Come January 2023, the 118th Congress may launch a new deregulatory agenda, encouraged by increased Republican presence on the Hill and ready to do battle with what may be a waning Biden legacy. While votes are still being counted, for some it feels like déja vu of January 2017, when a newly elected Republican Congress and White House set about dismantling existing rules and delaying pending ones.
One regulation unlikely to be affected by this shift in power, however, is the new clawback rule passed by the US Securities and Exchange Commission (SEC) on Oct. 26. The new rule could be challenged in court, but boards cannot count on a strike down. With the stock exchanges in charge of implementation and enforcement, and with a three-to-one Democrat vote at the SEC assured through at least January 2025, it is clear that the claws will soon be out for executive pay affected by restated financials.
A New Challenge
On Oct. 26, 2022, with the passage of a new rule on Listing Standards for Recovery of Erroneously Awarded Compensation, the SEC set up a new challenge to US public company boards and compensation committees. The final rule, implementing Section 954 of the Dodd-Frank Act of 2010 at long last, will greatly expand the circumstances under which companies must recover (or “claw back”) executive pay, and will impose new and complex disclosure requirements when doing (or not doing) so.
The transition will not be easy for boards. For the past 20 years, under the Sarbanes-Oxley Act of 2002, public companies have had no explicit obligation to claw back pay except in case of fraud. But soon (early to mid-2023, depending on how long it takes the exchanges to convert the SEC rule into accepted listing standards) exchange-listed companies will be required to develop, disclose, and implement policies to claw back executive pay under a wide array of specific circumstances, including unintentional, immaterial errors in accounting statements going back three years from the time of restatement. The final rule offers as an example a board’s decision in 2023 that the company will restate previously issued financial statements for 2020 through 2022, which it calls “the three-year performance period,” (note 210 on p. 69).
Under the new clawback regime, all listed companies must have clawback policies, and these policies must require recovery of any incentive-based compensation paid to its current or former executive officers (a very broad term left undefined) based on a misstated reporting measure, with the scope of the recoupment extending back three years prior to the time the restatement was required.
Clawback policies of Nasdaq-listed companies will come under review by the Nasdaq Investigations and Enforcement Team, while those listed on the New York Stock Exchange (NYSE) will be monitored by NYSE Regulation. The SEC will continue to monitor compliance with the clawback rules under Sarbanes-Oxley, which are written as SEC disclosure requirements, not stock exchange listing requirements.
The rule requires not only clawbacks triggered by so-called “Big R” restatements, which restate historical financial statements to correct errors that were material to those statements, but so-called “little r” restatements, by which companies restate prior period information within in the current period’s financial statement. A company must claw the pay back unless the likely cost of doing so is higher than the amount that would be recovered, along with two other narrow exemptions (home-country law and tax-qualified retirement plans). New Item 402(w) of Regulation S-K also requires the issuer to disclose why it determined not to pursue recovery, if that is the case. Any such determination must be made by the company’s committee of independent directors that is responsible for executive compensation decisions, or, in the absence of a compensation committee, a majority of the independent directors serving on the board (SEC rule, p. 95).
Under the rule, companies must take back the difference between what was actually paid under the incorrect statement and what would have been paid under a correct statement. As described in the SEC’s fact sheet on the rules, each company must include its policy as an exhibit to its annual report on Form 10-K and disclose in the 10-K (and proxy statement, as applicable) how it has applied the policy, including “the estimates used in calculating the recoverable amount in the case of awards based on stock price or total shareholder return.” This is just one example of the kind of complexities buried in the rule.
When the SEC rule requiring these listing standards was first proposed in 2015, NACD objected to including stock price calculations in the rule in a detailed comment letter responding to 14 clusters of questions (115 questions in all) about timing, triggers, definition of excess pay, and other factors. In the letter, we argued, among other points, that stock price-based incentives fall outside the scope of Congress’s intent. In the original language of Dodd-Frank Section 954, we said, the required clawback policy was intended to cover “incentive-based compensation that is based on financial information required to be reported under the securities law.” In our view, this did not require some arcane calculation of the difference in stock price that would have resulted had the restated financials been issued at the time of the erroneous financial statement. Equity markets judge the value of individual securities on the basis of multiple contemporaneous factors; replicating these for the purpose of determining a clawback would be at best difficult and at worst a “windfall for the plaintiffs’ bar,” we said, citing the comment of Pearl Meyer’s David Swinford.
The comments from NACD and Swinford were two of only 115 submitted during the seven years this rule awaited approval—most of them critical of the rule. Noticeably absent from the commentary was unified support from a variety of institutional shareholders such as BlackRock or State Street. Only the Council of Institutional Investors, a venerable but small trade group representing 140 pension funds, along with two of its members on the public side signaled their support for the proposed rule. The major index funds and proxy advisory firms did not comment.
The lack of support from leading shareholders is not surprising. To date, evidence of proactive shareholder demand for stricter clawback policies has been scarce. In 2022, of the 250 largest US public companies, according to Proxy Monitor, only three had proxy resolutions to institute new clawback policies (Marathon Oil Corp., Verizon Communications, and Wells Fargo & Co.), and none of these passed. Not surprisingly, the NYSE itself, now responsible for implementing the final rule, submitted a comment in 2021 objecting to the prescriptive, one-size-fits all nature of the then-proposed rule.
The Work Ahead
Boards have their work cut out for them. While more than 90 percent of all companies in the S&P 500 (and more than half in the Russell 3000) already have clawback policies according to current research from Institutional Shareholder Services, few conform entirely to the detailed demands of the new rule; new and stricter policies will need to be developed. Companies have about a year to get ready.
The likely timeline for rule implementation is as follows:
November 2022: Rule published in the Federal Register
February 2023: Exchanges propose listing rules
March 2023: SEC approves listing rules
November 2023: New listing rules effective
January 2024: Companies publish 10-Ks, proxies
As shown, regulatory implementation will occur in phases. The stock exchanges have up to 90 days to convert the SEC rule into listing standards. The new stock exchange listing standards must be effective at the latest by one year after publication of the SEC clawback rule in the Federal Register. Companies will then have up to 60 days to comply. The process will take time, but the outcome is inevitable: boards must work with their company officers and professional advisors to ensure that company clawback policies capture all aspects of the new rule.
Seven Steps to Consider
While the rules will not be written in stone (they could be subject to challenge in court, and they could get reversed in 2025, depending on 2024 election results), they are the law of the land now and a cost of doing business as a public company. Boards should not wait for the stock exchanges to propose their listing rules. The time to act is now. Here are seven actions boards and their committees can take to avoid running afoul of the new rule.
Identify both internal and external resources to create a new clawback policy compliant with the new rule. This is not a do-it-yourself project. Experts are available and the board should retain them. While it is not exactly rocket science, it is complex and highly legalistic—and not a rabbit hole into which directors need to fall.
Have the audit committee perform a check on the quality of financial reporting at the company to lessen the chance of any financial restatements, no matter how trivial.
As needed, invest in the internal audit function and increase communications over reported financials. Stay on top of it.
Analyze and consider revising incentive plans to minimize their exposure to restatements.
Check your directors and officers’ insurance policies to ensure coverage against the kind of shareholder lawsuits that could be forthcoming, given the lack of a safe harbor in this new rule.
Encourage the company to communicate these early proactive measures during the upcoming 2023 proxy season as an aspect of say-on-pay communications.
Continue to weigh the pros and cons of continuing as a public company, given the challenges of regulatory requirements such as these.
Despite its overreach, the new clawback rule requires preparation and compliance, at least for the next two years. Boards must familiarize themselves with the rule and meet its demands, relying on qualified advisors. Ideally, boards will work speedily to update their clawback policies, but never be forced to implement them.