On October 26, 2022, the Securities and Exchange Commission, by a 3-to-2 vote, adopted a rule that will require exchange-listed companies to have a policy mandating the recovery of erroneously awarded incentive compensation following an accounting restatement. Evaluations of whether a restatement is necessary often require the exercise of judgment, and audit committees should be aware of the impact that this new rule could have on management restatement decisions.
The SEC originally proposed the claw back rule, which implements Section 954 of the Dodd-Frank Act, in 2015. Following a lengthy period of inaction, the Commission re-opened comment on the proposal in 2021. See SEC Revives Proposal to Require Compensation Claw Backs After Restatements, September-October 2021 Update. A third comment period commenced in October 2021. See SEC Rulemaking is in Hyperdrive: Spring 2022 Regulatory Agenda, June-July 2022 Update. Although the Commission states that commenters “broadly supported the objectives” of the proposal, some aspects, particularly the scope of the restatements to which it should apply (discussed below), have been controversial.
New Securities Exchange Act Rule 10D-1 directs national securities exchanges to amend their listing standards to require listed companies to adopt and comply with a compensation recovery policy. The policy must provide that, in the event of an accounting restatement to correct a material error, the company will recover from current and former executive officers any incentive-based compensation received that exceeds the amount that would have been paid under the restatement. The recovery policy must apply to incentive compensation received by both current and former executives during the three-year period preceding the restatement.
Recovery of compensation is mandatory, regardless of whether the officers from whom recovery is sought were responsible for the errors that resulted in the restatement and regardless of whether the inaccurate financial reporting was the result of misconduct. Narrow exceptions to the recovery requirement are permitted if the cost of enforcing the policy would exceed the amount to be recovered, if recovery would violate home country law, or if recovery would cause a tax-qualified retirement plan to become non-qualified. A company would be subject to delisting if it failed to adopt and enforce the recovery policy.
The Commission also adopted new disclosures to complement the compensation recovery policy. A company will be required to file its recovery policy as an exhibit to its annual report. In the event of a restatement, the company must disclose, among other things, the aggregate dollar amount of erroneously awarded compensation, amounts due from any current or former named executive officer that have been outstanding for 180 days or more, and details regarding reliance on any of the recovery policy exceptions.
The rule encompasses a broad range of restatements. As originally proposed in 2015, the claw back requirement would only have applied to accounting restatements that correct a material error in previously issued financial statements (a "Big R" or reissuance restatement). However, the final rule also requires compensation recovery when the company is required to prepare an accounting restatement that corrects an error that is not material to previously issued financial restatements but that would result in a material misstatement in the current (or a future) period if the error were left uncorrected (a "little r" or revision restatement). Little r restatements are far more common than Big R restatements. Excluding restatements by SPACs, only 24 percent of 2021 restatements were reissuance or Big R restatements. See Fueled by SPACs, Restatements Surge, June-July 2022 Update. The claw back rule does not capture restatements made for reasons other than error correction – e.g., to reflect the retrospective application of a change in accounting principle or retrospective revisions for stock splits, stock dividends or other changes in capital structure.
Comment: The new rule potentially affects the work of the audit committees by changing the stakes of a decision to restate. As the disincentives to restate increase, audit committees will need to become more vigilant in making sure that they are fully and evenhandedly informed in situations in which a restatement is a possibility. In this regard, the SEC’s release adopting the recovery policy rule notes the role of audit committees in overseeing restatement decisions:
“Requiring recovery analysis for both “Big R” and “little r” accounting restatements does not eliminate the risk that an issuer could avoid a recovery obligation by manipulating its materiality analysis of an error. While this is an inherent risk, we note the involvement of an independent auditor in evaluating management’s materiality analyses, with the oversight of the audit committee, protects investor interests by helping ensure that material errors do not go uncorrected by an issuer seeking to avoid the recovery of erroneously awarded compensation. Furthermore, we note the potential serious consequences, including but not limited to Commission enforcement action and private litigation, of mischaracterizing material accounting errors as immaterial.”
The SEC’s Acting Chief Accountant has also recently noted the risk of bias in restatement decision-making and emphasized that audit committees should play an active role in overseeing restatement decisions. See Acting SEC Chief Accountant Warns Against Bias in Restatement Materiality Decisions, March 2022 Update. In this environment, any decision that an accounting error does not require a restatement is likely to attract scrutiny. Such decisions should be carefully considered and fully documented.
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