SEC’s long-awaited clawback rule leaves unanswered questions

It’s been a long time coming, but the SEC has finalized the compensation clawback rules for financial statement fraud and errors mandated by the 2010 Dodd-Frank Act.

The finalized clawback rule—which calls for executives to return performance-based compensation and incentives if fraud or errors require a financial restatement—now requires publicly listed companies to develop and disclose a clawback policy, or risk being delisted. And, such companies will now be required to file their clawback policies with the SEC and include them in their annual reports.

“I believe that these rules, if adopted, would strengthen the transparency and quality of corporate financial statements, investor confidence in those statements, and the accountability of corporate executives to investors,” SEC chairman Gary Gensler said in a statement before the rule was implemented.

While Dodd-Frank legally mandated the SEC to pass it, the finalized rule is broader and has more stringent criteria for clawbacks than original proposals.

“We shouldn’t hold corporations accountable for misconduct when we could instead hold the individuals who did the wrongdoing accountable. This is one way to get that accountability at the individual level,” said Matt Kelly, editor of Radical Compliance, a newsletter that follows corporate compliance and governance issues. “It’s not a bad idea; it’s just the implementation of it might be challenging.”

There are broad guidelines in the rule that set out clawback policies and procedures. However, practically accounting for who is responsible—and for how much—raises several challenges that finance departments are going to have to help organizations figure out as the rule comes into effect.

“That will be very difficult. I think companies are still feeling their way through that,” said Liz Dunshee, managing editor of CCRcorp, a legal publisher of board advisory resources. “That’ll be a big part of this: coming up with the processes for performing those calculations, which I imagine the finance team would be involved in.”

Digging in the claws. In the wake of the 2008 financial crisis, the 2010 Dodd-Frank Act mandated clawbacks in instances leading to a material restatement of past financial statements—also known as a “Big R restatement.” So imagine Enron admitting, “Golly, wouldn’t you know it? We didn’t actually have all that revenue,” and the executives having to give back all those fat stock and performance bonuses.

The new rule goes a step further and requires a clawback not just in cases of fraud or malfeasance leading to historical revisions, but in cases where accounting errors lead to adjustments in current statements—known as “little R restatements”—that don’t materially impact the statement. For example, if a company adjusts the way it accounts for leases, but that change doesn’t affect the bottom line, that adjustment would fall under the little R category.

According to the SEC, Big R restatements are decreasing, but little R restatements are seeing a significant increase, rising from 35% of all restatements in 2005 to 76% in 2020, according to the SEC.

The second, perhaps greater challenge for finance departments, is accurately assessing who would be held responsible and what the clawback penalty should be, Kelly said.

“What was the wrong amount of executive pay that was issued? What’s the right amount now that we’ve recalculated because we’ve cleaned up our financials?” he mused. “Understanding who would be covered by this is also unclear right now.”

Answering those questions is further complicated by the often quixotic ways that executives are compensated, said Dr. Thomas Kubick, professor of accounting at the University of Nebraska-Lincoln.

“If you have compensation metrics that are triggered by meeting a certain stock price or a certain stock return, and you have to reissue those financial statements, then this final ruling obligates the company to go back and reassess exactly how much incentive compensation you received that was erroneous,” Kubick said.

Start your engines. The rule is likely to take effect roughly a year from now, and the SEC may provide more specific guidance between now and then. But no matter what the SEC ultimately decides, finance departments should start preparing for the rule now, Dunshee told CFO Brew. That means coordinating policies and procedures around clawbacks with HR, finance, compensation committees, and legal teams.

“Some of it is going to be the CFO’s problem to solve. Some of it is going to be the general counsel’s problem to solve,” added Kelly. “But I would not recommend the CFO and general counsel try to solve their respective problems in a vacuum. You’re going to have to figure this out in a unified way.”—DA