After a decade of political quagmires, the Securities and Exchange Commission (SEC) last month finally enacted new rules that allow incentive-based compensation to be recouped from public company executives in the event of financial restatements. Here’s what companies, their senior executives and risk professionals need to know and how they can prepare.
Recovering executive compensation
In 2010, in the wake of the financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed by Congress and signed into law. Dodd-Frank included many provisions intended to protect investors from purported wrongdoing by public companies and their senior leaders, including errors or misconduct in reporting quarterly and annual earnings.
One such provision required companies listed on U.S. exchanges to create and adopt policies providing for incentive-based compensation to be “clawed back” from directors, officers and senior executives — or returned to companies and, therefore, shareholders — in the event that those companies restated their earnings. Over the last 12 years, however, enactment of this provision has been delayed.
At last, on October 26, 2022, the SEC adopted final rules (opens a new window) requiring the recovery of erroneously awarded compensation from companies listed on U.S. exchanges. Importantly, the rules apply to restatements to correct both material errors — commonly know as big “R” restatements — and less significant, little “r” restatements. The rules can also be triggered for restatements not caused by accounting fraud — for example, those caused by human error.
Listing standards TBD
The new rules will become effective 60 days following their publication in the Federal Register. The New York Stock Exchange, NASDAQ and various other U.S.-based markets will then have 90 days to file proposed listing standards.
What those standards will look like remains to be seen. There will likely be some dialogue between public companies, securities exchanges and the SEC about the precise nature of the listing standards, and it’s possible the SEC’s rules will be revised over time.
It’s important to note, however, that proponents of the rules argue they are necessary to ensure accurate financial reporting and discourage accounting fraud and carelessness in reporting. One should thus expect the SEC to look for exchanges to adopt fairly straightforward policies to support this goal.
Recommendations for public companies
Publicly traded companies should consider taking the necessary steps to prepare for the new rules becoming effective. These include, but are not limited to, the following:
Drafting policies to comply with the rules and forthcoming listing standards from securities exchanges. This can be done with support from in-house and outside counsel.
Reviewing directors and officers liability (D&O) policies to see how clawbacks under the new rules are or are not addressed and if more favorable language can be negotiated with underwriters. D&O policy language related to compensation clawbacks can vary significantly; some policies include language that explicitly excludes coverage for compensation that is returned by individuals under Dodd-Frank, the Sarbanes-Oxley Act of 2002 and similar laws, while other policies provide some limited coverage.
Reviewing executive compensation agreements. It’s important to understand how incentive-based compensation is rewarded and to whom, and thus what exposures companies and senior executives have to the new rules. In light of the new rules, some companies may elect to restructure compensation packages to limit incentive-based pay, although separating executive compensation from performance may not be in the best interest of shareholders.
For more information, contact your Lockton Financial Services advisor or email us at financialservices@lockton.com.