Part 2: The SEC's Dodd-Frank Clawback Proposal
So many lost clawback opportunities... Was it by default or design?
There is a tide in the affairs of men, Which taken at the flood, leads on to fortune. Omitted, all the voyage of their life is bound in shallows and in miseries. On such a full sea are we now afloat. And we must take the current when it serves, or lose our ventures. William Shakespeare
Today in Part 2 I will discuss what we can learn from the past. In Part 3 on Monday we’ll wrap up with how we salvage something for the future. If you are looking for some new issues I identified and my conclusions and recommendations, jump to Part 3. Part 1 described the SEC’s Dodd-Frank Sec. 954 Clawback Proposal, its reopening of the comment period and some of the history surrounding this initiative.
Financial Crisis Restatements That Never Happened
At the beginning of the financial crisis, it seemed that there would be tough action taken on fraud and on any executives that took financial advantage of it. At the Directorship Boardroom Leaders Forum in New York in November of 2009, I listened to luminaries pant at the possibility that activists would successfully sue to recover wrongfully rewarded remuneration.
During the panel in New York, Professor Coffee mentioned activist lawsuits initiated by plaintiff’s firms such as Coughlin Stoia, whereby letters have been sent threatening shareholder derivative suits to recover “ill-gotten gains.” In other words, we are referring to bonuses and incentive payments to executives of companies that had restatements or where fraud or accounting manipulation distorted results.
Incentive compensation clawbacks are a very hot issue, whether you’re talking about TARP recipients or just plain old companies that paid out incentive compensation to executives who manipulated results.
In my August 2011 Boston Review essay, I asked, “Why have there been no Section 304 clawback cases as a result of the crisis?”
The answer is simple: many of the failures and bailouts did not result in financial restatements. Accounts that reflected overly optimistic valuations of mortgage-related assets, insufficient reserves to cover losses on those assets, and no contingency for litigation have been adjusted slowly and over a long period of time rather than all at once. No one has admitted that anyone made any mistakes, let alone manipulated the numbers with fraudulent intent. The losses we’re seeing now have been written off, literally and figuratively, as an unavoidable, cataclysmic, once-in-a-lifetime economic event. Moreover, even in cases where a company is forced to restate its earnings, such as the huge Dell restatement case, the SEC has for some reason resisted using the clawback tool.
Some of the opportunities the government might have considered before, during, and after the financial crisis were high-profile cases involving financial restatements as a result of misconduct at well-known companies, including JPMorgan Chase, GM, and General Electric.
In 2013, the “London Whale” trading disaster cost JPMorgan Chase more than $6 billion. JPMorgan did cut Chief Executive Jamie Dimon’s 2012 compensation. Dimon gave up $11.5 million when the bank decided to eliminate his 2012 cash bonus and stock-appreciation rights grant, and to reduce his restricted-stock units grant by $2 million, effectively cutting his total compensation for the following year by 50%. The bank said Dimon bore “ultimate responsibility” for the losses and the internal problems that led to them.
Former JPM CFO Doug Braunstein also suffered the loss of future compensation when the bank restated its financials in 2011 by $459 million to adjust for improperly accounting for a $6 billion loss resulting from bad trades. He tossed back $4.5 million in future earnings by forgoing his 2012 cash bonus and stock-appreciation rights and absorbing a reduction in his restricted-stock grant.
The SEC never demanded that the bank follow federal “clawback” regulations, even though they met the criteria for such action. The financial restatement was material and disclosed, and there was clear misconduct. Bruno Iksil, the trader dubbed the “London Whale,” entered into a non-prosecution agreement with the U.S. Department of Justice under which he wouldn't be required to plead guilty to any crime. The Securities and Exchange Commission and British regulators later decided to take no action against Iksil.
Two more former JPMorgan traders, Julien Grout and Javier Martin-Artajo, faced extradition to the U.S. from France and Spain, respectively, to answer civil and criminal charges related to the bank’s $6 billion “Whale” trading loss. However, in July of 2017, the acting U.S. Attorney decided to dismiss the charges against the two.
As set forth in the proposed order, the Government sought charges in this matter based in part on the Government’s anticipated ability to call as a trial witness Bruno Iksil, a former colleague of the two defendants at JPMorgan. Based on a review of recent statements and writings made by Iksil, however, the Government no longer believes that it can rely on the testimony of Iksil in prosecuting this case, even if the defendants appeared.
JPM would have been required to determine the repayment amount using a precise calculation and then report details of that process to investors. Jamie Dimon is still CEO of JP Morgan. Doug Braunstein left JPM and is the founder and Managing Partner of Hudson Executive Capital since 2015. Neither JPM nor the SEC ever publicly explained why no clawback of already paid compensation to Dimon and Braunstein was pursued.
One year later, in September of 2016, the Wells Fargo fake account scandal hit, and there were many calls for “clawbacks” of the Wells Fargo executives pay. I wrote that the bank was unlikely to take back any of the millions in annual pay and share and cash bonuses already paid to Carrie Tolstedt, the executive formerly in charge of its banking unit where thousands of employees cheated customers for at least five years, or to CEO John Stumpf.
Clawback by Wells Fargo depends entirely on the company’s willingness to recoup. The compensation clawback provision of the Sarbanes-Oxley Act of 2002 and a proposed clawback rule under Dodd-Frank would not be applicable to the Wells Fargo situation.
Both laws require a restatement of the company’s accounts before a compensation clawback can be triggered.
The unearned income recorded on the Wells Fargo financial statements, reportedly $5 million in fees that will be paid back to customers, is not financially material enough to require a restatement.
In its 2015 proxy Wells Fargo says it “has strong recoupment and clawback policies in place designed so that incentive compensation awards to our named executives encourage the creation of long-term, sustainable performance, while at the same time discourage our executives from taking imprudent or excessive risks that would adversely impact the company.”
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.
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.
A MarketWatch analysis of forfeitures and so-called clawbacks of compensation by the Securities and Exchange Commission or by companies themselves shows that the Wells Fargo forced forfeiture of $41 million in future compensation by Chairman and CEO John Stumpf is neither the biggest nor the toughest ever.
The same goes for the giveback of $19 million in unvested share awards by the bank’s former community-banking head, Carrie Tolstedt, the analysis, supported by Audit Analytics, found.
While we have been waiting for a Dodd-Frank clawback rule, there have been some hits and some misses on enforcement of the more limited Sarbanes-Oxley clawback rule by the SEC and on a voluntary basis by companies themselves.
In August of 2015, Audit Analytics wrote in a blog post it had tried to evaluate the frequency of clawback exposure, based on the population of companies traded on NYSE or NASDAQ that disclosed an Item 4.02(a) non-reliance restatement in 2014. Of the 69 such companies, only four made any mention of the restatement at all in the executive compensation section of their 2015 proxy statements. Only a single company actually “clawed back” compensation from the period restated.
In its 2015 proxy, KBR discussed executive compensation in relation to a 2014 restatement of its fiscal 2013 financials due to errors in its revenue recognition that led to an $154 million overstatement of cumulative net income. From KBR’s 2015 proxy:
Due to the restatement of our 2013 financial results, our Compensation Committee and Board of Directors implemented our clawback policy and sought and recovered from our NEOs who are current executive officers and the former CEO and chief accounting officer the portion of their 2013 short-term incentive plan payouts that should not have been paid in light of the restatement.
In September of 2015 I did another roundup of the enforcement of the SOX Sec. 304 clawback rules to date based on that Audit Analytics data.
In fact, a new analysis finds, the enforcement of those rules—meant to reclaim compensation paid executives whose companies restated financial results as a result of misconduct—has been virtually nonexistent since they were adopted in 2002.
Companies restate financial statements because executives, auditors and their lawyers decide it is necessary to correct errors. An analysis by research firm Audit Analytics shows that there have been more than 12,000 restatements since the Sarbanes-Oxley Act was passed in 2002. In approximately 4,600 of those cases, the companies said the errors were so serious that their previously reported financial statements could no longer be relied upon. Those companies then corrected the information, refiling those financial statements with the SEC. In cases where someone at the company committed misconduct that led to a restatement, the CEO and CFO were potentially eligible for clawbacks.
It isn’t known how many of the 4,600 restatements were accompanied by misconduct, since that information is rarely made public unless the SEC makes such a claim in an enforcement order. But very few were accompanied by a company’s voluntary disclosure that it was either eligible to pursue a clawback or had recovered compensation from an executive.
In 2014, for example, 69 companies disclosed errors that required prior financial statements to be restated, according to Audit Analytics. Only four of those made any mention of the restatement in SEC filings and only one actually “clawed back” compensation from the period that was restated.
The SEC, meanwhile, has filed about 60 complaints asking for a clawback since 2002. Some of those cases are pending, but data compiled by MarketWatch shows that only 15 of those lawsuits have resulted in CEOs and CFOs paying back incentive compensation under the Sarbanes-Oxley law.
In three 2016 cases, Monsanto, Marrone Bio, and Lime Energy the SEC took a pass on Sarbanes-Oxley Section 304 clawback actions against executives because the executives reimbursed their respective companies for compensation they received after a restatement.
Joseph Hall, of Davis Polk &Wardell wrote in the Harvard Law School Corporate Governance Forum in 2016:
Even though companies have adopted more robust clawback policies, 73% of the companies surveyed still require evidence that the employee engaged in misconduct or contributed to the false financial reporting before the clawback is triggered. Thus, most companies’ clawback provisions would not be triggered in cases, such as Monsanto and Marrone Bio, where the CEO and CFO are not found to have engaged in misconduct.
In another 2016 case, the SEC successfully enforced Sec. 304 against Michael W. Laphen, the former CEO of Computer Sciences Corp, who was required to return $3.7 million of compensation, and CSC former CFO Michael J. Mancuso who was required to repay $369K.
There is always a lot of bluster and calls for executives to give back bonuses when one scandal or another occurs. But it’s often wasted breath because the situations rarely qualify for the narrowly defined SOx clawback law or even a potentially expanded Dodd-Frank one. That’s because unless the company “Big R” restates its financial results it’s a no-go. And unless we get a Dodd-Frank clawback rule that doesn’t require misconduct by someone related to the financial misstatements, it’s a no-go, again.
We’re counting on companies to do the right thing. Good luck.
In September of 2017 I wrote that Sen. Elizabeth Warren issued a statement about the Equifax breach and its CEO Richard Smith.
“I’ve called for Equifax executives to be held accountable for their role in failing to stop this data breach and hiding it from the public for forty days. It’s not real accountability if the CEO resigns without giving back a nickel in pay and without publicly answering questions.”
But the challenge was that Sen. Warren, and other critics of the Equifax and Wells Fargo executives, were spitting in the wind. I noted:
… despite the senators’ outrage and call for SEC action on clawbacks, neither one of the post-crisis clawback policies — the proposed Dodd-Frank clawback rule nor the 2002 Sarbanes-Oxley clawback rule — is applicable to the Equifax situation.
That’s because the broader Dodd-Frank policy, not yet finalized by the SEC, and the Sarbanes-Oxley clawback law that focuses only on CEOs and CFOs, both require a material restatement of prior financial results to trigger enforcement. So do most company policies, such as the one at Equifax or the one at Wells Fargo. Equifax’s policy is even more forgiving than Wells Fargo’s, exempting executives from clawbacks unless the misstatement of financial results is the result of fraud.
Coming up next: Part 3, where we’ll wrap up with some new issues, conclusions, and how we might salvage something for the future.
© Francine McKenna, The Digging Company LLC, 2021