SEC Executive Clawback Rules Bring Late Nights as Deadline Nears

Figuring out new SEC rules to recoup executive pay after a company makes accounting errors is, in a word, complicated. Complicated enough that it took one team of lawyers a five-hour call extending past midnight just to get to where it could explain the clawback regulations to clients.

The Securities and Exchange Commission rules—issued in 2022, more than a decade after major post-financial crisis reform compelled the agency to act—force companies to adopt clawback policies or risk expulsion from stock exchanges, which require compliance by Dec. 1. To come up with these policies, companies have to parse which types of accounting mistake corrections will require executives to return bonuses they wouldn’t have pocketed if the company financials were correct.

“It is the hot regulatory topic in every C-suite,” said Keith Halverstam, a partner at Latham & Watkins LLP who participated in his firm’s marathon, late-night call to produce a flowchart for clients. “I have not seen anything resonate or generate this amount of discussion.”

Checking Boxes

The long-delayed SEC rules, approved in October 2022 after languishing on the agency’s agenda since the passage of the Dodd-Frank Act in 2010, have a straightforward premise. If a company executive receives a bonus tied to earnings metrics that turn out to be miscalculated, that compensation must be returned, or clawed back, to the company.

Companies must write up policies to determine when to take back pay or risk getting kicked off Nasdaq or the New York Stock Exchange.

And there’s nuance. The SEC rules cover not just formal, or “Big R” financial accounting restatements, but also smaller revisions that companies long have slipped into their regular financial filings without fanfare.

Companies are far more likely to fix past errors quietly, with so-called “Little R” revisions, according to research firm Ideagen Audit Analytics. These quiet fixes do not require companies to publish special securities filings flashing mistakes to the market and explaining how errors impact past earnings.

Then there’s out-of-period adjustments, quick fixes companies make when they discover immaterial errors in past financial statements.

The new SEC rules do not require companies to develop clawback policies for out-of-period adjustments; such cases do not meet the threshold of fixing an accounting error. Nevertheless, the rules will draw attention to these fixes. Under the rules, companies must highlight via checkbox on the front page of their annual financial statements whether any past correction was made, including an out-of-period adjustment.

“If the numbers changed, that checkbox gets checked,” said Lindsay McCord, the chief accountant in the SEC’s Division of Corporation Finance, speaking at a financial reporting conference earlier this month.

A second checkbox must be marked if a correction warrants a clawback analysis. This means companies must highlight whether past financial statements included errors that qualify as Big R or Little R fixes.

Many companies were accustomed to using a Little R revision for all small error corrections, as there were few consequences for over-reporting such fixes. The new SEC executive pay rules change that.

Companies will have to carefully analyze when a Little R revision is warranted versus when a mistake can be taken care of with an out-of-period adjustment, Halverstam said.

“It’s very important that everyone, from the executive team to the accounting team, understand we live in a new universe now,” he said.

Future Questions

Questions about the SEC rules go beyond accounting. Some overseas companies listed on US exchanges may find themselves unable to comply with the rules at all because certain countries prohibit them from taking back pay from workers if they’ve already earned it. Such companies may qualify for what the rules call an impracticability exception.

The rules also apply to the pre-tax dollar figure of the erroneously awarded compensation, even if the money that hit an executive’s bank account had taxes taken out.

Other questions involve how long-term incentive programs that tie executive pay to company stock performance could get impacted by the rules. If a company fixes an accounting error that lowers revenue in a prior period, the company may have to go back under the rules and analyze how the stock would have performed if the error had been revealed sooner, said Latham partner Maj Vaseghi.

Veronica Wissel, a Davis Polk & Wardwell LLP partner who works on compensation matters, said her clients are preparing to position themselves to enforce their procedures and communicate with executives.

“We’ll be seeing how people actually implement their policies once they’re triggered,” Wissel said. “And that will introduce a whole host of additional questions and issues.”