Buried within the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is the requirement for public companies to develop and implement a mandatory policy to recoup excess incentive-based compensation from current and former executive officers after a material financial restatement.

While compensation recovery policies (or “clawback” policies) are not new, these latest requirements are more stringent and are designed to force companies to tighten up the provisions within their clawback policies and get tough on actual enforcement. As evidence of this “get tough” stance, the Dodd-Frank Reform Act goes so far as to require the national exchanges to delist any company that fails to comply with its own clawback policy.

The new clawback policy requirements

As many know, the concept of clawback policies originally came onto the scene back in 2002 as a result of the Sarbanes-Oxley Act (specifically, Section 304). At the time, the clawback provisions only applied to the chief executive officer and chief financial officer. Furthermore, the provisions were only applicable if the noncompliance resulted from misconduct and was only relevant for compensation events during the year following the misstatement.

Fast forward to July 2010 and we find new and more stringent clawback provisions that require any company listed on a national securities exchange to develop and implement a mandatory recoupment policy stating that following an accounting restatement due to material noncompliance with financial reporting requirements under securities laws, the company will recover certain incentive-based compensation (including stock options) from current or former executive officers for amounts received during the three-year period preceding the date on which the company is required to prepare the accounting restatement. The amount of compensation to be recovered is calculated as the excess amount paid on the basis of the restated results.

In contrast to Section 304 of the Sarbanes-Oxley Act of 2002, the new clawback provisions are broader and cover more individuals. They now apply to all current and former “executive officers” which includes not only the CEO and CFO but also a company’s president, any vice president in charge of a principal business unit, division or function and any other officer who performs a policy making function or person who performs similar policy making functions for the company. In addition, the new requirement to recoup compensation is not dependent on the restatement being a result of executive misconduct. Furthermore, the look back period has been extended from one year to three years and companies must now disclose their clawback policy.

While further clarification is needed, companies would be wise to get ahead of the curve

Some aspects of the Dodd-Frank Act clawback provision are ambiguous and it is clear that further guidance will be required. For starters, the Reform Act does not specify an effective date for implementing the clawback provisions nor does it clearly define what constitutes “material noncompliance” or “incentive-based compensation.”

Until the SEC issues more detailed rules (perhaps in time for 2011 proxy statements?), it will be difficult to ensure complete compliance, however, from a corporate governance perspective, it is recommended that companies not wait — review current policies and consult with an attorney to determine whether or not your policy aligns with the new legislation and subsequent guidance.

On the heels of a study that points out the imbalance in proportionate costs for small companies to comply with SOX, Accounting Today reports that The House Financial Services Committee voted that small and midsized public companies should be exempt from Sarbanes-Oxley audit requirements.

The result is a pending bill (Investor Protection Act) that will continue making its way through the legislative process.  But if it does progress it will be a game-changer for companies with market caps under $75 million, as the cost of audits has proven significant enough to alter companies’ strategy and perhaps even hold them back from peak performance. CFO magazine highlights the relief of small companies everywhere in this recent story, in which they note that:

Many financial executives say an exemption would mean the same level of integrity in their financials but with less cost. “We have a fairly good system of internal controls, and we’d like to keep that for our own well-being as much as anything else,” says Marty Schwenner, CFO of digital-power and motion-control systems manufacturer Magnetek, a company whose market cap dropped it from the accelerated filer range to the nonaccelerated filer range this year. “We view internal control as something that’s our responsibility whether or not Congress tells us it’s something that is.”

Mr. Schwenner took the words right out of my mouth, and I applaud his sense of obligation.  Internal controls will always be a crucial piece of the business that streamlines financials and paves the way for airtight fraud prevention, regardless of audit requirements.  We encourage non-accelerated filers to enjoy the potential relief of the exemption, but to remain vigilant when it comes to maintaining and monitoring their financial controls.