And then the SEC said, we'll claw back bad bonuses

If there's been an accounting blunder, execs may have to return incentives

Corporate executive officers who receive "erroneously awarded" incentive-based compensation will have to return those funds under newly confirmed securities rules.

The SEC – America's financial watchdog – on Wednesday voted 3-2 along party lines to adopt rules called for under a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in 2010 to stabilize the US financial system following the 2007-2009 Great Recession. They will allow the SEC to claw back bonuses from companies that misstated their financial figures.

"I believe that these rules will strengthen the transparency and quality of corporate financial statements, investor confidence in those statements, and the accountability of corporate executives to investors," said SEC Chair Gary Gensler, in a statement.

"Through today’s action and working with the exchanges, we have the opportunity to fulfill Dodd-Frank’s mandate and Congress's intention to prevent executives from keeping compensation received based on misstated financials."

The Sarbanes–Oxley Act of 2002 already provides a mechanism to clawback executive bonuses based on misconduct. The new SEC rules extend the mechanism for recouping funds to awards arising from financial miscalculations – criteria that could lead to the return of incentive pay in cases where errors followed from undisclosed or unchallenged misconduct.

Since the SEC first proposed the rule revision in 2015, business groups like the US Chamber of Commerce and the Investment Company Institute have been fighting to narrow its scope.

The newly adopted rules [PDF] state that if a publicly listed company has to restate its finances, the company must recover from any "current or former executive officers incentive-based compensation (including stock options awarded as compensation) that was received during the three-year period preceding the date the [company] is required to prepare the accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement."

They apply to both "Big R" and "little r" restatements – errors requiring previous financial quarters to be restated and errors that can be addressed by restating a single financial quarter. Seventy-six percent of restatements were "little r" in 2020, according to the SEC.

The rules call for calculating erroneously awarded compensation based on the full amount of the award, rather than what's left to the executive after taxes. This raises the question of whether the IRS will refund taxes paid on incentive pay that get clawed back.

Let me restate this

According to financial firm Audit Analytics, public companies filed 364 financial restatements in 2020, the lowest level in 20 years. In 2021, the number of restatements surged to 1,470, an increase of 289 percent. The only year in the past two decades with more restatements was 2006 – leading into the Great Recession.

The 2021 restatement boom is largely attributable to SPACs, special purpose acquisition companies that the SEC believes are prone to financial exaggeration. Excluding SPACs, restatements in 2021 declined 10 percent.

SEC Commissioner Hester Peirce, one of the two dissenting Republicans and a Trump appointee, said she could not vote for the new rules because they are too broad, inflexible, and impractical.

Among the objections cited in her statement, she said, "[T]he rule applies to too many company employees. Section 954 requires clawbacks from 'executive officers,' but leaves the term undefined. Affected employees would include anyone who performs a policy-making function for the [stock-issuing company] regardless of involvement with the events leading to the restatement. By one count, the rule will apply to as many as 50,000 public company employees."

According to the National Law Review, the rules cover "the company's president, principal financial officer, principal accounting officer/controller, any vice president in charge of a principal business unit, division, or function; and any other officer or person who performs a significant policy-making function for the company."

A 2017 research paper distributed via SSRN, "Clawback Provisions," by Ilona Babenko (Arizona State University), Benjamin Bennett (Tulane University), John Bizjak, (Texas Christian University), and Jeffrey Coles (University of Utah), found that when companies adopt clawback provisions, executives tend to respond by pursuing more cautious corporate policies (less R&D, fewer patent filings) and reducing risk, thereby boosting the firm's value in the stock market. ®