Accounting Errors to Cost Executives Their Bonuses Under SEC Rule

WASHINGTON—Regulators will make public companies take back executives’ incentive pay if they find significant errors in financial statements, aiming to improve corporate accountability at a time of rising shareholder discontent over pay practices.

The Securities and Exchange Commission voted 3-2 Wednesday to complete the so-called clawback rule, with all Democrats approving and Republicans dissenting. Required by the 2010 Dodd-Frank Act to discourage fraud and accounting mischief, the rule’s implementation has been delayed for years.

The approved rule will apply clawback provisions broadly to public companies, extending a practice that has become widespread in compensation agreements set by corporate boards in recent years. However, those voluntary policies sometimes set a high bar for recouping previously awarded compensation and can be difficult to enforce. That has led some companies to withhold executives’ incentive pay for longer periods to avoid the hassle of having to get it back after the fact.

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SEC Chairman Gary Gensler, a Democrat appointed by President Biden, reopened a 2015 proposal, which was never implemented, last year to collect fresh public feedback on the idea.

The rule passed Wednesday requires companies to set up procedures for recovering erroneously awarded compensation whether or not there was misconduct involved. It is also broader than the 2015 proposal, which would have triggered clawbacks only if companies identified major accounting errors that required a restatement of prior years’ financial results. Under the completed version, companies will also have to recover executive bonuses if they find smaller errors that significantly affect only the current year’s results.

SEC economists estimate the lesser category of accounting errors covered by the final rule are about three times as common as the more serious type.

Mr. Gensler said Wednesday that the rule will strengthen investor confidence in corporate reporting, as well as the accountability of managers.

“Corporate executives often are paid based on the performance of the companies they lead,” Mr. Gensler said. “If the company makes a material error in preparing the financial statements required under the securities laws, however, then an executive may receive compensation for reaching a milestone that in reality was never hit.”

Under the rule, which will go into effect in roughly one year, companies will have to adopt policies to recover wrongfully awarded incentive pay from both current and former executives, going back as many as three years. Companies would determine the amount of pay to claw back by calculating what an executive would have earned if the revised financials had been in place. For compensation based on stock performance, firms must use reasonable estimates. After recovery, the funds would be returned to the company.

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Companies wouldn’t have to pursue recovery of funds if the cost of doing so would exceed the amount they would claw back, or—in the case of a foreign issuer—if the process would violate the law in its home country.

The Wall Street Journal has reported that companies have played down the importance of their accounting errors in recent years, possibly to minimize the impact on share prices or executive compensation.

GOP lawmakers and business groups had urged the agency not to move forward with the rule without doing more analysis. They had criticized the SEC’s plan to capture restatements that only affect the current year in clawback policies, and said the final rule’s definition of “executive officer” was overly broad.

Tom Quaadman, an executive vice president at the U.S. Chamber of Commerce, said the SEC’s rule “is needlessly complex and overly prescriptive” and questioned the process by which it was adopted. He added, however, that clawbacks are an important tool for holding executives accountable.

Investor advocates, companies and executives rarely criticize clawback policies in principle, though companies seeking to claw back pay often find executives resistant.

Republican SEC Commissioner Mark Uyeda said the rule could lead companies to restructure compensation arrangements away from performance to shield executives from clawbacks.

“This may result in salary increases, rather than compensation mechanisms tied to financial-reporting measures,” Mr. Uyeda said, noting reports that companies are removing performance goals and replacing options with shares. He said the SEC’s approach “may ultimately weaken alignment of interests between shareholders and management.”

At least one study calls that thesis into question.

A group of finance professors at the University of Arizona, the University of Delaware and the University of Illinois at Chicago examined the stock-market reactions of S&P 1500 firms after the SEC unveiled the proposed clawback rule in 2015. They found that companies without existing clawback policies—those most likely to be affected by the rule—exhibited “positive abnormal stock returns” following the announcement.