Part 3: The SEC's Dodd-Frank Clawback Proposal
As usual, we don't need new laws and rules but, instead, for the SEC to more strongly enforce the existing ones.
The good and the wise lead quiet lives. Euripides
Today we’ll wrap up with Part 3 about how we salvage something for the future. Part 2 discussed what we can learn from the past. In Part 1 I described the SEC’s Dodd-Frank Sec. 954 Clawback Proposal, its reopening of the comment period and some of the history surrounding this initiative.
How did we get here?
After the Sarbanes-Oxley law was passed in 2002, there was a significant increase in Big “R” restatements. It was a phenomenon that became very troubling to regulators and issuers alike as it persisted.
Palmrose, Richardson, and Scholz (2003) explained that no one likes restatements and everyone wanted to reduce them.
Regulators have expressed great concern over restatements to correct non-GAAP accounting in previously issued financial statements. The perceived need to reduce the number of restatements helped motivate the U.S. Securities and Exchange Commission’s (SEC) earnings management initiative and formation of the Public Oversight Board (POB) Panel on Audit Effectiveness. It also influenced the SECs auditor independence rule-making on non-audit services provided to audit clients (Levitt, 2000; McNamee et al., 2000), a General Accounting Office probe of restatements (GAO, 2002), and certain provisions in the Sarbanes-Oxley Act of 2002 (e.g., Section 304). [Emphasis is mine.]
In 2007, SEC Chairman Christopher Cox announced the creation of the SEC Advisory Committee on Improvements to Financial Reporting, made up of professionals representing investors and other key constituencies in America's capital markets. Cox asked the Committee to develop recommendations on “reducing unnecessary complexity in the U.S. financial reporting system and making financial reports clearer and more understandable to investors”.
The chairman of the Committee, Robert C. Pozen, presented Chairman Cox with a final report including specific recommendations to deal with the persistent high number of restatements. Note that the focus was on mechanically reducing the number of restatements by narrowly redefining the users of financial statements, not by determining if the underlying reason for the restatements — material corrections to financial statements due to error or fraud — had been addressed for all users.
In 2006, more than 9% of all U.S. public companies restated their financial statements because of accounting errors. Although the number of restatements appears to have started to decline, the number is still quite high…While reducing errors in financial reporting is the primary goal, it is also important to reduce the number of restatements that do not provide important information to investors making current investment decisions. Restatements can be costly for companies and auditors, may reduce confidence in reporting, and may create confusion that reduces the efficiency of investor analysis. [Emphasis is mine.]
Pozen’s committee recommendations focused on separating the determination of whether an accounting error is material from the decision on how to correct the error. In particular, there was a deliberate focus on minimizing the possibility of what was defined then as “stealth” restatements. At that time, “stealth” restatements were defined as those made to correct material errors to prior period financial statements without disclosing to investors that they could no longer rely on those prior inaccurate financial statements.
The old “stealth” problem was theoretically solved with the adoption of the 8-K disclosure filing requirement in all cases of non-reliance. However, the unintended consequence — or was it — is that companies started pulling punches on whether or not errors in prior period financial statements were material enough to affect reliance or if they could quietly fix the problem and move on.
Pozen and his committee paved the way for companies and auditors and lawyers to exercise judgment and discretion about the audience for financial statements — investors making current investment decisions — rather than considering that users of financial statements also include those who also look back.
It’s Common Sense That Clawbacks Would Drive Fewer Big “R” Restatements
In March of 2014 I wrote again about the downward trend for formal Big “R” restatements on my legacy blog, re: The Auditors. My primary purpose was actually to write about PCAOB member Jay Hanson and his allergic reaction to the term “audit failure”. (Hanson would go on leave the PCAOB under a dark cloud and then testify for the defense when KPMG partners were criminally prosecuted for stealing regulatory data to cheat on their inspections.)
We know that formal restatements are way down, after hitting highs right after the passage of the Sarbanes-Oxley Act in 2002. Research firm Audit Analytics keeps telling us so.
But are restatements down because there is less corporate accounting and disclosure fraud? Many thinkle peep so but I definitely don’t. The SEC agrees with me and reinstated its Accounting Fraud and Disclosure Task Force last year. That’s the team dismantled by former SEC Enforcement Director Robert Khuzami who used the deceptively low formal restatement numbers as his excuse.
Not so fast, I wrote in Forbes in October 2012 right before Khuzami resigned. A drop in Big “R” restatements doesn’t mean corporate fraud has disappeared even though it was in everyone’s best interest to say so.
In a statement to FORBES, SEC Enforcement Director Robert Khuzami argued that the task force was no longer needed because accounting expertise exists throughout the agency, and the number and severity of earnings restatements (a flag for possible accounting fraud) has declined dramatically since the mid-2000s.
He added: "In a world of limited resources, we must prioritize our efforts. ... The reorganization helped to focus us on where the fraud is and not where the fraud isn't, while allowing us to remain fully capable of addressing cases of accounting and disclosure fraud."
A year after I quoted Khuzami in Forbes, Andrew Ceresney, Khuzami’s co-Director of SEC Enforcement, said the opposite.
Another trend we have seen over the last few years is a reduction in restatements. So for example, across all public companies, restatements fell from a peak of 1,771 in 2006 to 768 in 2012. Although I should also note that the number of large companies (market capitalization over $75 million) restating their financials actually jumped from 153 in 2009 to 245 last year. Some have suggested that these reductions resulted from Sarbanes-Oxley and the improvement in financial reporting caused by related reforms…
But I have my doubts about whether we have experienced such a drop in actual fraud in financial reporting as may be indicated by the numbers of investigations and cases we have filed. It may be that we do not have the same large-scale accounting frauds like Enron and Worldcom. But I find it hard to believe that we have so radically reduced the instances of accounting fraud simply due to reforms such as governance changes and certifications and other Sarbanes-Oxley innovations. The incentives are still there to manipulate financial statements, and the methods for doing so are still available. We have additional controls, but controls are not always effective at finding fraud. [Emphasis is mine.]
But by the time he took over as SEC Enforcement Director in 2014, Ceresney was singing the “fewer restatements means we are all winning” tune, too.
Separate from the Commission’s work in this area, there have been some signs of progress in the issuer reporting area more generally in recent years. For example, restatement trends are flat over the last five years, and down significantly from last decade. Specifically, across all public companies, over the past fourteen years, restatements fell from a peak of 1,842 in 2006 to a low of 761 in 2009. Since then, restatements have remained relatively flat, in the range of approximately 800 to 850 annually.
One reason for this is likely that since the accounting scandals of the early 2000s, the financial reporting regulatory landscape has changed significantly. For example, Sarbanes-Oxley resulted in significant changes to audit oversight, including the creation of the PCAOB and its oversight regime which included inspections of audit firms; the CEO and CFO financial statement certification requirements; the requirement for evaluating and reporting on internal controls over financial reporting; and enhancements to corporate governance and the role and responsibilities of audit committees. These reforms have been successfully implemented and have helped to bring renewed attention to the importance of reliable financial reporting, including the importance of maintaining effective internal controls in making disclosures.
In 2015, former SEC Chief Accountant James Schnurr said at a conference that Sarbanes-Oxley regulations have reduced corporate fraud, doubling down on Robert Khuzami’s comments to me back in 2012 for Forbes. Former SEC Enforcement attorney Bradley J. Bondi said to me at MarketWatch in 2015 that potential clawbacks are not among the chief concerns for companies considering restatements.
However, the objective evidence is overwhelming that companies and executives — with the help of lawyers and auditors — often make decisions about materiality, disclosures of misstatements due to fraud and error, and restatements based on whether their decisions would lead to compensation clawbacks.
One lawyer that defends companies and executives when the SEC comes after them admitted it. Back in 2009, the Financial Times quoted former SEC Enforcement attorney Nader Salehi regarding the SEC’s first SOx 304 case to recover incentive compensation from a CEO, Maynard Jenkins of CSK Auto, who was not accused of misconduct.
If they are successful, I expect to see them using it often and I bet it would change the way CEOs and CFOs behave when it comes to restatements, though it may also make people even more reluctant to take those jobs.
I wrote in November of 2015 that Pyzoha concluded that executives are less likely to agree to fix errors in financial statements when the bulk of their pay is incentive-based, in research published in the November 2015 edition of Accounting Review.
In “Why Do Restatements Decrease in a Clawback Environment? An Investigation into Financial Reporting Executives’ Decision-Making during the Restatement Process,” Pyzoha found that executives are less likely to agree with an auditor’s proposed restatement when the compensation structure is more heavily incentive-based, especially if that auditor is considered “lower quality” as defined by that auditor’s experience in that industry. Executives with the same high percentage of incentive compensation are more likely to accept the proposed restatement from an audit firm with more experience in their industry.
Challenges to Effective Implementation of the SEC’s Dodd-Frank Proposal
We are now seeing barely any Big “R” restatements but we still see still plenty of fraud — disclosure fraud as well as accounting fraud— and little “r” “stealth” restatements are now how the vast majority of all restatements are characterized. Why even bother to implement a rule that says corporate policies should be enforced only if there is a restatement that impacts the current investors? Is it even worth the trouble?
The restatements that would qualify for either Sarbanes-Oxley clawback or a potential Dodd-Frank clawback are approaching extinction.
Reissuance restatements are those Big “R” restatements where companies disclose in Item 4.02 of an 8-K filed with the SEC and/or with a formal statement of non-reliance on prior financials. Revision restatements are the so-called little “r” stealth restatements where errors are corrected only on a go-forward basis.
Why do I really think restatements, and in particular Big “R” restatements, are declining?
Auditors make the final call on the necessity of a restatement under pressure from executives and their lawyers. It’s in all parties’ best interest to minimize all restatements, but especially Big “R” restatements. When they do step up to cite material weaknesses, for example, or to push for adjustments they get squashed or, worse yet, fired for their nerve. Making fewer restatements reduces the likelihood auditors will be fired and/or named as a defendant in a shareholder lawsuit.
Compromising on the requirement for a restatement by downgrading the materiality of errors or misstatements reduces the likelihood auditors will irk executives by setting them up for SOx or Dodd-Frank clawbacks claims. A restatement is required to force reimbursement under both laws.
Fewer restatements means auditors can argue with PCAOB that a significant regulatory inspection deficiency didn’t result in “restatement” and, therefore, can be left out of its public inspection report. Likelihood of additional follow-up by the SEC resulting in sanctions or fines is also minimized.
There are several challenges to passing the SEC’s Dodd-Frank proposal and to effective implementation. I critiqued the SEC’s Dodd-Frank clawback proposal in a series of articles in 2015 for MarketWatch. That critique is still valid, even before one considers an expansion of the definition of restatement.
The SEC’s Proposal Comment Request Question 5 notes that there has been an increase in voluntary adoption of compensation clawback policies in recent years, together with accompanying disclosures about those policies. When I wrote in 2016, about the Wells Fargo fake accounts fraud, I noted banks adopted clawback policies because they had to not because they wanted to adopt them.
Wells Fargo had no policy until 2008. That’s because, that year, President George W. Bush signed the Emergency Economic Stabilization Act, which established the Troubled Asset Relief Program to bail out big banks battered by the financial crisis. In return for their bailout funds, banks like Wells Fargo were required to implement “a provision for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.”
Pyzoha (2015) writes: Since the passage of the Dodd-Frank Act, voluntary adoption of clawback policies has increased as firms await the final clawback rules that are forthcoming from the SEC.According to a survey of the Fortune 100, only 18 percent of firms had clawback policies in 2006, whereas approximately 87 percent had such policies in 2012. These firms have implemented and disclosed clawback policies without the benefit of specific guidelines from the SEC.
Bakke, Mahmudi and Virani (2017) write: We find that relative to firms that had voluntarily adopted a clawback provision prior to the SEC’s announcement [of proposed Rule 10D-1 that mandates clawback provisions], firms that did not have a clawback provision experienced positive abnormal returns, suggesting that clawback provisions are value-enhancing. Furthermore, the announcement had the greatest positive impact on firms without a clawback with more powerful managers. Our findings suggest that clawbacks create a valuable disincentive to misreport information, but that despite this, powerful managers may resist their adoption, which is why regulation mandating clawbacks may be necessary.
I critiqued the SEC proposal’s means of enforcement, the stock exchanges, in 2015.
The new rules also add a new enforcement layer between the company and the government. A company that doesn't seek clawbacks under its own policies could be delisted by its stock exchange—a stiff penalty, but also one experts say places a heavy burden on exchanges to monitor compliance with complex compensation policies and make rulings that could result in a financial loss to the company and the exchange.
That’s a lot to ask exchanges, experts say, and so they may be more likely to accept company explanations based on the significant discretion the law gives boards to determine whether or not to pursue a clawback.
In my opinion, exchanges are a very poor option for enforcement. Just take a look at their failure to block fraudulent Chinese companies from listing and their reluctance to force delisting now. Even when violations of securities laws, audit standards, and listing standards are obvious, the beat goes on.
The SEC is the best place to enforce securities laws, early and on a timely basis, before a company becomes too big or too politically powerful to smack down. The SEC is not lately very successful there, either, but at least they have the pre-IPO review process and the triennial review process that can be used to throttle companies that don’t implement the appropriate corporate governance policies.
Several other factors that likely limited past enforcement are still in place with the new proposal and not expected to change. I wrote in 2015:
The Sarbanes-Oxley clawback-eligible compensation period is limited to payments received in the 12-month period following the public release of financial information that is restated. If payments were made outside that window, the rule didn’t apply. The proposed Dodd-Frank rule will expand that window to three years, but because incentive compensation is typically paid after it is earned, even a three-year limit may exclude some otherwise-eligible compensation. (There has already been at least one case where that is an issue.)
Recoveries from Sarbanes-Oxley and Dodd-Frank clawbacks go back to the company. Some companies have told the SEC they don’t want the money back, discouraging SEC enforcement efforts.
The government’s cost-benefit analysis about whether to pursue a case has limited enforcement efforts. If the amount a company would recover is seen as too small, or the case lacks what a former SEC attorney called a “fun factor”—in short, an opportunity for the government to make a strong statement—it might be shelved, or the government could apply other laws to obtain payback without using the Sarbanes-Oxley rules. (In the latter case, the money goes to the U.S. Treasury, not the company.)
Deferred bonuses, which are payments earned for performance one year but paid out in a future year or at retirement, are relatively easy to reclaim. But money that isn’t spent on tangible items that can be seized—or is put in a trust, lost to bankruptcy, or given to an ex-spouse—may be more trouble to recover than it is worth, the attorneys I interviewed in 2015 all said.
Companies can decide to use more forms of compensation—such as increased salaries, or bonuses based on tenure rather than financial metrics—that aren't subject to clawback, making enforcement impossible.
Exemptions: When I was actively writing about the SEC’s Dodd-Frank clawback proposal in 2015-2016 for MarketWatch, I became very curious about how the SEC decided whether or not to pursue a SOx 304 clawback enforcement action. One strategy for companies that would have liked to avoid SOx clawback litigation is Section 304(b) which allows for exemptions.
In 2015, Luis Aguilar, a Democrat SEC Commissioner who served from July 31, 2008, until December 2015, told me that, “during my tenure as a Commissioner, the Commission has not received a request for an exemption from a Section 304 clawback.” Aguilar also said that at that time the SEC had not provided the staff with delegated authority to issue exemptions from the application of Section 304(a) clawbacks. There is currently no public record of any company requesting one or the SEC granting one. I have submitted a FOIA request to the SEC to see if there are any responsive records.
Positive Restatements: Another issue that hasn’t been touched on in the amended proposal is positive restatements. I wrote in 2015 that they are more common than you might think, and often quite significant. People knowledgeable about SEC enforcement, meanwhile, say very few executives inquired in the past about the possibility of using the current rules to bump up their compensation in such cases. But positive accounting restatements, though uncommon, do happen—and their effect can be huge.
According to research firm Audit Analytics, from 2010 to 2015 there were 140 instances of restatements to correct material accounting errors that resulted in a positive impact on financial metrics commonly used to determine bonuses. The top 30 cases swung net income to the good for between $9 million and $175 million —certainly enough to potentially impact the calculation of a CEO’s or CFO’s incentive compensation.
I took a new look at the restatement data from Jan. 1, 2010, when the Dodd-Frank Law was passed, to October 1, 2021, according to research firm Audit Analytics. There have been 1,429 cases of restatements to correct material accounting errors disclosed in a filing or press release that resulted in a positive impact on financial metrics commonly used to determine bonuses. The top 30 cases swung net income to the good for between $86 million and hundreds of millions — certainly enough to potentially impact the calculation of a CEO’s or CFO’s incentive compensation.
There have been 7,346 cases of restatements to correct material accounting errors disclosed in a filing or press release that resulted in a negative impact on financial metrics commonly used to determine bonuses from Jan. 1, 2010, when the Dodd-Frank Law was passed, to October 1, 2021. There are many companies with multiple error corrections during the period, often reporting a net -0- impact on net income. The top 30 cases swung net income to the bad for between $436 million and billions — certainly enough to potentially impact the calculation of a CEO’s or CFO’s incentive compensation.
Positive impact restatements result in a change in auditors much less often than negative ones, 17% versus 57% in the top 30 cases for each, according to the Audit Analytics data.
What Can We Do?
What strategies might mitigate the potential for companies to get around clawback rules by using more forms of compensation—such as increased salaries, or bonuses based on tenure rather than financial metrics—that aren't subject to clawback? One approach was described in Theo Francis’ WSJ article in February of this year:
Companies are withholding more of their top officers’ pay for longer, hoping to avoid the hassle of recouping money when—or if—executives are later found responsible for misconduct.
The changes build on clawback provisions that have become widespread in compensation agreements, and are a recognition by companies that retaining unpaid compensation is easier than trying to recover it once it is in an executive’s hands.
However, Francis tells us it doesn’t always go as we’d like, for example at the latest financial fraud at GE:
General Electric Co.'s board decided in December to not claw back pay from former CEO Jeff Immelt and other executives over accounting and other issues, after an outside law firm's three-year investigation concluded such a move wasn't warranted or in the company's interest.
It seems to me, too, that the SEC is doing everything possible — including adding untenable complexity— in order to avoid opening up the controversial discussion of how materiality is determined. The last time that happened it was a disaster and getting into the muck about materiality would definitely doom any hope to make any rule effective.
FASB’s proposal changes the definition of materiality that company accountants and external auditors would use when reviewing which financial statement disclosures make it to the quarterly and annual reports. The proposal consists of two drafts, now open for public comment. One proposal aims to clarify the concept of materiality and the other says how to apply discretion when determining what disclosures make it into financial statements. FASB said the updates were intended to “improve the effectiveness of disclosures in notes to financial statements.”
The FASB proposals are significant, say legal and accounting experts, because they redefine materiality as a legal concept to be interpreted by the courts, rather than an accounting concept. The proposals, in particular, aim to bring the accounting standards in line with the Supreme Court’s definition of materiality for lawsuits involving the securities laws, according to the FASB. They eliminate a detailed discussion of materiality in the accounting standards and replace it with a general description of the Supreme Court’s definition of materiality.
“FASB says it’s just a clarification,” says University of Denver law professor J. (Jay) Robert Brown, Jr., a member of the IAC and its secretary. “This is anything but just a clarification. There’s no way this cannot be seen as an effort to reduce disclosure.”
In the request for comment, the SEC reminds us that the staff “has provided guidance to assist registrants in carrying out these evaluations.” It points to two documents, Staff Accounting Bulletin No. 99, Materiality from1999 and Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements from 2006.
The statements in the staff accounting bulletins are not rules or interpretations of the Commission, nor are they published as bearing the Commission's official approval. They represent interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws.
It’s no wonder, then, that there’s plenty of ambiguity left in the materiality “guidance” for everyone to work with if they want to avoid Big “R” restatements and, therefore, clawbacks. Instead of creating more complexity and new rules to get back wrongful compensation from what is a disappearing population of qualified restatements, maybe the answer is as simple as enforcing the existing rules.
Maybe the SEC should step up and start questioning materiality decisions that lead to little “r” restatements more often than Big “R”. If all the Big “R” restatements that are out there were reported as such, based on qualitative as well as quantitative grounds, maybe we’d see more clear cut mandates for companies to take back ill-gotten compensation.
That would serve the dual purpose of getting compensation paid under erroneous or fraudulent circumstances back and stopping an ongoing stealth attack on the integrity of financial reporting.
© Francine McKenna, The Digging Company LLC, 2021
“Can we get some cash money, now?” “Plenty of dollars!”