New Rules Aim to Claw Back Incentive-Based Pay

On July 1, the SEC proposed new rules to require public companies to clawback certain types of incentive-based executive compensation if the award was improperly given due to accounting misstatements. For example, if an executive received a bonus based on the company achieving a revenue target and it is subsequently determined that revenue was misstated, the bonus would be subject to clawback.

Expanded Rules

This is not the first instance of clawbacks for public companies. The Sarbanes-Oxley Act of 2002 required public companies to recover awards given to CEOs and CFOs in the one year period prior to a financial restatement due to the executive’s misconduct. However, the proposed SEC rules are more onerous. Under the new rules, recovery would apply to excess incentive-based compensation received in the three fiscal years leading up to the date a company is required to prepare an accounting restatement. Further, the definition of an executive officer is expanded to include “the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs policy-making functions for the company.”

Clawbacks under the new rules would also be required on a “no fault” basis, without regard to whether any misconduct occurred or an executive’s responsibility for the erroneous financial statements. Companies are, however, given discretion on recovery if the costs of enforcing recovery would exceed the amount to be recovered, or if recovery would violate home country law (for certain foreign issuers).

How does it apply?

The proposed rules would apply to incentive-based compensation that is tied to accounting-related metrics (such as sales or profitability targets), stock price performance, or total shareholder return metrics.

The clawback amount is based on the difference between the amount of compensation originally received by an executive and the amount that would have been paid based on the accounting restatement. For awards tied to an accounting metric like sales, this might be a fairly straightforward calculation. However, for incentive-based compensation based on stock price performance or total shareholder return, the measurement issues could become significantly more challenging. For these types of awards, the SEC proposal allows companies could use a “reasonable estimate” of the effect of the restatement on the applicable measure to determine the amount to be recovered.

As described in the proposed rules, a reasonable estimate of the “but for” price of the stock (as if the financial statements had been correct) must be determined. One method to address this situation is to perform an event study, which would estimate the drop in the stock price attributed to a restatement announcement, separate from any change in the stock price due to other market factors.

Next Steps

While the SEC intends for the new rules to result in increased accountability and a heightened focus on the quality of financial statements, some concerns have been voiced. These concerns include potentially costlier audits and restatements, increased litigation, and a delay of information to investors. Listed companies might also choose to move away from incentive-based compensation toward other types of pay that cannot be clawed back or to tie incentive plans to non-financial metrics that do not fall under the provisions of the new rules.

The SEC is accepting comments regarding the proposed rules through September 14, 2015.

Related Links

• Why Quality Matters in Valuation for Equity Compensation Grants
• 8 Things You Need to Know About Section 409A
• Review Finds Equity-Based Compensation Reporting Works as Intended