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SEC approves rule to claw back executive pay after 'material error' in financial statements

The SEC approved a rule to claw back executive compensation of companies that have to materially correct financial statements, raising the bar for Corporate America's highly paid CEOs.

"Corporate executives often are paid based on the performance of the companies they lead, with factors that may include revenue and business profits," SEC Chair Gensler said in a statement. "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. Whether such inaccuracies are due to fraud, error, or any other factor, today’s rules would implement procedures that require issuers to recover erroneously-rewarded pay, a process known as a 'clawback.'"

The vote, which passed along party lines 3 to 2, occurred at Wednesday's Open Commission Meeting.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in July 2010 in the wake of the Great Financial Crisis, mandated that the SEC adopt rules directing national securities exchanges to require clawback policies as part of their listing standards. The SEC first proposed this clawback rule in 2015 and reopened it for public comment in 2021 and 2022 to consider recent shifts in the markets and how companies issue restatements of financials.

WASHINGTON, DC - SEPTEMBER 15: Securities and Exchange Commission (SEC) Chair Gary Gensler testifies before the Senate Banking, Housing, and Urban Affairs Committee, on Capitol Hill, September 15, 2022 in Washington, DC. The Committee met to hold an oversight hearing on the SEC. (Photo by Kevin Dietsch/Getty Images)
Securities and Exchange Commission (SEC) Chair Gary Gensler testifies before the Senate Banking, Housing, and Urban Affairs Committee, on Capitol Hill on September 15, 2022 in Washington, DC. (Photo by Kevin Dietsch/Getty Images)

The new rule will require U.S.-listed companies to put a plan in place for recovering incentive-based compensation paid to its current or former executive officers in situations where an issuer is required to restate its financial statements.

The SEC will also require that national securities exchanges create standards that would make companies listed on the exchanges adopt and comply with the clawback policy and would require issuers to provide details about the policies are being implemented.

The rule will go into full effect in a year and two months unless issuers comply earlier.

When asked whether he thinks companies could restructure executive compensation to avoid clawbacks, Gensler replied, “I don’t share the view that companies could shift toward more salaries. It may change how they’re doing it, but it better aligns it with incentives that you don’t get paid on errors…I think boards would rather have incentive pay based on valid financials and take away any possible incentives to have faulty financials. This better aligns the incentives.”

While the SEC is focused on cracking down on financial restatements and better aligning that with monetary incentives, since their peak in 2006, the number of annual financial restatements has declined by over 80%, according to Audit Analytics. 2020 saw the lowest percentage of companies disclosing a financial restatement in 20 years with just 4.9% of companies restating previous financial statements, compared to 6.8% in 2019 and 17% at the peak in 2006.

Also on Wednesday, the SEC is set to adopt a rule that would simplify shareholder reports to help retail investors better understand the performance of mutual funds and exchange-traded funds.

The SEC would request funds to give investors a 3-4 page report instead of 100 pages, consolidating information to the highlights of the fund’s expenses, performance, holdings, and any material changes. Investors would still have access to all the required information, including full financial statements online.

This post was updated after the vote occurred.

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