Cracking the clawback code: what are the odds of a compensation payback?
A deep dive into the complexities of the SEC’s new clawback regulations and their impact on executive compensation.
The new SEC Rule 10D-1, which mandates the recovery of executive compensation following an accounting restatement, might seem straightforward on paper—overpaid bonuses based on incorrect metrics should be paid back. However, as Bloomberg has pointed out, the practical implementation is far from simple.
I was excited to see my work cited:
“There is diversity in practice around how companies do this,” said Olga Usvyatsky, an accounting analyst who reviewed more than 6,000 SEC filings.”
Let’s look at the numbers:
Number of 10-K and 10-K/A filings analyzed: 6,697;
Number of unique companies with error correction flag checked: 205;
Number of unique companies with recovery analysis flag checked: 29;
Number of unique companies with recovery analysis disclosures: 17;
Number of clawbacks: 2.
Source: Nonlinear Analytics LLC/Deep Quarry based on SEC filings
(Note: company-level data underlying this analysis is available for premium subscribers of Deep Quarry.)
Out of 6,697 10-K filings reviewed, 205 companies flagged the error correction box. However, only 29 registrants flagged a recovery analysis, and just two executed clawbacks. The reason for this low rate, according to legal experts, largely comes down to timing—many companies corrected errors before paying out bonuses, avoiding the need for clawbacks altogether:
“Companies that close their fiscal books on Dec. 31 usually issue their 10-Ks in February or March but don’t pay out bonuses until the spring, when they share details about which executives got cash or stock payouts and the value of those awards in documents they file with the SEC. In many cases, companies uncovered errors and accounted for them prior to paying out bonuses.”
If timing is the primary reason, we should see more recovery analysis – and a higher fill rate of the corresponding recovery analysis check box.
Recovery analysis and SEC comment letters
But timing is just one part of the story. The level of disclosure around recovery analyses varies widely, likely due to the newness of the rule and the lack of clear guidelines.
For instance, Rule 402(w) of Regulation S-K requires companies invoking a clawback to disclose certain details of the restatement, including the date and aggregate impact of the restatement. The amount of compensation to be recovered should also be disclosed (the discussion of the disclosure requirements is on pages 205 and 206 of the SEC release).
Suppose a company determines that the clawback is not required based on the recovery analysis. In that case, the company must “…briefly explain” why the application of the recovery policy resulted in this conclusion.
Arguably, the term "briefly explain" leaves room for interpretation, leading some companies to provide minimal disclosure. A case in point is AEON Biopharma (Ticker: AEON), which, after an accounting error, stated in its 10-K report that no compensation was tied to the restated metrics, so no recovery was required:
“Clawback Policy Considerations
In connection with the error identified, our management has performed a recovery analysis and determined there was no incentive-based compensation tied to financial performance for any of our executive officers during the relevant recovery period. As such, there are no amounts to be recovered.”
The SEC, seeking more clarity, asked AEON on June 27, 2024, to elaborate on why no clawback was necessary and to ensure future disclosures are filed in the Interactive Data format, as prescribed by the rules.
“We note that in 2023 your executive officers received bonuses based on the achievement of key performance indicators as determined by your board of directors. We also note the statement that you performed a recovery analysis and determined there was no incentive-based compensation tied to financial performance for any of our executive officers during the relevant recovery period. Please briefly explain to us why the application of the recovery policy resulted in this conclusion. See Item 402(w)(2) of Regulation S-K.”
AEON’s response was straightforward: their executive bonuses were based on non-financial Key Performance Indicators (KPIs) like corporate milestones and product development, with the sole financial KPI related to cash management goals unaffected by the non-cash restatement. Additionally, the company acknowledged the Interactive Data requirement and promised to comply with it in the future. Satisfied with the explanation, the SEC did not pursue the matter further, resolving the issue in just one round of comments.
This interaction with the SEC doesn’t raise red flags but underscores the diversity in how companies interpret and implement the new rule. Bloomberg, citing Ronald Mueller, partner at Gibson Dunn LLP, reported that while SEC staff is addressing the implementation challenges in speeches, we do not have written C&DIs:
“The SEC staff is trying to be helpful and responsive to companies; they are answering these questions but they seem more hesitant to put interpretations in writing,” he said. “On something like this I think it would be just helpful to have one of their compliance and disclosure interpretations.”
For companies preparing recovery analyses, SEC comment letters like the one to AEON can offer valuable, albeit informal, guidance in navigating the complexities of Rule 10D-1.
SEC Director of the Division of Corporation Finance (Corp Fin), Erik Gerding, has emphasized in a speech that reviewing clawback-related disclosures is a top priority of the Corp Fin, so we can expect more scrutiny and comment letters in the near future (emphasis added):
“Clawbacks
On October 26, 2022, the Commission adopted new rules mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which direct national securities exchanges to adopt listing standards that require listed companies to develop and implement a policy providing for the recovery of erroneously awarded incentive-based compensation received by current or former executive officers (a Clawback Policy) and to disclose such policy.[17]
The Division staff will review disclosures to confirm the filing of the Clawback Policy and to assess disclosures when a recovery analysis is triggered.”
Given this focus, companies should pay close attention to their disclosures and consider the SEC's feedback a helpful benchmark in an area still marked by varied practices.
Note also that companies are required to file a written clawback policy as an exhibit to the annual reports. However, based on my analysis, hundreds of 10-K reports did not include this exhibit. Some companies amended later their 10K filings to provide the missing disclosure.
Materiality of restatements and clawbacks
While Rule 10D-1 requires the recovery of erroneously paid compensation following both material (Big R) and immaterial (little r) restatements, only two companies have had to ask their executives to return part of previously paid awards. This low number isn’t surprising—most restatements correct immaterial, minor errors, that do not impact compensation metrics or payouts. However, if a little r error did trigger a clawback, it could be a red flag that merits closer examination.
Why focus on little r corrections? Accounting rules mandate that companies consider quantitative and qualitative factors when evaluating materiality. A quantitatively small error can be deemed material if it affects the ability to meet compensation performance targets or influences analysts’ consensus estimates. PwC guidance highlights this:
“Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are –…
whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.
whether the misstatement has the effect of increasing management's compensation - for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation.”
A clawback invoked under Rule 10D-1 suggests that errors inflated executive compensation, hinting that these little r errors might have been qualitatively material and raising the question of whether the misstatement should have been corrected as a material Big R restatement. A material error would have required more extensive disclosure and alerted investors via an 8-K filing. Little r errors are typically disclosed in a footnote and are easier to overlook.
Moreover, a clawback after a quantitatively immaterial correction—say a 4-5% adjustment—suggests that compensation targets were set so tightly that executives barely met them.
While setting challenging goals can align managerial incentives with shareholder interests, it can also pressure executives to adopt more aggressive accounting methods or business practices, such as pulling forward revenue or cash flow. The concern is that this pressure to deliver results could lead to short-term improvements at the expense of future performance. Since compensation targets often correlate with analysts’ estimates, investors might want to reconsider how these seemingly minor errors could impact consensus earnings per share, income, or free cash flow.
Let me be clear: I'm not implying that financials were intentionally manipulated, or errors were deliberately left uncorrected. The presence of an incentive to engage in opportunistic behavior doesn’t necessarily mean that such behavior occurred. However, in my opinion, clawbacks associated with no-fault little r corrections do highlight a risk that deserves consideration.
Different types of clawbacks
There’s also an important distinction between Rule 10D-1’s mandatory recovery of erroneously awarded compensation and some companies' voluntary clawback policies.
A recent survey of 45 large-cap companies by FW Cook revealed that 80% of these companies have compensation policies that extend beyond the SEC’s minimum requirements. Many of these voluntary provisions don’t require a restatement; instead, they’re often triggered by corporate misconduct, unethical behavior, or reputational harm caused by executives. These provisions are discretionary, leaving companies to decide if and how they should be enforced.
The devil, as they say, is in the details. Take Wells Fargo, for example. The bank’s scandal over unauthorized customer accounts led to a $3 billion DOJ fine and an SEC enforcement action against Wells Fargo’s executives—clear indications of misconduct and reputational damage. Despite this, no compensation was clawed back from past payouts.
As Francine McKenna reported for Market Watch and The Dig, while Wells Fargo did forfeit future compensation from the CEO and another executive, these actions were partially driven by political pressure:
“Wells Fargo’s clawback and recoupment policy is triggered primarily by either misconduct by an executive that leads to a restatement of the company’s financial statements or conduct that leads to material impact on financial information or significant reputational harm to the company….
Wells Fargo’s policy states that an “improper or grossly negligent failure, including in a supervisory capacity, to identify, escalate, monitor or manage, in timely manner and as reasonably expected, risks material to the Company or the executive’s business group” is what’s necessary to hold an executive responsible and clawback pay.”
And also:
“Wells Fargo did eventually take back future compensation from CEO John Stumpf and Tolstedt, but did not claw back any dollars that were already in their pockets. The compensation take-backs that occurred were solely the result of political pressure by Congress and the Fed, and Wells Fargo’s own policy enacted as a result of TARP, not the Sarbanes-Oxley law or the proposed Dodd-Frank law, since both require an accounting restatement that never occurred.”
In contrast to voluntary provisions described in FW Cook’s survey, Rule 10D-1 leaves little room for discretion, requiring recovery when an accounting restatement occurs, regardless of whether misconduct is involved.
Conclusion
In conclusion, while, in theory, the SEC's new clawback rules are clear, their application is anything but. Companies must navigate a landscape filled with ambiguities, timing issues, and varying levels of disclosure, all while under the watchful eye of the SEC. As more comment letters emerge and the landscape evolves, staying informed and vigilant will be crucial for companies looking to comply with these new regulations.
For questions and data inquiries please contact olga@deepquarry.com.
Disclaimer: This newsletter does not provide an investment advice. The view expressed in this newsletter are personal views of the authors based on their interpretation of publicly available information.