Don’t bank on the bonus

Scott Paer, Managing Director, New York at Bladonmore, looks at the new rules surrounding performance-based executive compensation and the impact on the reporting cycle.

Executives beware, from December 1st, the days when accounting errors in corporate managements’ favour were shrugged off are over. New rules handed down by the Securities and Exchange Commission (SEC) mean that executives at public companies will be compelled to return erroneously-awarded compensation.

The new rule is extensive. It doesn’t only apply to cash compensation either, stock options, even those yet to be exercised, will be subject to clawing back, too.  It is not only awards from the year of a restatement that become subject to questioning. Under new rules, clawbacks now cover the three fiscal years prior to a restatement.

What’s more, smaller and emerging growth companies and foreign entities are not exempt from new clawback requirements. If you’re listed on the NYSE or Nasdaq, clawbacks will soon be a reality.

It is hard to say how many public companies may be calling on their executives to return bonuses and other compensation, but figures from recent years suggest it could be a decent number.

In 2021, 1,470 public companies filed financial restatements in the US, a 289 percent increase over 2020, according to a 2022 study by Audit Analytics. Over three-quarters (77 percent) of these companies were SPACs, or special purpose acquisition companies, which the SEC urged to revisit their accounting practices in terms of redeemable shares and warrant liabilities.

Even without SPACs, though, approximately 350 public companies issued restatements in the US in 2021. These numbers suggest that hundreds and even thousands of executives may need to rethink lavish holidays and instead return some portion of their financial awards.

Closer look

The spectre of clawbacks has long been part of corporate life.

What’s different about the new rules is that they apply to far more restatements than ever before.

New policies cover all instances in which restatements are required. That means it includes both “little r” restatements (restatements in which previous reported financial results in current filing are revised) and “Big R” statements (when financial statements are reissued). This change to include “little r” restatements will potentially dramatically increase the number of clawbacks.

As a reference point, in 2021, 75 percent of restatements fell into the ‘little r’ bucket, according to the Audit Analytics study.

In addition, clawbacks will no longer be a judgement call for companies that have restated financials but will be mandated by listing rules.

The SEC hasn’t explicitly defined who qualifies as an executive, however it is thought that the president, CFO, principal accounting officer or controller, vice presidents of principal divisions, and officers with policymaking functions fall under this heading. And these rules don’t only apply to current executives, either. Former executives could also find themselves financially liable.

Finally, public companies listed in the US will soon be required to file compensation recovery policies as an exhibit to their annual reports.

Revisiting compensation practices

For companies based outside the US but listed on the NYSE or Nasdaq, updating policies may be no small task.

In Canada, for instance, these policies may already be in place, but with a view to Canadian law. The law there requires a double trigger of restatement and executive misconduct to be activated. That means it is at odds with the new rules from the SEC and companies may have to find a way to reconcile the two.

This may cause a way in which executive compensation packages are put together. Basing compensation on hard-to-pinpoint metrics like ESG goals may soon become less common with the threat of clawbacks looming.

Changing a compensation structure to provide discretionary bonuses or use personal, not financial, performance criteria when awarding bonuses may appear like an appealing workaround, but there are important caveats.

Remember that proxy advisors weigh in on compensation and they may not turn a blind eye to changes designed to circumvent clawback rules.

As law firm Faegre Drinker Biddle & Reath points out, ISS generally believes a CEO’s equity awards should be at least 50 percent performance based. Making compensation criteria too subjective might unleash a fresh set of problems with the rating agencies and perhaps even with your own investors.

Reporting repercussions

These changes will create more scrutiny on reporting teams than ever before. However, the increased onus on getting the numbers right doesn’t change the importance of creating an engaging story to go alongside them. It will still be just as important to provide clarity on your performance, your strategy, and the journey you’ve been on to reach your current position.

And remember, if your company does fall foul of the new rules, investors are likely to want to know how it happened and what you’re going to do about it. It will be important to explain, simply and clearly, what went wrong and what is being done to ensure it doesn’t happen again. Not just to prevent executives digging into their pockets to pay back the company, but to maintain the all-important trust from your investors.

If you’re looking for help communicating with investors, get in touch.

 

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Scott Paer

Managing Director, New York

Scott is responsible for driving and overseeing Bladonmore’s New York Office.

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