Accountability for Restated Financial Statements

On October 26, 2022, the SEC issued a final rule aimed at ensuring that executive officers do not receive “excess compensation” if the financial results on which previous awards of compensation were based are subsequently restated because of material noncompliance with financial reporting requirements. Such restatements would include those correcting an error that either:

(1) is material to the previously issued financial statements” (a “Big R” restatement) or

(2) would result in a material misstatement if the error were corrected in or left uncorrected in the current period” (a “little r” restatement).

SEC Rule

The final rule implements the mandate in Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, under which the SEC is required “to adopt rules directing the national securities exchanges to prohibit the listing of any security of an issuer” that has not adopted and implemented a written policy providing for the recovery of incentive-based compensation under certain circumstances.

Deloitte points out that the final rule requires issuers to “claw back” excess compensation for the three fiscal years before the determination of a restatement regardless of whether an executive officer had any involvement in the restatement. The final rule also requires an issuer to disclose its recovery policy in an exhibit to its annual report and to include new checkboxes on the cover page of its annual report to indicate whether the financial statements “reflect correction of an error to previously issued financial statements and whether [such] corrections are restatements that required a recovery analysis.” Additional disclosures are required in the proxy statement or annual report when a claw back occurs. Such disclosures include the date of the restatement, the amount of excess compensation to be clawed back, and any amounts outstanding that have not yet been clawed back.

Clawbacks have been around for a while. Section 304 of the Sarbanes-Oxley Act of 2002 contains a recovery provision that is triggered when an accounting restatement results from an issuer’s misconduct. The provision applies only to CEOs and CFOs, and the amount of required recovery is limited to compensation received in the 12-month period after the first public issuance or filing of the improper financial statements with the SEC. In addition, in the interim period before the issuance of the final rule, many companies already had voluntarily adopted compensation recovery policies based on investor sentiment and good governance practices. However, it is likely that even those companies will be required to make substantial changes to their policies in light of the following aspects of the final rule:

• The inclusion of a broader list of executive officers, including former executive officers, within the rule’s scope.
• The broader events that would trigger recovery analysis (“Big R” and “little r” restatements).
• The “no-fault” nature of the final rule.
• The longer look-back period of three completed fiscal years.

Examples of Claw-Backed Executive Compensation

The following is a list of executives who may be subject to the claw back rules.

• President and/or CEO
• Principal financial officer (i.e., CFO)
• Principal accounting officer (if there is none, the controller)
• Any vice president in charge of a principal business unit, division or function
• Any other person who performs policymaking functions for the company, including executive officers of the company’s parent(s) or subsidiaries who perform such policymaking functions for the company.

This is often a broader group than covered by a company’s existing claw back policies, which tend to focus on officers listed in the proxy statement filed with the SEC.

Individuals in these roles are only considered an executive officer subject to recovery if they serve as an executive officer at any time during the recovery period (described below), and the recovery is only required for incentive compensation received while the individual served as an executive officer.

The new rule provides that, regardless of when the restatement takes place, incentive compensation is only subject to recovery if it is received during the three-year period before the restatement is “required.” The three-year lookback period begins when the board, compensation committee or officer(s) authorized to take such action conclude or reasonably should have concluded (or a court or regulator determines) that a material error existed in prior financial statements.

The SEC provides the following as examples of incentive-based compensation:

• Restricted stock, restricted stock units, performance share units, stock options, and stock appreciation rights that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal;
• Bonuses paid from a bonus pool, the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal; and
• Proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based wholly or in part on satisfying a financial reporting measure performance goal.

Ethical Issues

An interesting question is whether claw back policies are ethical. One way to make the evaluation is by using the Justice Theory or, in this case, fairness. Executives who were involved/in-charge during the periods when financial statement material errors and/or noncompliance with accounting and financial reporting rules occurred should not benefit by receiving compensation from stock options and bonuses during that time. They should be held accountable for their failure to detect and/or disclose the transactions that are the subject of the claw backs.

Executives who were in charge during the time that financial statements were restated need to take responsibility for failing in their fiduciary responsibilities to protect shareholder interests and adhere to regulatory requirements. The failure to do so implicates executives in a way where legal actions should be considered by the SEC.

Rewarding bad behavior compromises ethical values such as honesty in financial reporting, integrity of the financial reporting process, diligence in reporting financial matters, and accountability for one’s actions. These values are essential to transparency and effective corporate governance. Anything less violates the basic standards that underlie ethical financial reporting.

Blog posted by Steven Mintz, PhD on November 14, 2023. Find out more about Steve’s professional activities on his website (https://www.stevenmintzethics.com/). You can sign up for his newsletter and connect on LinkedIn (https://www.linkedin.com/company/ethics-sage/about/.)

 https://dart.deloitte.com/USDART/home/publications/deloitte/heads-up/2022/sec-rule-clawback.