Compliant Clawback Policies
A comprehensive and clear clawback policy should outline how a company plans on recovering erroneously awarded incentive-based compensation from executive officers when necessary. It must also detail procedures for identifying affected executives and determining the aggregate dollar amounts subject to recoupment.
Key Disclosure Elements Required by SEC
The following are some critical elements companies should include in their clawback disclosures:
- Events triggering a clawback event: Clearly define what constitutes an event that would trigger a potential recovery action under your company's clawback policy. Examples include material noncompliance with reporting requirements under federal securities laws or other instances leading to restatements in the last completed fiscal year.
- Incentive-based compensation subject to potential recoupment: Provide details about which types of IBC may be subject to recovery actions. This may include stock options, restricted shares, performance share units (PSUs), or non-equity incentive plans like cash bonuses tied directly or indirectly to financial measures like revenue growth or EPS. Note, the new rule doesn't apply to time-vested stock options, time-vested restricted stock, base salaries, tax-qualified retirement plans, or discretionary or subjective bonuses not linked to the attainment of a financial reporting measure or metric.
- Identification criteria for affected executives: Outline the process and criteria used to identify executive officers who may be subject to clawback actions. This should include factors like their role in the company, involvement in financial reporting or oversight, and any other relevant considerations.
- Recovery procedures: Describe how your company will pursue affected executives for recovery of incentive-based compensation you erroneously awarded. Include information about timelines, legal processes, and potential challenges that may arise during enforcement efforts.
In addition to these key elements, companies should also consider disclosing any significant changes made to their existing clawback policies as a result of adopting the new SEC rules. By providing clear and comprehensive disclosures related to your company's clawback policy, you can demonstrate commitment toward transparency and accountability while minimizing potential regulatory risks associated with noncompliance.
Simply put, you must disclose your clawback policies in a compliant manner, heeding the regulatory nooks and crannies in the new rule that a CFO might otherwise inadvertently miss. To that point, the new rule amends Form 10-K, Form 20-F, and Form 40-F cover pages, adding checkboxes to indicate:
- Whether the issuer's financial statements included in the filing reflect a correction of an error to previously issued financial statements, and;
- Whether any of those error corrections are restatements that required a recovery analysis of IBC received by any executive officers during the relevant recovery period
Also, when a restatement – whether Big R or Little r – occurs, a company must check both boxes if the three-year recovery period included IBC for its executive officers. This is true even if the company determines it provided no excess IBC to the executives. Further, the company must also tag the checkboxes and other specific data points in its recovery policy via XBRL tagging.
Finally, the new rule also requires listed issuers to disclose their recovery policies as exhibits in their annual reports.
Listed companies must file their compliant clawback policy with the SEC within 60 days of listing rules to ensure transparency and accountability in executive compensation practices. To comply, companies need a well-documented and comprehensive clawback policy outlining how they plan on recovering erroneously awarded incentive-based compensation from executive officers when necessary. Key disclosure elements required by the SEC include events triggering a clawback event, identification criteria for affected executives, recovery procedures, and details about which types of incentive-based compensations may be subject to recovery actions.
Accounting Considerations and Enforcement Challenges for Clawbacks
As companies navigate the new SEC clawback rules, it’s essential to consider various accounting aspects that could impact their compliance efforts. Depending on the type or nature of the IBC subject to recovery, the accounting may fall under the purview of ASC 718, ASC 710 or ASC 450. Since questions often arise around the accounting for clawback provisions for awards subject to ASC 718, we’re going to hone in on them specifically.
ASC 718 Accounting Considerations
Recoveries of share-based payments are viewed as clawback features under ASC 718. Put differently, they are not factored into the determination of the grant-date fair value of the award, nor in recognizing compensation cost. Instead, companies account for clawback features when the entity receives the consideration triggered by the clawback provision. In other words, they are contingent events recognized when they occur.
Keep in mind, however, that adding a recovery policy to a share-based award does not necessarily trigger modification accounting for the award under ASC 718 since such a policy does not impact an award’s fair value on its own. If a company – in tandem with adding a recovery policy to an award agreement or plan – also included other changes that impacted vesting conditions, fair value, or classification, then modification accounting would apply.
Another common question around ASC 718 is whether or not a clawback policy impacts the establishment of a grant date under the standard. A critical criterion for establishing a grant date is a mutual understanding of key terms and conditions of an award between the grantor and grantee. When key terms and conditions of an award are highly subjective or discretionary, it can prevent the establishment of a grant date for accounting purposes.
In these instances, companies will need to ensure their policies are clear and objective to ensure they meet the criteria to establish a grant date. However, policies that are amended with this new rule should not generally impact the grant date determination because those clawback triggers are objective.
Board Discretion on Recovery
The rule provides flexibility to Boards in exercising discretion for how they recover impacted IBC amounts subject to clawback. The means of recovery will vary based on facts and circumstances from company to company. For example, some boards may provide a payment plan to executives as a means of recovery.
In addition to the means of recovery, companies should also be mindful of other factors affecting clawback enforcement, such as indemnification agreements and fiduciary duty. For instance, companies are specifically prohibited from indemnifying any executives against the potential clawback of erroneous IBC. Therefore, by addressing these issues proactively, organizations can better prepare themselves for compliance with the new SEC rules while minimizing potential risks associated with clawbacks.
Just remember, the enforcement of clawback policies will likely be an area of scrutiny for regulators, so companies must establish clear guidelines and processes for implementing these policies effectively.
Ensuring Proper Implementation Through Clear Guidelines
Obviously, companies must carefully assess their existing clawback policies to strike the right balance between materiality concerns and regulatory compliance. This involves evaluating factors such as:
- The nature of the restatement triggering the clawback;
- The amount of incentive-based compensation at stake;
- Potential reputational risks associated with pursuing or not pursuing a recovery; and
- The costs involved in enforcing the policy.
On the process improvement front, companies should consider taking several steps to ensure proper implementation of compliant clawback policies:
- Create well-defined criteria for identifying affected executives: Companies need a consistent approach when determining which executive officers, both current and former, are subject to potential recoupment due to material noncompliance with reporting requirements under federal securities laws.
- Maintain accurate records related to incentive-based compensation: Companies should keep detailed records of all forms of incentive-based compensation, including performance metrics, vesting schedules, and award agreements.
- Develop a clear process for clawback analysis and decision-making: The board of directors or its designated committee should establish procedures for evaluating potential clawback events, considering factors such as materiality, costs associated with enforcement actions, and the impact on shareholder value.
- Communicate the company's clawback policy to stakeholders: Transparency is vital in maintaining investor confidence. Companies should disclose their compliant clawback policies in accordance with SEC requirements under new Item 402 disclosures of Regulation S-K.
- Create a system for monitoring compliance: Regularly review existing policies to ensure they remain up-to-date with evolving regulations and best practices. Additionally, companies may consider engaging external advisors or auditors who can provide an objective assessment of their current processes.
To tie a bow around these points, companies must obviously be diligent in implementing effective guidelines that balance regulatory compliance and business needs. By taking proactive steps to update existing policies and establish robust internal controls around executive compensation recovery efforts, organizations can better position themselves for success amid ongoing regulatory scrutiny.
Companies must establish clear guidelines and processes for implementing clawback policies effectively, while balancing materiality concerns with regulatory compliance. This involves evaluating factors such as the nature of the restatement triggering the clawback, potential reputational risks associated with pursuing or not pursuing a recovery, and creating well-defined criteria for identifying affected executives. To ensure proper implementation of compliant clawback policies, companies should maintain accurate records related to incentive-based compensation and develop a clear process for decision-making while communicating their policy to stakeholders.
The new rules related to listing standards for recovery of erroneously awarded compensation were published in the Federal Register on November 28, 2022, establishing the following important deadlines:
- January 27, 2023: The date the final rule became effective, 60 days after publication in the Federal Register
- February 24, 2023: The date national stock exchanges had to file new listing standards by in compliance with the final SEC clawback rules
- November 28, 2023 or sooner: The date listing standards must be approved by the SEC and become effective
- Impacted companies must adopt a recovery policy 60 days following the date the listing standards are approved and become effective
The bottom line – as the timeline above indicates, companies will need to have a compliant recovery policy in place by the end of 2023 or early 2024 at the latest.
A Final Word from Embark
Suffice it to say, the new SEC clawback rules are essential for leadership positions in corporate accounting and finance functions to understand. But that can be a feat in itself given the complexities involved. So, to state the obvious, if you need help navigating this morass of regulatory goodness, Embark is at the ready. We’ve been there, done that, and have the expertise and experience to help you get and stay compliant. So let’s talk.