The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In the latest example of the SEC’s use of its compensation clawback authority under Section 304 of the Sarbanes-Oxley Act, the SEC reached a settlement with the former CFO of Beazer Homes to return more than $1.4 million in bonus compensation he earned during a period when the company was committing accounting fraud. As is contemplated under Section 304, the former CFO, James O’Leary, was obligated to return the bonus compensation even though he was himself not charged with any wrongdoing in connection with the accounting fraud. The SEC’s August 30, 2011 press release about the settlement can be found here.

The SEC has previously accused Beazer Homes and its former chief accounting officer, Michael Rand of accounting fraud. In September 2008, Beazer settled its SEC enforcement action. The SEC action against Rand is continuing. Last year, as reported here, Rand was separately indicted on charges including securities fraud and witness tampering. The SEC alleges that during various fiscal years including 2006  Rand and other employees misreported the company’s income by releasing redundant reserves to avoid missing analysts’ estimates.

O’Leary served as CFO from 2003 to 2007. However, in the SEC complaint against him, he was not charged with any involvement with or even any awareness of the accounting improprieties. Under Section 304, if any reporting company fails to comply with the financial reporting requirements of the federal securities laws, then the company’s CEO and CFO can be compelled to return bonus compensation or stock sale profits earned during the twelve months following the financial misreporting. Section 304 does not require that the CEO or CFO be personally charged with the misconduct or to have otherwise violated the securities laws.

Under the terms of his settlement with the SEC, which is subject to court approval, O’Leary agreed to reimburse Beazer more than $1.4 million in case, including his fiscal 2006 bonus of $1.02 million, plus $131,733 in stock compensation. He also agreed to reimburse the company $274,525 in stock sale profits.

O’Leary’s settlement follow the SEC’s similar March 2011 settlement with  Beazer’s CEO Ian McCarthy, who returned several millions of dollars in bonus compensation and stock compensation he had received.

These SOX Section 304 clawback actions against Beazer Homes CEO and CFO follow prior Section 304 clawback actions in which the SEC has sought reimbursement of compensation paid to corporate officials they had earned during periods in which their companies had made financial misstatements, as I discussed in an earlier post. As was the case in the actions against Beazer’s CFO and CEO, in the prior actions the officials involved were not alleged to have been involved in or aware of the financial misreporting. At least one court (refer here) has affirmed the SEC’s authority to pursue the compensation clawback under these circumstances, under SOX Section 304.

Though statutorily authorized, the implementation of a forfeiture without culpability or fault raises troubling questions, including even basic questions of fairness. On the other hand, it might also fairly be asked whether the CEO or CFO ought to be able to retain benefits accumulated at a time when the investing public was being misled, by financial statements that the CEO and CFO certified, about the company’s financial condition. As an SEC official was quoted as saying in the press release about the SEC’s settlement with O’Leary, “Section 304 of the Sarbanes-Oxley Act encourages senior management to take affirmative steps to prevent fraudulent accounting schemes from occurring on their watch.”

Regardless of where you come down on the propriety of the compensation clawback without culpability of any kind, the question is about to extend a much broader array of corporate officials. As discussed here and here, under Section 954 of the Dodd-Frank Act, the national securities exchanges are required to promulgate rules requiring reporting companies to adopt and disclose procedures providing for the recovery of any amount of incentive based compensation paid to any current or former executive that exceeds the amount which would have been paid under an accounting restatement in the three years prior to the date on which the company was required to prepare the restatement. The Dodd-Frank provision is quite a bit broader than Sox Section 304, as it extends to all executives and it reaches back three years and to all incentive based compensation.

As I have previously noted (here), these provisions allowing for the return of compensation without fault or culpability raise a host of potentially troublesome insurance coverage issues. The marketplace has responded, as many carriers are now willing in at least some cases to add a provision to their policy stating that the policy will cover defense expenses incurred in connection with a SOX 304 action.

With the advent of the Dodd-Frank Section 954 requirements, it may be worth asking whether the relatively new Section 304 policy provisions need to be further extended to clarify that the policies will also provide coverage for defense expenses incurred in a Section 954 action or any other compensation clawback provision.

Beazer Homes financial misreporting has led to a slew of litigation. As discussed here, Beazer previously settled for $30.5 million the subprime-related securities class action lawsuit that had been filed against the company and certain of its directors and officers. And as discussed here, the company also settled the separate subprime-related shareholders’ derivative suit that had been filed against the company, as nominal defendant, and certain company officials.

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The SEC has made it clear that it intends to use Section 304 of the Sarbanes-Oxley Act to "clawback" compensation from CEOs and CFOs of companies that restate their financial statements, even if the individuals are not alleged to have engaged in any wrongdoing. A recent district court opinion confirms that the statute gives the SEC the authority to proceed on that basis. These actions raise complex D&O insurance coverage concerns that arguably suggest certain necessary policy adjustments.

Section 304 provides that if a company restates its financials, the company’s CEO and CFO, who certified the financial statements under Sox Section 302, "shall reimburse" the company for any bonus compensation received during the 12 months following the restated period, as well as any stock sale profits earned during those twelve months.

There is no requirement in Section 304 that the CEO or CFO from whom reimbursement is sought have any involvement in the events that necessitated the restatement; indeed, the statute doesn’t require any showing of wrongdoing or fault.

The SEC’s first use of this statutory provision to clawback compensation from a corporate official against whom no wrongdoing is alleged was the enforcement action filed in July 2009 against Maynard Jenkins, the former CEO of CSK Auto. I first wrote about this enforcement action in a prior post, here.

CSK Auto had restated its financial statements for the fiscal years 2002 to 2004. The SEC filed separate enforcement actions against the company and four company officials for securities law violations in connection with the restatements. However, Jenkins is not among the company officials alleged to have violated the securities laws.

The SEC’s action, filed in reliance on Section 304, seeks to compel Jenkins to reimburse CSK Auto for more than $4 million he received in bonuses and stock sale profits "while CSK was committing accounting fraud." Jackson not only is not alleged to have had any role in or awareness of the alleged scheme, but the SEC has actually alleged in its separate enforcement action against the other CSK officials that the others concealed their scheme from Jenkins.

Jenkins moved to dismiss the SEC’s clawback action on numerous grounds, arguing that he cannot properly be forced to disgorge compensation in the absence of any personal wrongdoing.

In a June 9, 2009 order (here), District of Arizona Judge G. Murray Snow held that the SEC’s complaint against Jenkins alleges facts sufficient to state a claim under Section 304, stating further that "the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer’s CEO or CFO."

Judge Snow elaborated by saying that "the misconduct of the issuer is the misconduct that triggers the reimbursement obligation of the CEO and the CFO." Before reimbursement can be required "the issuer’s misconduct must be sufficiently serious to result on material noncompliance with a financial reporting requirement."

The SEC has already made it clear that it intends to use Section 304 to try to clawback compensation from other CEOs and CFOs who are not alleged to have done anything wrong. For example, just a few days ago, the SEC settled a Section 304 filed against Walden O’Dell, the former CEO of Diebold, even though, as noted in the SEC’s June 2, 2010 litigation release, the SEC’s complaint does not allege that O’Dell engaged in the alleged fraud at Diebold.

Judge Snow’s opinion in the Jenkins case confirms that the SEC may properly pursue Section 304 clawbacks even against corporate officials who are not alleged to have engaged in personal wrongdoing (although he did leave open the question whether the statute could be used in ways that would be unconstitutionally punitive).

Though statutorily authorized, the statute’s use to effect a forfeiture without culpability or fault raises troubling questions, including even basic questions of fairness. On the other hand, it might also fairly be asked whether the CEO or CFO ought to be able to retain benefits accumulated at a time when the investing public was being misled, by financial statements that the CEO and CFO certified, about the company’s financial condition.

Beyond these issues, these kinds of actions may also raise complex D&O insurance coverage questions.

A Section 304 claim potentially would raise at least two possible coverage concerns – first, whether the claim involves an allegation of a "wrongful act" as required to trigger coverage; and second, whether coverage for the claim is precluded by the "profit or advantage" exclusion.

D&O insurance typically is only triggered by a claim made against an insured person for an actual or alleged wrongful act. Under a Section 304 claim in which no personal wrongdoing is alleged, the question would arise whether a wrongful act has been sufficiently alleged to trigger coverage under the policy.

I think it could fairly be argues that a Section 304 claim does involve a wrongful act even if no personal wrongdoing is alleged against the individual defendant. As Judge Snow’s opinion in the Jackson case emphasized, a prerequisite to a Section 304 claim is misconduct by the issuer (which is an "insured" under the typical public company D&O insurance policy’s "entity coverage" provision).

Given the statutory prerequisite of issuer wrongdoing, a Section 304 claim necessarily involves a claim for a wrongful act, even if the wrongful act alleged is not that of the targeted individual. The typical D&O policy emphatically does not say that the claim must be made against an insured person for that insured person’s own wrongful act – to the contrary, the typical policy requires only that the claim be made for "an actual or alleged wrongful act," without specifying whose act it must be.

Nevertheless, I can still imagine a carrier bent upon denying coverage urging that this policy provision requires a wrongful act by the insured person against whom the claim has been made, which may indicate the need for certain policy revisions, as detailed below.

Even if the wrongful act concern can be overcome, there is still the policy exclusion to be dealt with. The typical D&O policy excludes coverage for any loss based on a claim for any "profit or advantage" to which the insured is not legally entitled. A carrier might attempt to rely on this provision not only to deny coverage for the amount of any reimbursed compensation, but also to try to deny coverage for the costs of defending the claim.

One way to try to circumvent this concern about Section 304 defense costs is to amend the exclusionary provision to required a judicial determination in the underlying claim that the insured was not legally entitled to the "profit or advantage," which would at least allow defense costs to be advanced up until there has been such a judicial determination. The limitation of this approach is that once there has been a judicial determination, the carrier might seek to be reimbursed for the advanced defense costs.

The point here is that the question of D&O insurance coverage for the costs of defending a Section 304 clawback claim could be problematic. One approach to try to address these concerns would be to amend the policy to provide that the "profit or advantage" exclusion will not be applied to the costs of defending a Section 304 act, and to further amend the policy to provide that the carrier will not take the position that a Section 304 action does not allege a wrongful act.

At least one insurer has taken an alternative approach to address the Section 304 defense cost issue in its revised policy form. Under this approach, the costs of defending a Section 304 claim are expressly included in the policy’s definition of Loss.

It is not my intention here to debate the merits of these alternative approaches (which indeed may not be mutually exclusive) or of any other alternative approaches that might exist. My purpose here is simply to point out that this issue has reached the point where the question of Section 304 defense expenses ought to be addressed in the D&O policy form.

Just as a few years ago, the D&O insurance industry quickly adapted express policy language designed to address concerns arising from SOX whistleblower claims, it may now be time for the industry to adapt express policy provisions addressing Section 304 defense costs. Policyholders should not have to wait until the claim has been filed to find out what the carrier’s position will be on Section 304 defense expenses.

2010 World Cup: Some Early Notes:

1. Vuvuzela: Did the site selection committee know about those damned vuvuzela horns when they chose South Africa as the 2010 World Cup venue? What an awful, idiotic noise. (There are reports that the event organizing committee is considering a ban.)

2. Remember, The Beautiful Game is Fast, Too: England was up on the U.S. by a goal before I even had a chance to turn the T.V. on.

3. U.S. Goal Inspires Headline Writers Everywhere: Here’s my entry – "English Green’s Gift Gaffe Gives Yanks a Goal."

4. Most Underappreciated: Tim Howard ought to be one of the most celebrated athletes in the U.S. He certainly is one of the most talented.

5. Go Figure: The official nickname of the Australian team is the "Socceroos." Discuss.

6. Self-Destruction (and Team Takeout, Too): Substitute Algerian striker Abdelkader Ghezzal entered his team's game against Slovenia in the 58th minute (which was a scoreless tie at the time). Approximately five seconds later he was given a yellow card for an aggressive tackle. Then in 74th minute, he earned his second yellow (and an automatic red card, requiring his ejection from the game) for a flagrant hand ball . Within minutes, his shorthanded team conceded Slovenia's winning goal.

7. Divided By a Common Language: The "pitch" is the playing field. A "side" is a team. A "strike" is a shot. To "win a cap" is to be selected to play for your country’s team. "Nil" means zero. "Draw" means tie. And "nil-nil draw" (usually preceded by the word "dreaded") means a scoreless tie. The phrase "argy bargy" is not susceptible to translation. 

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By the SEC’s own account, an enforcement action the SEC initiated on July 22, 2009 represents the first occasion on which it has used the Sarbanes-Oxley Act’s "clawback" provision to recover compensation from an individual not otherwise alleged to have violated the securities laws. While this type of action apparently was contemplated by the statute, it has never been pursued before and it raises some interesting questions.

As reflected in the SEC’s July 22, 2009 press release (here), the SEC enforcement action charges Maynard L. Jenkins, the former CEO of CSK Auto, with violation of Section 304 of the Sarbanes Oxley Act, the statute’s compensation clawback provision. The action seeks to compel Jenkins to reimburse CSK Auto for the more than $4 million he received in bonuses and stock sale profits "while CSK was committing accounting fraud." A copy of the SEC's complaint can be found here. (Hat tip to the Courthouse News Service for the complaint.)

In May 2009, the SEC brought a settled enforcement action against CSK for filing false financial statements for fiscal years 2002 though 2004. The SEC has also brought a separate civil enforcement action against four CSK officials, but Jenkins is not among the officials that the SEC is pursuing.

Section 304 does provide that if a company restates its financials, then the company’s CEO and CFO "shall reimburse" the company any bonus compensation received during the 12 months following the restated period, as well as any stock sale profits earned during those twelve months.

There is no requirement in Section 304 that the CEO or the CFO from whom the reimbursement is sought have any involvement in the events that necessitated the restatement. Indeed, the statute doesn’t require any showing of wrongdoing or fault at all.

Professor Larry Ribstein criticizes the SEC’s use of the statute this way in a post on his Ideoblog (here), for "punishing business executives even when they are not accused of making a mistake." Jenkins undoubtedly will attempt to challenge the SEC’s attempt to use the statue this way. This provision has never been challenged on this basis before, so it will be interesting to see whether it withstands the legal challenge.

The SEC’s use of the statute in this way will undoubtedly add yet another item to the long list of criticisms of Section 304. As noted here, the statute previously has been criticized, among other reasons, because it lacks a private right of action; because it can only be used against the CEO and CFO, but not other corporate officials; and because it is only available in the event of a restatement, but not for other accounting discrepancies. Now it will be criticized as well because it can, if the SEC’s position withstands judicial scrutiny, effect a forfeiture without a requirement of fault, involvement or knowledge of the circumstances requiring the restatement.

To be sure, the logic of the statute is that since the financials were restated, the compensation was never earned in the first place. But litigation has its costs, and the burden an executive hit with a suit like this must endure goes beyond just the compensation he or she might be required to return. Among other things, defending against an SEC enforcement action can be extremely costly.

An executive facing an action like this might well seek to have his or her defense expenses paid by the company’s D&O insurer. But there could be problems with that as well. There would likely be no coverage under the typical D&O policy for any returned compensation, among other reasons because of the standard exclusion for claims for any "profit or advantage" to which the executive was "not legally entitled."

Many of these exclusions are written with a broad preamble (that is, precluding coverage for any loss "based upon, arising out of, or in any way relating to"), which some carriers might attempt to rely upon to preclude coverage not just for the returned compensation but for costs incurred in defending against the claim, even before a liability finding. While this interpretation of the policy would be highly suspect, the possibility of this interpretation highlights the need to try to revise the exclusion to require an actual judicial determination of the absence of "legal entitlement" to the profit or advantage before the exclusion’s preclusive effect is triggered. This revision may help to ensure that if an executive is hit with one of these suits that there is at least insurance coverage available for the executive to mount a defense.

An interesting July 22, 2009 Bloomberg article discussing the case can be found here. The article quotes a number of commentators with a variety of perspectives on the SEC’s action.

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The recent news about the eleventh hour award of nearly $4 billion in bonuses to Merrill Lynch employees is only the latest in a series of events exciting enthusiasm for "clawbacks" of allegedly excessive or undeserved Wall Street bonuses. Reports that New York City financial firms disbursed $18.4 billion in cash bonuses is 2008 added further fuel to the fire.

Senator Chris Dodd stated, with particular reference to executives receiving bonuses from financial institutions benefiting from government bailouts, "I’m going to look at every possible legal means to get that money back," adding "I’m going to be urging – in fact not urging, demanding—that the Treasury Department figures some way to get the money back."

President Obama, for his part, referred to the award of bonuses during a recession and while financial companies are seeking financial help to be "shameful" and the "height of irresponsibility."

The idea of compelling executives to disgorge compensation has been a recurring part of the public discussion surrounding the current economic crisis. The suggestion that the government should clawback financiers’ prior compensation has been a rallying cry for academics (here) and commentators (here) alike.

Indeed, the Dealbook blog reports (here) from Davos that a discussion of the topic of executive compensation turned a conference session into " a bit of a lynch mob, Davos-style" in response to a proposal to force those financiers who benefitted from the boom to "disgorge some of the money they ‘earned’ in bonuses based on profits that have since vanished."

This lynch mob mentality is familiar to those who recall the public outcry that accompanied the last era of corporate scandals. In fact, the perceived compensation excesses at Enron and Tyco, among others, resulted in a statutory provision specifically designed for the purpose of clawing back unwarranted compensation, Section 304 of the Sarbanes Oxley Act.

Section 304 has in fact been used to recover executive compensation, in the noteworthy options backdating settlement involving UnitedHealth Group (about which refer here). However, the fact that over six years’ after the enactment of the statutory clawback provision that there is only one noteworthy example of its utilization underscores the provision’s limited usefulness.

Simply put, and as discussed in detail here, Section 304 has several critical limitations: the provision lacks a private right of action; the provision’s language is poorly written; and it can only be used against the CEO and the CFO, limiting its use against other executives.

Moreover, as discussed in a December 24, 2008 CFO.com article (here), a federal district court recently ruled that the provision cannot be enforced against a company’s CEO or CFO if the company did not restate its financial results, even if the company had accounting discrepancies. The restriction clearly could further limit the provision’s usefulness and could constrain the government’s attempt to use the provision to recover the recent controversial bonus payments.

There are, however, other legal avenues that litigants might pursue to try to recover executive compensation, as discussed in the January 29, 2009 New York Law Journal article entitled "Limiting, Clawing Back Executive Pay in the Wake of the Financial Bailout" (here) by David Pitofsky and Matthew Tulchin of the Goodwin Proctor law firm.

The authors note that while the business judgment rule traditionally has shielded compensation decisions "shareholders seeking equitable rescission and restitution via derivative suits have been successful in recovering ill-gotten gains, even in the absence of compelling proof of personal impropriety." The authors cite as an example the recovery of $40 million in bonuses from HealthSouth CEO Richard Scrushy.

The authors also reference the mixed results presented in recent attempts to use state corporate governance laws to recoup executive compensation. On the one hand, they note the unsuccessful regulatory efforts to recoup a $187 million compensation package from former NYSE Chairman Richard Grasso (about which refer here).

On the other hand, the authors also note the more recent and successful use of New York’s fraudulent conveyance laws by current New York Attorney General Andrew Cuomo, who obtained AIG’s agreement, in response to the Attorney General’s demand letter, to freeze salaries and eliminate bonuses for certain former top AIG executives. (An October 15, 2008 New York Times article discussing Cuomo’s letter can be found here.)

University of California law professor Jesse Fried, among others, suggests (here) that the New York fraudulent conveyance laws, upon which Cuomo relied in his efforts involving AIG, might be used to recover unwarranted bonuses. Fried points out that the statute applies to all firms in New York, even those that have not applied for bankruptcy, and gives creditors the right to recover payments made to insiders under certain circumstances.

Provisions regarding executive pay were in fact a part of the federal bailout bill enacted by Congress last fall. However, amendments specify that the provision only applies to firms that receive government bailout funds by selling assets to the government in an auction. Because the bailout funds have not been deployed as originally intended to buy assets, the compensation recoupment provision may prove "toothless," as discussed in a December 18, 2008 Washington Post article (here).

Nevertheless, the lynch mob mentality in evidence at Davos is likely to continue to arise elsewhere, and in all likelihood, popular interest in recouping executive compensation will continue as a prominent topic while Congress continues to grapple with the current economic crisis.

Among other things, we can also expect continued discussion on whether or not Congress should enact a legislative limit on executive pay, as discussed in Robert Frank’s January 3, 3009 New York Times column (here).

In addition we can expect increasing pressure on companies to adopt their own clawback provisions, either as part of their incentive compensation plan, as governance policy, or as a statement of intent. My prior post discussing corporate clawback policies can be found here.

Whenever the issue of possible litigation against corporate officials comes up, the question arises concerning who will bear the costs. Obviously, the amounts of any compensation clawed back or disgorged would not be covered by the typical D&O policy. However, under the wording of the typical policy, a corporate official that is the target of a compensation clawback lawsuit would have substantial grounds on which to argue that his or her costs of defending against the suit should be covered.

To the extent that current popular sentiment for compensation recoupment translates into litigation, the resulting defense expense could become yet another area of growing claims expense for increasingly beleaguered insurers.

The Heat is On: Banco Santander started it, with its offer to make good on its clients' Madoff related losses. The word is out now, and at least some other banks have gotten the message.

As reported in the January 29, 2009 Financial Times (here), the National Bank of Kuwait has fully reimbursed all of its clients that lost money on the Madoff-related Ponzi scheme -- full reimbursement meaning both the clients initial investment as well as "the gains, thought to be ficticious, that they thought they had made."

As the Financial TImes article notes, the NBK move "puts pressure on other banks and fund managers whose clients lost money in Mr. Madoff's alleged fraud." (I wonder why the FT found it necessary to add the work "alleged.") The article goes on to note that NBK had the advantage of relatiively small losses to cover

Proud to Be a ‘KM Pick’: Knowledge Mosaic, the online subscription information service for attorneys, regulators, journalists and academics, offers a number of excellent services, including a weekly newsletter entitled Wired Mosaic. A feature of the newsletter is the KM Pick, in which the newsletter highlights a legal-oriented blog.

I am proud to report that in the January 29, 2009 issue of the newsletter (here), The D&O Diary is featured as the KM Pick. Modesty prevents me from reciting here the blush-inducing words of the newsletter's glowing encomium, but suffice it to say that I sure hope everyone will take a look at the item (right hand column, scroll down).

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If the facts don’t fit, you must remit. That seems to be the view of an increasing number of companies, as they have adopted provisions requiring repayment of executive compensation found to have been based on incorrect financial statements.

The concept of compensation clawbacks was actually built into the Sarbanes Oxley Act. Section 304 requires CFOs and CEOs to reimburse their companies for incentive compensation and stock sales profits if the financial statements for that year are restated and the restatement is due to “misconduct.”

According to a June 2008 report (here) from the Corporate Library, an increasing number of companies have adopted their own clawback provisions, “either as part of the rules of an incentive plan, as governance policy, or simply as a board statement of intent.”

In its prior 2003 review, the Corporate Library had found that just 14 companies had adopted clawback provisions. But in its June 2008 survey, the report found that 295 of the 2,121 companies examined had “disclosed the adoption and implementation of a clawback provision of one kind or another.”

The survey found that the provisions vary from company to company, but could generally be classified as either “performance based” (if the provision applies to all executives who received an incentive payment of some kind based on incorrect financial) and “fraud based” (if it applies only to those executives who have engaged in fraudulent activity or misconduct that has caused a restatement). The survey found that 44.4% of the clawback provisions were “fraud-based” and 39% were “performance based.” An additional 16.6% of the provisions could not be classified.

The report cites several examples of the clawback provisions and even notes one example, involving Warnaco, in which a clawback has already occurred. The company reported in this year’s proxy statement (here, see page 21) that its compensation committee had cut the incentive pay for three executives in 2006 by a total of $120,000. The reduction occurred after the company restated its 2005 financial results due to certain accounting errors and irregularities.

These kinds of provisions have the support of various governance groups. As the June 8, 2008 New York Times stated in an article discussing the Corporate Library report (here), “why should executives keep compensation if it is discovered later that benchmarks were unmet?”

Not only do these kinds of provisions address basic principles of pay equity; they may also have a deterrent effect as well. Indeed, a June 4, 2008 CFO.com article entitled “Clawbacks Claw Their Way Into Corporate Strategy” (here), comments that “the emergence of clawbacks could be one factor in the recent decline in the number of financial restatements.” (For further background regarding the declining number of restatements, refer here.)

The possibility of a compensation clawback is not the only consequences that could affect executives at restating companies. A March 2008 study by Juan Manual Sanchez and Adi Masli of the University of Arkansas Sam M. Walton School of Business, Denton Collins of Texas Tech University, and Austin Reitenga of the University of Alabama entitled “Earnings Restatements, the Sarbanes-Oxley Act and the Disciplining of Chief Financial Officers” (here) found not only that companies restating earnings “have higher rates of involuntary CFO turnover,” but that CFOs of restating companies “face stiff labor market penalties.”

The authors looked at 167 restating companies and then matched them with a control company of comparable industry, size and age. The authors looked for instances where CFOs left the restating company within two years of the restatement. They then tracked the CFOs for four years to determine their subsequent employment.

The authors found “higher CFO turnover rates following restatements in both the pre- and post-SOX periods, which implies that governance mechanisms served to identify and discipline CFOs implicated in the restatements in both periods.”

The authors also found that “former CFOs of restatement firms are less likely to find a position with a job title that is comparable to their prior CFO position, less likely to find employment in a publicly traded company, or less likely to find a comparable position in a public firm.”

Finally, the authors found that “executives terminated in the post-SOX period appear to suffer greater reputational/labor-market penalties compared to the pre-SOX period, suggesting that firms are less willing in the post-SOX period to hire a former CFO with a tarnished reputation. This appears to be consistent with the intent of the legislation to increase executive accountability.”

With all the disincentives for bad behavior, one might optimistically hope that the sins of the past will not recur. Unfortunately, certain aspects of the current credit crisis arguably belie that hope. Nevertheless, one useful takeaway from this analysis is that the presence of corporate clawbacks could provide a deterrent for bad behavior, and could be a positive risk assessment factor.

Hat tip to the CFO.com for the reference to the academics research paper about career consequences for CFOs of restating companies.

Update on a Backdating Settlement That Went Awry: In a prior post (here), I discussed the recent opinion in which Judge Alsup used harsh language in rejecting the Zoran options backdating-related derivative lawsuit settlement. Among other things, Judge Zoran questioned the parties’ representations of the settlement’s value, and questioned the absence of any cash payment to the corporation.

According to a June 9, 2008 Forbes article entitled “Fee Fixers” (here), “it turns out that Alsup was on to something.” According to the article, on May 29, the lawyers resubmitted the settlement, but this time, the settlement included $3.4 million in cash, $3 million from Zoran’s insurance company and $395,000 from Zoran’s CEO and another executive. The article noted that “for having done such a good job,” the plaintiffs’ lawyers “have requested $1.5 million in fees and expenses, $300,000 more that the first time around.”

According to the company’s June 12, 2008 press release (here), Judge Alsup has granted preliminary approval to the settlement. The rejiggered settlement may have passed judicial muster. But let’s be explicit about what the sequence of events really consists of.  Basically, and other than with respect to the $395,000 payment, the insurance company is being asked to pony up the additional $3 million, and undoubtedly will also be called upon to pay the additional increment in the plaintiffs’ fees, as well as all of the additional defense expense incurred after the first settlement cratered. Perhaps there is nothing remarkable in all of this. But at some point, you really do start to wonder about the social utility of all of this activity. It is enough to make anybody cynical.

Hat tip to the 10b5-Daily (here) for the link to the Forbes article. Special thanks to Zusha Ellinson of The Recorder for the link to the Zoran press release.

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