The SEC has approved a rule to strip executive compensation of companies that need to materially correct financial statements, raising the bar for Corporate America’s highly paid CEOs.
“Corporate executives are often compensated based on the performance of the companies they lead, with factors that may include revenue and business profits,” SEC Chair Gensler said in a statement. “If the company makes a material error in preparing the financial statements required under the securities laws, however, an executive may receive compensation for reaching a milestone that in reality never occurred. If such inaccuracies are due to fraud, error, or any other reason, today’s rules will implement procedures that require issuers to recover the wrongly awarded pay, a process known as a ‘clawback. ‘”
The vote, which passed along party lines 3 to 2, took place at Wednesday’s Open Commission Meeting.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in July 2010 during the Great Financial Crisis, mandated that the SEC adopt rules directing national securities exchanges to require policies on clawback as part of their listing criteria. The SEC first proposed this clawback rule in 2015 and reopened it for public comment in 2021 and 2022 to take into account recent changes in markets and how companies issue restatements.
The new rule will require US-listed companies to put in place a plan for the recovery of incentive-based compensation paid to its current or former executive officers in situations where an issuer is required to restate its financial statement.
The SEC will also require that national securities exchanges create standards that will enforce and comply with exchange-listed companies’ clawback policy and will require issuers to provide details about the policies implemented.
The rule will take full effect in one year and two months unless issuers comply sooner.
When asked if he thought companies could change executive compensation to avoid clawbacks, Gensler replied, “I don’t share the view that companies can move toward more pay. It might change how they do it, but it would better align it with incentives that you don’t get paid for mistakes…I think boards would prefer to have incentive pay based on sound financials and remove any possible incentives to have corrupt finances. It is better aligned with incentives.
Although the SEC is committed to cracking down on financial restatements and better aligning that with financial incentives, since their peak in 2006, the number of annual financial restatements has declined by more than 80%, according to Audit Analytics. 2020 saw the lowest percentage of companies disclosing financial restatements in 20 years with only 4.9% of companies disclosing past financial statements, compared to 6.8% in 2019 and 17% at a peak in 2006 .
Also on Wednesday, the SEC is set to adopt a rule that will simplify shareholder reports to help retail investors better understand the performance of mutual funds and exchange-traded funds.
The SEC will require funds to provide investors with a 3-4 page report instead of 100 pages, combining information that highlights the fund’s expenses, performance, holdings, and any material changes. Investors will still have access to all necessary information, including full financial statements online.
This post was updated after the vote took place.
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