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E-MailSonia Gupta Barros, John P. Kelsh, and Corey Perry are partners at Sidley Austin LLP. This post is based on a Sidley memorandum by Ms. Barros, Mr. Kelsh, Ms. Perry, and Claire H. Holland. Related research from the Program on Corporate Governance includes Rationalizing the Dodd-Frank Clawback by Jesse Fried (discussed on the Forum here).
On June 8, 2022, the U.S. Securities and Exchange Commission (SEC) once again reopened the period to solicit input from the public on the compensation clawback rules it proposed in 2015 to implement Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The proposed rules would direct the national securities exchanges to establish listing standards that would require a company to adopt, disclose and comply with a compensation clawback policy as a condition to listing securities on a national securities exchange. The proposed clawback rules were summarized in our 2015 post on this Forum.
The SEC first reopened the comment period for the proposed rules last fall—from October 14, 2021 through November 22, 2021—as discussed in the Sidley Update available here. In that reopening release, the SEC requested comments and supporting data on the proposed clawback rules in light of regulatory and market developments since the rules were proposed in 2015. The SEC also identified 10 new topics on which it specifically requested public comment. Most notably, the SEC asked whether it should expand the types of accounting restatements that would trigger application of a clawback policy. Under Section 954 of the Dodd-Frank Act, a clawback would be triggered “in the event that the 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.” Based on its initial interpretation of the Section 954 mandate, the clawback trigger under the SEC’s 2015 proposed rules was limited to material restatements of previously issued financial statements (so-called “Big R” restatements). In the reopening release, the SEC asked the public whether it should expand its interpretation and revise the rule proposal to include all required restatements made to correct an error in previously issued financial statements, including restatements required to correct errors that were not material to previously issued financial statements but would result in a material misstatement if (1) the errors were left uncorrected in the current report or (2) the error correction was recognized in the current period (so-called “little r” restatements). This new request resulted from concerns raised that companies may not be making appropriate materiality determinations for errors to avoid triggering application of a clawback policy.
The SEC reopened the comment period again on June 8, 2022 for a period running until 30 days after publication of the current reopening release in the Federal Register. The stated reason for the second reopening is to allow interested parties time to review and comment on a memo prepared by the staff of the SEC’s Division of Economic and Risk Analysis (DERA) containing supplemental analyses and data about clawback policies and accounting restatements. The DERA memo first addresses the increase in voluntary adoption of clawback policies. The memo reveals that the number (and percentage) of public companies that disclose a clawback policy has doubled compared to the estimates provided in the 2015 rule proposal—from 1,116 (23%) to 2,451 (46%) in 2021. The DERA staff note their belief that this increase may reduce the expected benefits and mitigate the expected costs of the rule proposal.
The DERA memo also provides an estimate of the number of additional restatements that would trigger a clawback analysis if the SEC were to extend the proposed rules to include “little r” restatements. The DERA staff estimate that “little r” restatements may account for approximately three times as many restatements as “Big R” restatements for 2021—173 to 54 according to Audit Analytics data (excluding special purpose acquisition company (SPAC) restatements) . However, according to the DERA staff, while including “little r” restatements would increase the overall number of restatements that could potentially trigger a clawback analysis, that increase may not be proportional to the total actual number of clawbacks because “little r” restatements may be less likely as compared to “Big R” restatements to result in a clawback. This is because “little r” restatements on average are less likely to negatively impact net income or cause a marked stock price decline than “Big R” restatements. The DERA staff note that this would mitigate the potential impact of including “little r” restatements on the rule proposal’s anticipated benefits and costs. Finally, the DERA staff provide examples of how encompassing “little r” restatements may increase both the benefits and costs of the rule—highlighting that it would likely reduce the risk of company executives reporting misstatements as “little r” rather than “Big R” restatements in an attempt to avoid triggering application of a clawback policy.
Practical Implications
In light of the current reopening release, companies may consider submitting or contributing to a comment letter on the proposed clawback rules or the DERA memo to the SEC. Interested parties may submit comments here, and comments received to date are available here.
We do not know whether the proposed rules will be adopted and, if so, when the corresponding listing standards will be proposed and become effective. It is also uncertain what the terms of the listing standards will be and whether there will be meaningful differences in the standards adopted by the national securities exchanges. In the meantime, companies may consider updating their compensation committees on the proposed rules and their implications and comparing their current clawback policies to the proposed rules.
