Understanding the updated SEC clawback rules

What executives and leadership teams need to know

Sep 14, 2023
Financial consulting
SEC matters Dispute advisory Financial investigations Financial management

On Oct. 26, 2022, the United States Securities and Exchange Commission (SEC) adopted a new rule and rule amendments to require stock exchanges to update their listing standards for registrants to include compliant clawback rules.

Summary of key provisions and affected parties

Listed companies will need to standardize requirements for the recovery of incentive-based compensation erroneously awarded to executive officers due to material financial statement misstatements. The rule implements section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). The rule was effective on Jan. 27, 2023, and both the NYSE and Nasdaq submitted their proposed listing standards to the SEC on Feb. 22, 2023. The listing standards need to go into effect by Oct. 2, 2023. Issuers will have 60 days from the date the listing standards are implemented to adopt a compliant clawback policy, which will be by Dec. 1, 2023, at the latest.

The SEC clawback requirement affects executives of most listed companies that received incentive-based compensation during the three fiscal years preceding an accounting restatement. Emerging growth companies, smaller reporting companies, and foreign private issuers are not exempt.

The term executives are not explicitly defined by the SEC, but will apply at a minimum to the president; principal financial officer; principal accounting officer or controller; and vice-president of the issuer in charge of a principal business unit, division or function; and any officer who performs a policymaking function. The scope of the new rule requires recovery of all incentive-based compensation, including incentives based on metrics such as stock price and total stockholder return. As a result, in addition to cash compensation, this rule will also affect stock options awarded as compensation. The nature of the clawback could include the recapture of stock options previously awarded, regardless of whether they have been exercised. The determination of the number of options to be clawed back will be subject to analysis and may require the involvement of valuation experts.

Affected companies will be required to develop and document a clawback policy, which must be disclosed in an exhibit to its annual report. Additional disclosure will also be required in the event there is a restatement that triggers a clawback, including the aggregate dollar amount of erroneously awarded compensation, estimates used to determine the amount, and the names of the executive officers affected, including the total amount clawed back from each individual and the outstanding amounts.

SOX 304 v. Dodd-Frank Act clawback

The new regulation has expanded the scope of the existing clawback provision stated in section 304 of the Sarbanes-Oxley Act (SOX 304), which will result in an impact on a larger number of companies and individuals. The Dodd-Frank Act clawback is triggered as soon as a restatement is required, whereas SOX 304 only applies if a claim is made by the SEC. Additionally, the Dodd-Frank Act clawback applies to both so-called "little r" and "Big R" restatements, whereas SOX 304 has only historically been applied to a portion of Big R restatements.

In addition to the increased number of affected companies, the number of individuals within a company affected by the new rules will also increase. SOX 304 applies when the restatement is a result of misconduct, and applies only to incentive compensation received by the CEO and chief financial officer. The new Dodd-Frank Act rule applies to both current and former executives, regardless of fault. This ruling affects executives at both the parent and subsidiary levels, where applicable.

Boards are prevented from reimbursing or indemnifying executives, and the clawback cannot be offset against future payments. There are only two allowable situations where recovery may be deemed impracticable: where (1) the direct cost of recovery would exceed the amount of recovery, and (2) the recovery would violate home country law if additional conditions are met. When determining if the cost of recovery exceeds the amount to be collected, companies can only include direct costs paid to a third party, such as reasonable legal expenses and consulting fees. Indirect costs may not be included in the analysis.

According to an Audit Analytics report, the total number of restatements declined by over 80% during the period from 2006 through 2020. Despite this, the inclusion of little r restatements in the Dodd-Frank Act rule could result in a considerable increase in the number of companies and executives that could be subject to clawback of incentive compensation. In 2020, 246 little r restatements accounted for 76% of all restatements, a number which has continued to increase since 2005.

Additionally, SOX 304 has historically only been implemented in a fraction of Big R restatements. Following the implementation of SOX in 2002, the provision was not utilized until 2007 and hasn’t been widely used in practice since.

How to protect against clawback

The expanded scope of the new SEC ruling and lack of discretion granted to boards in whether to recover the incentive compensation could result in a disproportionate impact on companies in the middle market. Smaller reporting companies are not exempt from the ruling, and due to a lower respective quantitative materiality threshold may be more susceptible to experiencing a restatement.

The most effective way to avoid the consequences of the new SEC clawback regulations is to build a strong system of internal controls and a strong team with appropriate experience and expertise, mitigating the possibility of a restatement. Strong internal controls implemented and enforced by an experienced team:

  • Appropriately analyze and account for complex transactions
  • Mitigate the risk of financial inaccuracy due to fraud or error

The control environment should include both preventive controls, which are implemented to decrease the possibility of inaccuracies due to fraud or error, and detective controls, which serve to identify, in a timely manner, inaccuracies that have already occurred. Preventive controls avoid inaccuracies that could require a restatement, to begin with. Detective controls can identify errors timely and allow the company to correct them before financial statements are issued.

Listed companies subject to the new regulation should start working now to evaluate ways to enhance their current control environment. A comprehensive risk assessment performed by experienced personnel is the most effective way to evaluate existing controls and identify control gaps. For companies with less mature internal audit departments or less experienced accounting personnel, this may require involving external advisors with the required experience and knowledge.

Once a risk assessment has been performed, companies can identify areas where controls or department personnel need to be enhanced or implemented to mitigate the risk of financial inaccuracy that might lead to a restatement. New policies need to be established to document how companies will comply with the SEC clawback rules.  Companies should ensure that any new or enhanced control policies are documented, including identification of responsible parties and frequency.

Under the new SEC rules, recovery of incentive-based compensation paid to executives over the previous three years will be triggered as soon as a restatement is required, without discretion. To avoid a clawback enforcement action, ensure a strong internal control environment exists. Seek the necessary knowledge required to build this type of environment; when the knowledge does not exist in your company, seek out external advisors to help your company achieve a sound control environment.

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