SEC Clawback Rule

The SEC proposed another rule this summer, satisfying the last of their additional duties under the Dodd-Frank Act. The rule concerns executive compensation and so-called ”clawback” provisions, as required by section 954 of Dodd-Frank, which added section 10D to the Securities Exchange Act of 1934. The SEC proposed its rule for adoption in July by a 3-2 vote, meaning the 60-day comment period is now coming to a close.

In its simplest sense, the rule is designed to clawback performance-based compensation from executives whose companies are forced to file restated financials. The rule itself is formulated as an additional listing requirement -- exchanges must require any listed company to adopt the clawback principals outlined in the rule or be delisted. The rule applies to all executives who received incentive based compensation, and all incentive based compensation received during the three years preceding the date on which the company is required to prepare restated financials is subject to clawback.

Only "erroneously awarded compensation" is subject to a clawback, and is defined in the rule as the amount of incentive based compensation awarded in excess of the amount of incentive-based compensation that ought to have been awarded, had it been determined based on the restated financials. In the event that it is impossible to calculate the amount of "erroneously awarded compensation" from the restated financials, for example when incentive awards were based on stock price or total shareholder return, companies must recover an amount that is a "reasonable estimate" of the effect of the accounting restatement on the company's stock price. In instances where the cost of calculating and recovering the clawback amount would exceed the amount that would be recovered, the company's compensation committee (after a genuine effort to investigate recovery) can determine that clawback is impracticable. Companies will also be required to disclose via their annual report the amount of clawbacks, and against whom, that occurred as a result of restating their financials (amending item 402 of Regulation S-K).

While SEC chairwoman Mary Jo White stated that, "The proposed rules would result in increased accountability and greater focus on the quality of financial reporting, which will benefit investors and the markets," many critics disagree. They argue that the practical effect of the clawback provisions will be to discourage companies from using incentive-based compensation, which often serves to align the interests of executives with the interests of shareholders.

Though the SEC's rule has some unique features, clawback rules are not a new concept. Section 304 of the Sarbanes-Oxley Act requires the CEO and CFO to repay any bonuses, incentive based pay or profits realized on the sale of securities that were received during the 12-month period prior to a financial restatement. The SEC's rule applies to more parties ("executives" instead of just the CEO and CFO), but only targets "excess" incentive compensation, not the total amount.