SEC Approves Rule to Claw Back Executive Pay ‘Material Error' in Financial Statements | December 2022
December 2022 | Volume 14, Issue 5
Read the full article on Yahoo Finance.
The SEC recently approved a rule to claw back executive compensation of companies that have to materially correct financial statements, raising the bar for Corporate America's highly paid CEOs.
"Corporate executives often are paid based on the performance of the companies they lead, with factors that may include revenue and business profits," SEC Chair Gensler said in a statement. "If the company makes a material error in preparing the financial statements required under the securities laws, however, then an executive may receive compensation for reaching a milestone that in reality was never hit. Whether such inaccuracies are due to fraud, error, or any other factor, today’s rules would implement procedures that require issuers to recover erroneously rewarded pay, a process known as a 'clawback.'"
The vote, which passed along party lines 3 to 2, occurred at the recent Open Commission Meeting.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in July 2010 in the wake of the Great Financial Crisis, mandated that the SEC adopt rules directing national securities exchanges to require clawback policies as part of their listing standards. The SEC first proposed this clawback rule in 2015 and reopened it for public comment in 2021 and 2022 to consider recent shifts in the markets and how companies issue restatements of financials.
The new rule will require U.S.-listed companies to put a plan in place for recovering incentive-based compensation paid to its current or former executive officers in situations where an issuer is required to restate its financial statements.
The SEC will also require that national securities exchanges create standards that would make companies listed on the exchanges adopt and comply with the clawback policy and would require issuers to provide details about the policies that are being implemented.
The rule will go into full effect in a year and two months unless issuers comply earlier.
When asked whether he thinks companies could restructure executive compensation to avoid clawbacks, Gensler replied, “I don’t share the view that companies could shift toward more salaries. It may change how they’re doing it, but it better aligns it with incentives that you don’t get paid on errors…I think boards would rather have incentive pay based on valid financials and take away any possible incentives to have faulty financials. This better aligns the incentives.”
While the SEC is focused on cracking down on financial restatements and better aligning that with monetary incentives, since their peak in 2006, the number of annual financial restatements has declined by over 80 percent, according to Audit Analytics. 2020 saw the lowest percentage of companies disclosing a financial restatement in 20 years with just 4.9 percent of companies restating previous financial statements, compared to 6.8 percent in 2019 and 17 percent at the peak in 2006.
Also, the SEC is set to adopt a rule that would simplify shareholder reports to help retail investors better understand the performance of mutual funds and exchange-traded funds.
The SEC would request funds to give investors a 3- to 4-page report instead of 100 pages, consolidating information to the highlights of the fund’s expenses, performance, holdings, and any material changes. Investors would still have access to all the required information, including full financial statements online.
Discussion Questions
- Regarding executive compensation, what is a “clawback?”
A “clawback” is an action by a company to recover compensation that has been paid to an executive if certain offenses have occurred. The clawback may be self-imposed by the company, or pursuant to a government mandate (the subject case). As indicated in the article, the new SEC rule will require U.S.-listed companies to put a plan in place for recovering incentive-based compensation paid to its current or former executive officers in situations where an issuer is required to restate its financial statements. - As the article indicates, the SEC clawback mandate passed along party lines, with three votes in favor of the provision, and two votes against it. Does this surprise you? Why or why not?
The partisan vote does not surprise your author, given the partisan divide at all levels of government. It is, however, somewhat unsettling that such partisanship is appearing at the administrative agency level. Traditionally, administrative agencies were thought to be more immune from partisanship than, for example, the United States House of Representatives. - What is the best argument in favor of the new SEC mandate? What is the best argument against it?
In your author’s opinion, the best argument in favor of the new SEC mandate is that it will serve to encourage executives to be even more attentive to the accuracy of corporate financial statements prior to their release to the public. It is important to realize that investors use these financial reports as vital information from which to make investment decisions. The best argument against the new SEC mandate is that corporations should have the freedom to make their own rules regarding executive pay “clawback,” including the freedom to decide what violations trigger the clawback, and what the extent of the clawback will be based on the violation(s).