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SEC Commissioner Peirce on Flaws in New Clawback Rules

What we are doing today [October 28]—implementing the statutory clawbacks mandate—is commendable. But how we are doing it—expansively, inflexibly, and impractically—is not. Accordingly, I cannot vote to adopt this rule.

Section 954 of the Dodd-Frank Act generally requires the Commission to direct exchanges to require listed companies to “develop and implement a policy” for disclosing how they handle incentive-based compensation tied to reported financial information and, when that reported information has to be restated, a policy for clawing back related erroneously awarded compensation.[1] Congress did not prohibit us from allowing listing exchanges and issuers some flexibility in crafting, respectively, the required listing standards and policies and procedures. Nor did Congress, in adopting this provision, prohibit us from using our exemptive authority under Section 36 of the Exhttps://clsbluesky.law.columbia.edu/wp-admin/edit.phpchange Act, which allows the Commission to tailor the implementing regulations if doing so is “necessary or appropriate in the public interest, and is consistent with the protection of investors.”[2] Instead of taking advantage of this statutory flexibility, the release before us adopts a prescriptive approach that, because of its breadth and inflexibility, in some cases, could impose costs on shareholders greater than the benefits they derive from the clawbacks.

Had we built flexibility into the rule, listing exchanges and companies could have developed sensible approaches to achieving the laudable goal of clawing back compensation paid on the basis of subsequently restated financial metrics. The adopting release, however, fails to permit listing exchanges to craft workable listing standards and enforce them in a common-sense manner. Likewise, the final rule does not permit company boards, guided by their fiduciary duty, to determine when clawing back compensation makes sense. Such an approach would have served shareholders by ensuring that companies claw back erroneously awarded compensation when doing so yields a net benefit to shareholders.

The Rule’s Scope Is Too Broad

This rule is unnecessarily broad in at least four ways. First, the rule is not limited to “Big R” restatements, which restate historical financial statements to correct errors that were material to those previously issued financial statements. The final rule explicitly also requires clawbacks based on so-called little r” restatements, by which companies restate prior period information in the current period comparative financial statements. Issuers use “little r” restatements for errors that are not material to previously issued financial statements, but would result in a material misstatement if either the errors were left uncorrected in the current report or the error correction were recognized in the current period. Section 954, which looks to when an “issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws,” does not force the inclusion of “little r” restatements. Including them unnecessarily complicates the rule and may require clawback analysis when the error did not lead to erroneous compensation during the three-year period, or require a clawback of de minimis amounts. The Commission explained in 2021, when it reopened comment on the 2015 proposal, that it was concerned about opportunistic behavior by companies when choosing between a “Big R” and “little r” restatement.[3] The release does not substantiate these concerns, but if companies and their auditors are misjudging the materiality of financial statement errors, a compensation clawback rule is not the proper remedy.[4] A better approach—and one that would be easier to apply—would have required clawbacks only when a company has to “prepare a financial restatement to correct a material error of the type required to be reported under Item 4.02(a) of Form 8-K.”[5]

Second, the rule applies to too many company employees. Section 954 requires clawbacks from “executive officers,” but leaves the term undefined. After quoting from the Senate Banking Committee Report that the clawback provision “is required to apply to executive officers, a very limited number of employees, and is not required to apply to other employees,”[6] the Commission adopts an intentionally broad definition of “executive officer.”[7] Affected employees would include anyone who performs a policy-making function for the issuer 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.[8] Better approaches might have been to limit this definition to the company’s top five executives,[9] to claw back compensation only from people with a material role in the events leading to the restatement,[10] or to allow exchanges or compensation committees the flexibility to define the term.

Third, the rule applies to all listed issuers, including emerging growth companies (“EGCs”), Smaller Reporting Companies (“SRCs”), and Foreign Private Issuers (“FPIs”). The Commission “acknowledge[s] that SRCs and EGCs may face disproportionate costs of compliance as compared to other companies,” but also speculates that they “may realize disproportionate benefits.”[11] The Commission does not show that those benefits will outweigh the costs, and the Regulatory Flexibility Analysis does not seriously assess ways to ease the burden for small issuers. The Commission should have used its exemptive authority to exempt EGCs or SRCs from the rule, tailor it for these companies,[12] provide them with a more extended compliance period, or delay their XBRL tagging implementation period.[13] The Commission also could have permitted listing exchanges to make reasonable accommodations for FPIs subject to different clawback regulations.[14]

Fourth, the definition of “incentive-based compensation” is too broad. We reasonably could have limited the definition to accounting-based metrics. Instead, the Commission is requiring companies to claw back compensation based on stock price and total shareholder return (“TSR”). Whereas Section 954 requires clawing back compensation that is “based on financial information required to be reported under the securities laws,” stock price and TSR are market-driven metrics of how the stock performs that reflects “many factors beyond its reported financial information.”[15] Although “affected by accounting-related information,” stock price and TSR are not “accounting-based metrics,” which the release acknowledges.[16]

The Rule Is Unnecessarily Prescriptive

The rule’s broad scope is paired with an unduly prescriptive attempt to deprive listing exchanges and companies of any discretion. The Commission allows the exchanges to play only an essentially ministerial role in crafting listing standards and similarly seeks to direct the manner in which exchanges conduct oversight and enforcement. The rule also limits boards’ ability to tailor their policies to their unique facts or to determine when clawing compensation back is worth the effort. Allowing boards to decide to whom the policy should apply, when it should apply, and when attempting recovery does not make sense would fall comfortably within the discretion normally afforded to boards, a discretion that is bounded by directors’ fiduciary obligation under state laws to exercise their authority properly.[17]

A few examples illustrate the rule’s unnecessary prescriptiveness. First, the rule’s impracticability standard is itself impracticable. The rule requires a company to recover erroneously awarded compensation unless: the direct expense it would have to pay to a third party to help would exceed the amount to be recovered; recovery would violate a home country law that was adopted before this rule was finalized; or recovery would jeopardize a broadly-available tax-qualified retirement plan.[18] To qualify for the first exception, the company has to “make a reasonable attempt” to claw back the compensation and document its efforts.[19] Moreover, internal costs like “resources required to work with, manage, or monitor the third party’s efforts” or those “associated with defense of counter-claims” do not count in the cost-benefit analysis.[20] A de minimis threshold under which companies would not need to attempt to recover compensation would have been a more practicable approach.[21]

Another example of the rule’s over-prescriptiveness is its disclosure mandates. Companies must disclose: their clawback policies as a tagged exhibit to their annual reports[22]; the amount of erroneously awarded compensation attributable to an accounting restatement[23]; an analysis of how the erroneously awarded compensation was calculated[24]; the estimates used to determine the amount of erroneously awarded compensation linked to stock price or TSR and an explanation of the methodology used for such estimates [25]; amounts recovered[26]; amounts still owed[27]; and amounts forgone.[28] The rule could instead have required website disclosure of policies and procedures and provided for streamlined, fully anonymized disclosure about amounts recouped, owed, and forgone.[29]

The release strains to read inflexibility into the statutory language, but Section 954 affords the Commission discretion to craft a workable standard. The statute requires only that a company “develop and implement” a clawback policy, not that every company adopt an identical policy or that companies recover all erroneously paid compensation from employees. As one commenter suggested, the Commission could have “simply direct[ed] the exchanges to require companies to adopt clawback policies and then provide annual disclosure in their proxy statements that describe the rationale for the company’s clawback policy, any revisions to that policy, and the role of the compensation committee in making clawback decisions.”[30] An approach that afforded greater discretion to exchanges and boards could have been less costly and yet still effectuated the statutory purpose. Some companies might make the same choices the Commission is making here, but affording companies discretion would best protect shareholders.

Shareholders Will Pay for the Rule’s Complexity

Balanced clawback policies can benefit shareholders, which is why many companies already have implemented such policies. Now the Commission is upsetting the balance by dictating a new approach that will require many companies to replace their existing policies and renegotiate contracts with affected employees in a fairly short time period.[31] Almost every one of the Commission’s discretionary choices increases the complexity and cost of the rule as compared to the statutory baseline. The Commission instead should have used its discretionary authority to ensure that clawback policies would yield a net benefit for shareholders.

Again, a few examples illustrate how shareholders will pay for this rulemaking more than they benefit:

  • The release does not provide a de minimis threshold. As one commenter noted:

    [I]t hardly seems worthwhile for a board to have to “make a reasonable attempt to recover” an excess incentive compensation amount of $100. Even spending time discussing such a matter is not in the shareholders’ best interests, no less the fact that the value of any amount of time spent pursuing such amount would far exceed the recovery.[32]

  • Because of the broad scope of covered executives,[33] companies likely will spend too much trying to recoup compensation from lower level executive officers. As Professor Fried noted, “below-5 executives pay packages are much smaller than top-5 executive pay packages.”[34] Recovering compensation from lower-level executives will likely be as costly as recovering from their more senior counterparts, but less lucrative.
  • Clawbacks associated with “little r” restatements are likely to involve lower dollar amounts than “Big R” restatements given the immaterial nature or prior year adjustments. To ease the burden of clawing back compensation after “little r” restatements, the Commission could have provided Boards with more discretion to determine when it would be too costly to attempt a recovery effort or could have exempted compensation based on TSR.
  • More generally, compensation returned could be extremely minimal and recoupment costs very high for a significant portion of TSR-related clawbacks, so the Commission’s decision to require companies to conduct these clawbacks may not benefit shareholders.[35]
  • Finally, this rule opens up companies to new forms of litigation risk.
    • The Commission acknowledges that its decision to include a trigger date—“the date that the issuer’s board . . . concludes, or reasonably should have concluded, that the issuer is required to prepare an accounting restatement”[36]—“creates some risk that the board’s conclusions will be subject to litigation.”[37]
    • The rule requires that companies must recover the money “reasonably promptly,”[38]which also invites litigation risk and may discourage recovery practices that could mitigate costs to companies, like netting overpayments with other incentive-based underpayments, or set-offs.[39]

Conclusion

A seemingly simple mandate—make sure companies claw back compensation when they restate their financials—is not, as it turns out, so simple when a Commission with a penchant for prescription is charged with putting it into practice. The passage of time has not been shareholders’ friend. As we did in implementing the pay versus performance rule under Section 953 of Dodd-Frank, we have added complexity at every stage of the rulemaking process. Rather than scoping the rule appropriately to meet the statutory objective and affording listing exchanges and companies reasonable discretion in applying the rule, our path will cost shareholders more and benefit them less.

While I take issue with a number of the policy decisions the Commission made, the staff has worked very hard on this rule. Seven years between proposal and adoption is a long time, so I know this day is particularly welcome for many in the Division of Corporation Finance, the Division of Economic and Risk Analysis, the Office of General Counsel, and other staff who have worked on this rule. I appreciate your hard work and lively engagement with me and my staff. Special thanks go to Luna Bloom, Steven Hearne, Brian Galle, and Jessica Barberich for answering my many questions on the release, along with Lindsay McCord and Jonathan Wiggins for lots of time patiently discussing the fine points of “little r” restatements.

ENDNOTES

[1] Pub. L. No. 111-203, § 954, 124 Stat. 1376, 1904 (2010) (codified at 15 U.S.C. § 78j-4).

[2] 15 U.S.C. § 78mm. In other places, Congress did prohibit the Commission from exercising exemptive authority. See, e.g., Dodd-Frank Act § 772 (prohibiting invoking the Commission’s exemptive authority in connection with security-based swaps reforms).

[3] Reopening of Comment Period for Listing Standards for Recovery of Erroneously Awarded Compensation, Rel. No. 34-93311, 86 Fed. Reg. 58232, 58234, Oct. 21, 2021 (“Since the Commission issued the Proposing Release in 2015, concerns have been expressed that issuers may not be making appropriate materiality determinations for errors identified. Some commentators have suggested that this could be because some of these issuers are seeking to avoid compensation recovery under their clawback policies.” (footnote omitted)).

[4] Our Acting Chief Accountant recently warned companies to conduct objective materiality analyses and invited them to come in and talk to the Office of Chief Accountant. Paul Munter, Assessing Materiality: Focusing on the Reasonable Investor When Evaluating Errors, SEC (Mar. 9, 2022), https://www.sec.gov/news/statement/munter-statement-assessing-materiality-030922.

[5] See Comment Letter from American Bar Association Committee on Federal Regulation of Securities of the Section of Business Law at 17, Feb. 11, 2016, https://www.sec.gov/comments/s7-12-15/s71215-67.pdf (hereinafter “ABA 2016”).

[6] See Adopting Release at 7 n.9 (quoting S. Rep. No. 111-176 at 136 (2010)).

[7] See 17 CFR § 240.10D-1(d); Adopting Release at 50-55.

[8] Jesse M. Fried, Rationalizing the Dodd-Frank Clawback, 13 (Eur. Corp. Governance Inst., Working Paper No. 314, 2016) (hereinafter “Fried”).

[9] See, e.g., id. at 62 n.144. In addition to easing the rule’s burdens, such an approach might better achieve the objective of improving corporate behavior, since these five people are most able to affect what the company does. As Fried explains, “there is a vast difference in power between the most powerful executives in the top-5 and the most powerful executives in the below-5.” Id. at 48.

[10] See Comment Letter from Society for Corporate Governance at 2-3, Nov. 29, 2021, https://www.sec.gov/comments/s7-12-15/s71215-9411438-263053.pdf (hereinafter “SCG 2021”).

[11] Adopting Release at 178.

[12] See, e.g., Comment Letter from ABA 2016 at 74-75 (listing specific ways in which the Commission could tailor regulations for EGCs and SRCs).

[13] See Pay Versus Performance, Rel. No. 34-95607, 87 FR 55134, 55162, Oct. 11, 2022 (Allowing SRCs “to provide the required Inline XBRL data beginning in the third filing in which it provides pay versus-performance disclosure, instead of the first.”).

[14] See, e.g., Comment Letter from Sullivan and Cromwell at 2, Sep. 22, 2015, https://www.sec.gov/comments/s7-12-15/s71215-63.pdf (“Because employment law is often governed by the location of the employee, a limited conflicts of law exception for a foreign private issuer’s home country law will not adequately address the issues faced by multinational corporations (including US issuers) with executive officers resident in and performing services in numerous jurisdictions. For this reason, the Proposed Rule would potentially put an issuer in the position of failing to comply with the applicable listing standard or governing local law.”).

[15] Comment Letter from ABA 2016 at 28.

[16] Adopting Release at 63 (“Although the phrase ‘financial information required to be reported under the securities laws’ might be interpreted as applying only to accounting-based metrics, in consideration of the statutory purpose described above, we have determined that it is appropriate to interpret the term to include performance measures including stock price and TSR that are affected by accounting-related information and that are subject to our disclosure requirements.”) (emphasis added); see also Comment Letter from McGuireWoods, LLP and Brownstein Hyatt Farber Schreck LLP at 18, Nov. 22, 2021, https://www.sec.gov/comments/s7-12-15/s71215-9385310-262666.pdf (“[N]either stock price nor TSR is a financial reporting measure used in preparing financial statements.) (hereinafter “McGuireWoods”). The Commission implausibly argues that Congress’ intent to include a broad set of metrics is evident in the phrase “based on financial information.” Adopting Release at 63-64 (emphasis added). If Congress intended “based on” to encompass compensation that was only “in part” based on financial metrics, it would have said as much. Dodd-Frank uses the phrases “based in whole or in part” and “based, in whole or in part” elsewhere.

[17] See, e.g., Comment Letters from the U.S. Chamber of Commerce Center for Capital Markets Competitiveness at 7-8, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-29.pdf (“In many ways, the Proposal seems premised on the faulty, cynical notion that notwithstanding their well-established fiduciary duties under state law, independent directors are not to be trusted to do the right thing when it comes to matters of executive compensation or legal compliance.”); Center On Executive Compensation at 2, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-38.pdf (“The Commission’s approach to the implementation of the Dodd-Frank clawback requirement should be considered in concert with the fiduciary duties of a registrant’s Board of Directors. Pursuant to these duties, which extend to all areas of board oversight, a board must act in good faith and with reasonable care to make decisions which are in the best interest of the corporation and its shareholders. These fiduciary duties weigh in favor of granting the Board discretion in key areas of the final rule to ensure the clawback requirement is implemented in a manner which both fulfills congressional intent and protects shareholder interests.”); FedEx Corporation at 2, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-31.pdf (“A company’s board of directors should have discretion whether to seek recovery of incentive-based compensation if there is a triggering financial restatement. The board of directors has a fiduciary duty to act in the best of interests of stockholders.”); ABA 2016 at 60 (“We firmly believe that Boards of Directors will be sufficiently motivated both by their fiduciary obligations, as well as the implicit pressure that is likely to result from the required disclosure [of clawback policies under Section 954], to take appropriate action to recover excess incentive-based compensation in an expeditious and pragmatic manner. Additional detailed requirements that will either govern or impact the manner of recovery would simply make an already overly-prescriptive rule even more formalistic and difficult to enforce”).

[18] See CFR § 240.10D-1(b)(1)(iv).

[19] See Adopting Release at 92 (“The final rules also require the issuer to make a reasonable attempt to recover incentive-based compensation before concluding that it would be impracticable to do so. The issuer must document its attempts to recover and provide that documentation to the exchange.”).

[20] Comment Letter from Society for Corporate Governance (formerly Society of Corporate Secretaries & Governance Professionals) at 8, Sept. 18, 2015, https://www.sec.gov/comments/s7-12-15/s71215-60.pdf (hereinafter “SCG 2015”); see also Comment Letter from ABA 2016 at 48 n.91.

[21] See, e.g., Jesse M. Fried & Nitzan Shilon, Excess-Pay Clawbacks, 36 Iowa J. Corp. L. 721, 749 n.120 (“[T]here could of course be a carveout for ‘de minimis’ amounts of excess pay. We see no real cost to such a carveout. Refraining from clawing back small amounts of excess pay will not substantially affect shareholders’ returns nor meaningfully reduce the deterrent effect of the clawback. At the same time, such a carveout will confer a benefit on shareholders by avoiding the transaction costs associated with effecting a clawback.”).

[22] See 17 CFR § 229.601(b)(97) and 17 CFR § 229.402(w)(4).

[23] 17 CFR § 229.402(w)(1)(i)(B).

[24] Id.

[25] 17 CFR § 229.402(w)(1)(i)(C).

[26] See Instruction 5 to 17 § CFR 229.402(c), and Instruction 5 to 17 § CFR 229.402(n).

[27] 17 CFR § 229.402(w)(1)(i)(D).

[28] 17 CFR § 229.402(w)(1)(ii).

[29] Many commenters raised concerns about the disclosures and suggested alternate approaches. See, e.g., Comment Letters from ABA 2016 at 5-6, 62 (recommending website disclosure); Davis Polk 2021 at 5 (suggesting that disclosure of the methodology for calculating the recoverable amounts would be burdensome, lack comparability, and involve litigation risk); SCG 2021 at 4 (suggesting that the disclosure could be confusing and would add legal, audit, compensation consulting, and other expenses); Business Roundtable at 3, Sept. 15, 2015, https://www.sec.gov/comments/s7-12-15/s71215-42.pdf (raising safety concerns associated with disclosing names); Compensation Advisory Partners LLC at 2, Sept. 10, 2015, https://www.sec.gov/comments/s7-12-15/s71215.htm (expressing reputational concerns); Mercer at 11, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-10.pdf (suggesting that, instead of public disclosure, exchanges could require individualized information as needed) (hereinafter “Mercer”); Sullivan & Cromwell LLP at 7, Sept. 22, 2015, https://www.sec.gov/comments/s7-12-15/s71215-63.pdf (suggesting that the specific identity of an executive will in most cases not be material to the evaluation of the boards’ determination not to pursue recovery); UBS Group AG at 5, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-51.pdf (suggesting that naming individuals from whom the issuer determines not to recover is irrelevant and provides no benefit to shareholders); McGuireWoods at 12 (recommending generalizing compensation recovery disclosure); Exxon Mobil Corporation at 4, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-22.pdf (expressing concern that disclosure of individuals’ names could conflict with local data privacy laws); Japanese Bankers Association at 8, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-17.pdf (expressing concern that proposed disclosures could conflict with Japanese data privacy laws).

[30] Comment Letter from SCG 2021 at 6.

[31] The process of revising existing clawback policies and renegotiating contracts with executive officers is likely to be expensive. See, e.g., Comment Letters from Keith Paul Bishop at 6, Sept. 13, 2015, https://www.sec.gov/comments/s7-12-15/s71215-24.pdf (indicating that issuers will face significant costs and litigation risk as policies are re-written); SCG 2015 at 16 (indicating that current recovery plans prevent or restrict amendments unless approved by the participant affected by the amendment, and that it is unlikely that someone no longer working for the issuer will agree to an amendment that results in costs to herself).

[32] Comment Letter from McGuireWoods at 22; see also Comment Letter from SCG 2015 at 9 (“[W]e do not believe it will always be necessary for a reasonable attempt to be made in order for the compensation committee to determine that recovery is ‘impracticable.’ For example, consider when the amount to be recovered is de minimis in amount. Because there is no de minimis exception or threshold to the recovery amount, issuers are expected to recover any amount of excess compensation in connection with every accounting restatement, no matter how small. In such cases, we believe the compensation committee may very well determine that the recovery is ‘impracticable’ and not in the best interests of the issuer or its stockholders without first having to seek recovery to make that determination.”).

[33] 17 CFR § 240.10D-1(d).

[34] Fried at 49.

[35] One study of restatements from 2003 through 2012 found that “restatements at over 4,000 companies caused only an average 1.5% decline in stock price and a median decline of 0.01%.” Comment Letter from Mercer at 6 (citing a study of restatements by the Center for Audit Quality – Financial Restatement Trends in the United States: 2003-2012). According to one commenter, conducting an event study to determine what TSR would have been absent a restatement could cost an estimated $100,000 to $200,000. Comment Letter from Davis Polk & Wardwell LLP at 2, Sept. 11, 2015, https://www.sec.gov/comments/s7-12-15/s71215-14.pdf. Litigation risk may lead companies to conduct these studies despite the rule’s allowance for a “reasonable estimate” of TSR. See, e.g., Comment Letter from Pearl Meyer at 3, Sept. 15, 2015, https://www.sec.gov/comments/s7-12-15/s71215-47.pdf (“Arriving at this reasonable estimate will necessitate extensive research, testing, and expense to understand how stock price and TSR would have been impacted by a restatement, and there are countless assumptions that go into the ‘but for’ price of the stock. . . . If adopted as is, the Proposal will be a windfall for the plaintiffs’ bar as any “reasonable estimate” will be fair game for challenge, and executive officers will also likely dispute these estimates if subject to a clawback.); see also Comment Letter from McGuireWoods at 17-18 (Under a “reasonable estimate” standard, “an issuer will still be faced with the complexity of doing an event study if selected as the methodology utilized, or will be faced with the complexity of selecting and developing another method. In our view, the subjectivity, difficulty, and costs associated with the development of reasonable estimates on which to determine the impact of a restatement on stock price or TSR to calculate excess executive compensation subjects issuers to an undue burden . . . .”).

[36] 17 CFR § 240.10D-1(b)(1)(ii)(A).

[37] Adopting Release at 45.

[38] 17 CFR § 240.10D-1(b)(1).

[39] See, e.g., Exxon at 2 (“Money is fungible. As a practical matter . . . it is easier to cancel or retain amounts that remain within the control of the company than to recover amounts already paid out to an executive. In the absence of recovery via set-off, if the executive resists recovery, litigation to recover compensation already paid can be costly and time consuming. If the Commission is concerned about the time value of money for certain recovery practices, the Commission could have required that interest costs must be taken into account for any recovery.”).

This statement was issued on October 26, 2022, by Hester M. Peirce, commissioner of the U.S. Securities and Exchange Commission. 

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