Public company executives know the financial stakes are high when it comes to clawback rules.
If a public company has to restate its financial reports, the Securities and Exchange Commission’s rules on compensation recovery mean executives might have to give back bonuses or extra pay—even if the executives in question didn’t cause the mistake.
While the rules are meant to promote fairness, they’ve raised questions about whether it’s right to penalize someone who wasn’t at fault.
For executives who are truly concerned, it turns out there is an insurance solution that may be worth exploring.
Compensation Recovery AKA Clawbacks: A Brief Background
The Dodd-Frank Act of 2008 required the SEC to regulate how companies pay their top executives, including the recovery of incentive-based compensation (“clawbacks”).
Compensation incentives tied to financial performance, such as bonuses or stock options, that are received within the three years before a financial restatement are within scope for a potential clawback. The SEC took years to finalize its clawback rules. When it finally did in 2015, people had mixed feelings.
Critics worried about a few things, including that:
● Base salaries might go up. Executives might demand more guaranteed pay upfront if their bonuses could later be clawed back.
● Executives and shareholders might clash. If bonuses shrink or disappear, executives might feel less connected to the company’s success.
The proposed rules basically sat untouched until late 2021, when the SEC reopened them for discussion. By the end of 2022, the SEC finally made them official.
These rules apply to most publicly traded companies listed on the NYSE or Nasdaq and impact a wide range of executive officers, including current and former presidents, chief financial officers, accounting officers, vice presidents in charge of major business areas and other corporate policymakers.
Clawbacks are triggered when a company finds itself in material noncompliance with any financial reporting requirement There are two triggers for clawbacks:
● “Big R” restatements: These happen when a big mistake is found in the company’s financial reports—something serious enough that it could mislead investors and needs to be corrected.
● “Little r” restatements: These are for smaller mistakes that weren’t material but could cause problems if they aren’t fixed moving forward. This means the clawback rule could be triggered for relatively small amounts of money and include situations where the executive’s pay wasn’t actually wrong.
Since the SEC rules are a “no-fault” policy, executives can lose money even if they act in good faith.
The amount of compensation to be clawed back is the difference between what the executive was paid and what the executive would have earned had the financials been correctly stated in the first place. This is a bit hard to describe; it’s even harder to implement in practice.
Importantly, companies are prohibited from indemnifying any current or former executive officers against clawbacks.
The SEC’s rules have forced public companies to implement clawback policies that meet certain minimum standards. In addition, NYSE and Nasdaq require companies to have compliant clawback policies or risk being delisted.
And, in the name of the good governance, most companies end up including clawbacks for things other than restatements such as personal misconduct or activities that could lead to reputational damage.
A Potential Solution For Executive Clawbacks: Insurance
Picture this: Two years after receiving a significant bonus, your company realizes its financial reports were wrong, releases a financial restatement and demands that you re-pay your bonus.
You’ve already invested that money into other things—maybe you purchased a new home, funded your child’s college tuition or something else—and now you have to come up with that money again.
Needless to say, clawbacks are a big deal for executives who rely on bonuses as a significant part of their income. These executives want to know their pay is protected, especially from mistakes made by others, something they cannot control.
Some might say this is just part of being a senior executive at a public company. On the other hand, some executives are looking into special “clawback” insurance.
Clawback insurance can help cover the money you would have to repay if your company needed to enforce the clawback rules.
Note, however, that buying this insurance isn’t a perk your company can bestow on you. In fact, the SEC prohibits it. Thus, covering the cost of the insurance is up to you.
This is a newly developing market, so limits are still pretty low. Currently, clawback insurance provides coverage in the $500,000 to $1 million range per executive. If this type of insurance becomes popular, you can expect more insurance carriers to offer it and at higher limits over time.
Of course, this insurance will not respond if you are involved in fraud or intentional wrongdoing that leads to a clawback.
Clawback insurance can also cover legal fees if you want to challenge the clawback amount or the need to repay it. (The clawback insurance will kick in after other company insurance has been used for defense.)
And, unlike some other types of insurance, clawback insurance doesn’t force executives to use lawyers from the insurer’s pre-approved list. You can choose your own counsel—but you must still get your insurance carrier to approve your counsel and the rates being charged.
These policies are still relatively new, so availability varies. The good news is that when these policies are available, insurers mainly rely on publicly available company information to evaluate risk, so the process is quick and doesn’t require much effort from the executive.
Preparing For Clawbacks
Ideally, your company will avoid making financial reporting mistakes altogether. But if you are concerned that this might happen, having some insurance protection may help to prevent a clawback situation from derailing your financial plans.