Implementation Issues Abound For The SEC's Proposed Clawback Rules

When adopted, the incentive compensation clawback rules recently proposed by the Securities and Exchange Commission are likely to present issuers with a number of implementation challenges.  Some of these challenges have been discussed in prior posts.  Below is a brief outline of just a few of the many and multifarious headaches that I foresee for issuers in effectuating the SEC's rules:

  • Committee Decisions.  Many equity compensation plans include a provision defining the authority of the compensation committee to administer the plan.  Usually, these provisions include a statement along the following lines: "The decisions of the Committee are final and binding on all persons."  If a committee has determines to award or pay incentive compensation, is that decision no longer "final and binding"?
  • Mutuality.  A related issue is whether executives will demand mutuality.  If there is an accounting restatement resulting in additional compensation, will covered executives be entitled to an upward, retroactive adjustment in compensation?
  • Period Covered.  As discussed last week, the SEC's proposal deviates from Section 10D of the Exchange Act by defining the recovery period as "three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement".  Issuers that have adopted clawback policies in anticipation of the rules are likely to have echoed the statutory language ("3-year period preceding the date on which the issuer is required to prepare an accounting restatement").  Will these issuers be able to change these policies with retroactive effect (particularly, with respect to former officers)?
  • Change in Accountants.  Changing accountants is never easy for issuers.  It is not unusual for the new accounting team to second-guess positions of the predecessor accountants.  A 2004 empirical study, for example, found that firms with new auditors experienced higher levels of restatements.  An unintended consequence of the SEC's clawback proposal will be to raise the stakes for management.
  • Change in Control.  Management will have more to fear in change in control situations as incoming management will have an incentive to restate prior period financials and clawback the incentive compensation received by prior management.
  • Conflict with State Law.  The SEC's proposing release studiously avoids any discussion of whether its rules will, or could, have preemptive effect.  See What The SEC Pretermitted In Proposing A Clawback Policy Rule.
  • Pre-Tax v. After-Tax.  The SEC is proposing that recoupments of incentive compensation be made on a pre-tax basis.  Section 10D of the Exchange Act is silent with respect to the impact of taxes on recoveries.  Because computing recoveries on a pre-tax basis may put executives in a significantly worse position, some issuers have adopted plans providing for recovery on an after-tax basis.
  • Individuals Covered.  Section 10D refers to "executive officers".  Even though the SEC Rule 3b-7 already defines "executive officer" for purposes of the Exchange Act, the SEC has proposed to use the definition of "officer" in Rule 16a-1(f).  The difference between the two definitions is slight, but adoption of the proposed rules will require some issuers to amend their existing recoupment policies to conform to the SEC's chosen definition.

The above is just the beginning of what will probably prove to be numerous tortures and nightmares that issuers may encounter when forced to implement the SEC's final rules.

Courtyard_with_Lunatics_by_Goya_1794Painting By Francisco Goya (1793)