October 27, 2022

Clawback Rules: Why All the Fuss about Little “r” Restatements?

The focus on clawback policies dates back to the post-Enron era and the enactment of Section 304 of Sarbanes-Oxley, which permits the SEC to order the disgorgement of bonuses and incentive-based compensation earned by the CEO and CFO in the year following the filing of any financial statement that the issuer is required to restate because of misconduct. Following the lead from Sarbanes-Oxley and the fundamental concern that executives should not be able to keep incentive compensation paid based on misstated financial statements that had to be restated, companies began adopting clawback policies as a good governance practice. The ensuing couple of decades of “private ordering” largely led to clawback policies which focused on the consequences of a full-blown accounting restatement (usually arising from some sort of fraud or other misconduct) which requires the company to amend its prior periodic reports to correct the errors in the financial statements included in those reports. Essentially, these are restatements that lead to the filing of an Item 4.02 Form 8-K. As originally proposed, the SEC’s Dodd-Frank Act era clawback appeared to follow suit.

But then, a funny thing happened on the way to adoption of the final clawback rules. In recent years, full-blown accounting restatements have not been happening quite as often as they once did, for a variety of reasons. While such restatements have by no means gone the way of the dinosaur, they are certainly not the fixture of public company reporting that they once were. At the same time, we have seen an increase in what is often referred to as a little “r” restatement, which requires no Item 4.02 Form 8-K and which allows a company to fix its prior periods in a periodic report with no amendment of previously filed reports. Little “r” restatements are required to correct errors that were not material to previously issued financial statements, but would result in a material misstatement if: (i) the errors were left uncorrected in the current report; or (ii) the error correction was recognized in the current period. The SEC staff has been focused on little “r” restatements over the past decade or so, raising comments on filings to test whether a purported little “r” restatement should have been a full-blown accounting restatement under GAAP, so there has certainly been some skepticism about this approach.

Incorporating little “r” restatements as a triggering event in the final clawback rules will certainly expand the reach of clawback policies adopted pursuant to the listing standards that the stock exchanges are obligated to promulgate. The concept moves clawback policies even farther away from the original concern that executives should return their incentive compensation earned based on misstated financial statement where the misstatements arose due to some sort of fraud or misconduct, toward the more mundane world of recovering compensation erroneously earned due to run-of-the-mill accounting errors. The change also required the Commission to consider ways to make the little “r” restatement more visible, thus necessitating the check box approach on the cover of the annual report. All in all, the change means that compensation recovery policies are going to be invoked much more often, and perhaps for much smaller recoveries.

– Dave Lynn