Effective on October 2, 2023, restatements of companies’ financial statements will trigger mandatory clawbacks of executives’ incentive-based compensation payments. This article seeks to provide a step-by-step summary of how a company would claw back erroneously paid incentive compensation.
The process is detail-intensive but is scalable to meet every organization’s unique circumstances. Our suggestion is to start is with:
- A formal, written process of repeatable actions that can be quickly delegated
- A timeline that ensures those involved can help the company exercise the clawback “reasonably promptly,” per the U.S. Securities and Exchange Commission’s (SECs) regulatory requirement.
After that, there are four essential steps every organization needs to follow, which fall under the assumption that the compensation committee is responsible for administering and enforcing the clawback.
Step 1: Make key process decisions up front
Soon after restatement, the compensation committee should convene a special meeting to decide how the process will work and who will help assemble the needed data. There are several agenda items to include in that meeting.
Potential impact on incentive pay
Management should be prepared to provide a summary of the potential impact of the restatement on all elements of incentive compensation.
Data and documentation
Identify who from management will provide the financial data, compensation plans, meeting minutes and any other relevant information to the team charged with performing the calculations.
Clawback team management
Fundamentally, the compensation committee must consider conflict-of-interest questions when management helps determine clawback values. This risk diminishes when clawback amounts are smaller – the calculation is simpler and there are fewer assumptions or judgment calls needed to complete the calculation.
However, when more money is at stake, it is more likely that both shareholders and officers will question the results and ask about the source of funds, state legal authority and individual taxation. Additionally, the calculations become more complicated, and that makes the objections more plausible.
For these reasons, the committee will hire its own legal counsel and compensation experts to form the clawback team. You also may want to preserve the attorney-client privilege in communications among the committee, the clawback team and executive officers as much as possible.
Expectations and timing
The clawback team’s deliverables will include:
- A complete compensation review report that details all compensation potentially affected
- A calculation methodology report that provides details on the methodology employed as well as actual calculations
- A presentation of the potential sources of funds to satisfy the clawback
- A recommended proxy disclosure
A timeline for completion of each deliverable also should be established.
Recovery
After the committee determines the amounts subject to clawback, it must understand who has the legal authority within the company to carry out the recovery and ensure it is completed with a preset time frame.
Step 2: Perform the calculations
To calculate the clawback, the clawback team needs to execute the fundamental steps outlined in its listing exchange’s manual. The process and dependencies established in Step 1 will help govern how the data and information changes hands. That process and those dependencies also will identify who is involved in the following list of to-dos for the three fiscal years completed immediately preceding the restatement (i.e., the lookback period):
- Identify everyone who was an executive officer any time during the lookback period
- Determine if incentive compensation was granted, paid or vested during the lookback period
- Calculate the extent to which incentive compensation must be clawed back
While identifying executive officers during the lookback period is mostly straightforward, determining incentive compensation grants and calculating how much must be clawed back are more complicated.
Determine incentive compensation
Complications can arise when reviewing the documentation about how compensation levels were determined, and pay was settled for each compensation element received during the lookback period. The first issue to address is identifying elements of compensation that aren’t obviously incentive compensation but still might be affected by the restatement (e.g., salary increases based on prior-year financial results, compensation deferred into a nonqualified plan based on a prior-year bonus).
The second issue involves looking at pay that is clearly incentive compensation (e.g., annual bonus) and figuring out which portion might be attributable to non-financial performance, whether based on a specific non-financial metric or at the committee’s discretion. Making this determination requires a review of plan documents, grant agreements and so on, plus reading committee reports and minutes to eliminate compensation not based on financial reporting measures. When there isn’t enough documentation, the committee likely will err on the side of including that compensation in the clawback amount.
Calculate the clawback
Most of this work is straightforward math; however, in some cases powerful statistical tools may be required to calculate the value of erroneously paid incentive compensation. This work becomes complicated when incentive pay previously received was calculated based on stock price or total shareholder return performance that is affected by a restated financial metric.
The regulations outline the SEC’s understanding that trying to determine what stock prices would have been if the restated financials had been presented accurately for prior fiscal years isn’t a simple quantification exercise. Determining “what could have been” requires companies to make a reasonable estimate using a statistical tool like an event study, which is often used in accounting, finance and economics.
An event study estimates the expected impact of specific actions or activities (an event) over a specific time (the event window) on stock price returns. There are two types of event studies:
- Multi-firm event study: Looks at the average stock price movement of many firms that experienced the same type of event (e.g., announcing a stock repurchase, being the target of a merger, announcing an earnings restatement) over the same period of event time (i.e., time relative to when the event occurred vs. calendar time)
- Single-firm event study: Focuses on the shareholder returns for the company relative to its specific event (i.e., stock price movements from one week before to two weeks after the date that the organization announced its restatement)
While multi-firm event studies are more common in academic work, single-firm event studies have been recognized in securities fraud litigation in the Delaware Chancery as a preferred method for determining the impact of a particular event on share price.
Using event studies
The mechanics may be complicated to execute, but they’re relatively straightforward to explain. An event study starts by looking at the correlation between share price movements of a company and a peer group over a period significantly before the restatement. This establishes a baseline of how the company share price moves relative to its peer group. This is what economists call normal conditions based on this pre-event period.
Next, look at the company’s shareholder returns and those of peer-group firms from just before to just after the restatement (the event period). The goal is to determine the abnormal impact on share prices due to the restatement, which is the difference between the actual shareholder returns during the restatement’s event period and the expected returns under normal conditions compared with the peer group.
It is important to note that not all stock plans or total shareholder return-based plans will require an event study for every restatement. The clawback team may need to conduct a lot of homework before the company knows one way or the other. There are several factors that will influence this determination (see Figure 1).
