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

A number of different organizations  generate annual publicity for themselves by designating a word (or words) of the year. We are not yet half way through 2011 but I am already prepared to propose my own candidate for this year’s word of the year – the word is “whistleblower.” From the provisions of the Dodd-Frank Act and the predecessor provisions of the Sarbanes Oxley Act to the litigation activities of activist investors, whistleblowers’ actions and protections are a growing source of attention and concern – and litigation.

Since the Dodd Frank Act’s  passage last summer, the whistleblower provisions of the Dodd-Frank Act have received a great deal of scrutiny. The SEC proposed rules to implement the provisions last November (refer here).  The proposed rules have not yet been enacted by the SEC. However, according to a May 5, 2011 Reuters article (here), the vote on the final rules implementing the whistleblower provisions could come as early as May 25, 2011.

Among the issues surrounding the final rules is the question of whether or not they mandate  that would-be whistleblowers must first report wrongdoing internally before reporting violations to the SEC, in order to be eligible for the so-called whistleblower bounty.  According to the Reuters article, the SEC has “no plan to make internal reporting a mandatory first step for whistleblowers.” However other alternatives are under consideration, including the possibility of allowing company employees to reap full benefits of the bounty provisions if a combination of the employee’s tip and information from a company’s internal probe lead to the imposition of fines or penalties for securities law violations.

While the final rules on the whistleblower bounty provisions are pending, there have also been developments related to the other significant components of the Dodd-Frank whistleblower provisions -- the provisions’ anti-retaliation protections. A May 4, 2011 order in a case pending in the Southern District of New York took a detailed look at who may invoke the anti-retaliation provisions and what is required to invoke the protection. The order can be found here.

The opinion arose in a case brought by an employee of Trading Screen. The employee believed the company’s CEO was diverting opportunities and assets from Trading Screen to a company solely controlled by the CEO. The employee reported the CEO’s actions to the company’s President, who in turn reported the information to the company’s Board. The Board hired outside counsel (the Latham & Watkins firm) which investigated and concluded that the activity was taking place as the employee reported. However, when the Board sought the CEO’s voluntary resignation from the company, the CEO  was able to wrest control of the Board. The CEO later fired the employee who had reported the violation.

The employee filed suit against TradingScreen, the CEO and a variety of related entities asserting a number of claims, including a separate cause of action for retaliatory discharge under the Dodd Frank whistleblower provisions (about which generally refer here). Among other things the relief available under the provisions includes reinstatement, double back pay, and costs and fees.

In moving to dismiss with respect to these allegations the defendants contended that the plaintiff is not covered by the Dodd Frank anti-retaliation provisions because he did not personally report the alleged violation to the SEC and because he does not otherwise come within the four other categories of activity that would bring his conduct within the provision.

The four other categories of disclosures protected under the Dodd Frank anti-retaliation provisions are disclosures: under the Sarbanes Oxley Act; under the Securities Act of 1934; under federal statutory provisions relating to investigative officers; or disclosures under any other law, rule or regulation of the Commission. In his May 4, 2011 order, Southern District of New York Judge Leonard Sand found that because TradingScreen is a private company, the employee’s disclosures did not come within the Sarbanes Oxley Act or the Securities Act, and that plaintiffs’ allegations were otherwise insufficient to bring his actions within the other two categories of disclosures.

The employee himself had not disclosed the alleged violation to the SEC. But the employee contended that he nevertheless came within the statute because he had made the disclosure to the SEC “jointly” with the outside law firm that investigated his allegations of misconduct. Judge Sand allowed that if the disclosures had been made to the SEC by the law firm, they were made “jointly” by the employee with the law firm, because law firm’s investigation of his report had led to the disclosure. However, Judge Sand also found that the plaintiff had not sufficiently alleged that the law firm had in fact disclosed the information to the SEC, but he granted the plaintiff leave to amend his complaint in order to try to establish that the law firm had in fact disclosed the information to the SEC.

Judge Sand’s May 4 opinion is a reminder of the breadth of Dodd-Frank anti-retaliation provisions. Much of the focus of discussion about the Dodd Frank whistleblower provisions has been on the whistleblower bounty. However, given the breadth of the anti-retaliation provisions, those provisions could also prove to be critically important.

On May 3, 2011, the Ninth Circuit issued an opinion (here) in a separate alleged whistleblower retaliation case, this one under the whistleblower protections in the Sarbanes Oxley Act.  The case involved two individuals who had been part of the IT Sarbanes Oxley audit group at Boeing. The two had become concerned that Boeing was putting pressure on the audit team to rate Boeing’s internal controls “effective.” After raising concerns internally, the two had communicated with a reporter at the Seattle Post-Intelligencer, who wrote articles about the company’s audit process. After an investigation, the company concluded that the two had violated the company’s policy against releasing internal information to the press without authorization, and the company terminated the employment of the two individuals.

The two individuals filed an action against the company alleging retaliation for actions protected by Sarbanes Oxley. The district court had granted the company’s motion for summary judgment and the two individuals appealed.

In its May 3 order, the Ninth Circuit concluded that the individuals were not protected under Sarbanes Oxley because it provides protections only for disclosures to a federal regulatory agency; a member or committee of Congress; or a supervisor or other individual authorized to investigation such misconduct. “Members of the media,” the court found, “are not included,” noting that Congress had limited the activity protected under the provisions to “employees who raise certain concerns of fraud or securities violations with those authorized or  required to act on the information.”

The court concluded that the provision “does not protect employees of public companies who disclose information regarding fraud or certain securities violations to members of the media.” The court concluded that Boeing was within its rights to terminate the employees for violating company policy. The Ninth Circuit affirmed the district court.

The Ninth Circuit’s opinion and to a lesser extent Judge Sand’s opinion in the case discussed above serve as a reminder that those who comply with the statutory requirements will be able to bring themselves within the statutory protection.  The statutory provisions do not protect whistleblowing in and of itself, but only certain kinds of whistleblowing under certain kinds of circumstances and conditions. Along with cases exploring the protections available under these statutory provisions, we can expect further cases examining the question of when supposed whistleblowers are entitled to the protection of the statutory provisions.

One final note during on the general whistleblowing theme is the lawsuit that was unsealed this past week in which taxpayers allege that certain loans extended by the Federal Reserve Bank of New York in the fall of 2008 as part of the bailout of AIG had defrauded taxpayers. The lawsuit, which first filed in the Southern District of California in 2010, and which was ordered unsealed last month, asserts claims under the False Claims Act. The taxpayers’ amended complaint can be found here.

The taxpayers’ complaint relates to two emergency loans the government extended to AIG that totaled over $40 billion and that were used to settle trades involving blocks of mortgage-backed securities that AIG had guaranteed. The lawsuit, which names as defendants not only AIG but also the transaction counterparties (which included Goldman Sachs, Deutsche Bank, Bank of America and Societe Generale), alleges that the Fed’s loans were improper because they were made without first obtaining a pledge of appropriate collateral as required by applicable law. The plaintiffs seek to recover for the U.S. government the losses sustained by the government as a result of the fraud and false claims alleged in the complaint.

Though the taxpayers’ action may be different in kind and character than the other cases discussed above, the cases collectively serve to underscore the prevalence of whistleblowing activity. Courts undoubtedly will continue to sort out the prerequisites necessary to invoke the statutory whistleblower protections. But even while there may be many issues yet to be sorted out, whistleblowing itself already is a significant phenomenon, as witness by a host of current devopments, including the Wikileaks disclosures. With the protections and bounties under Dodd-Frank, its importance seem likely to increase. The likelihood for increased litigation involving whistleblower-related activity seems high.

Speakers' Corner: On May 11, 2011, I will be moderating a session in Menlo Park, California entitled "Dodd-Frank and the Rise of Shareholder Empowerment." The session is sponsored by the Orrick law firm, The Directors Network and Deloitte, and will take at place at the Orrick law firm's Menlo Park offices. The program, which is free and which will run from 8:45 am to 11:45 am, will provide insights and practical advice regarding fundamental changes in the corporate governance environment and the emerging role of shareholders in the U.S. corporation.

The session includes an all-star cast of panelists, including; Consuelo Hitchcock, Principal, Regulatory and Public Policy at Deloitte; Marc Gross, of the Pomerantz, Haudek, Grossman & Gross law firm; Anne Sheehan, Director of Corporate Governance at CalSTRS; George Paulin, the President of George Cook & Co.; and Jonathan Ocker and Bob Varian of the Orrick law firm.

Further information about the program, including registration information, can be found here.

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In a June 28, 2010 decision (here), the Supreme Court issued its opinion in Free Enterprise Fund v. Public Company Accounting Oversight Board case. This case had been widely followed because the petitioners challenged the constitutionality of the Sarbanes-Oxley Act and of the Public Company Accounting Oversight Board (PCAOB).

The petitioners prevailed before the Supreme Court, and a majority of the Court held that restrictions on the removal of PCAOB board members were unconstitutional, but the Court declined to hold either that the Sarbanes Oxley Act itself or the PCAOB are unconstitutional. The net effect is that Sarbanes-Oxley remains fully operational, other than the provisions governing the removal of PCAOB members.

Background

This case arises out of a dispute involving a small Nevada accounting firm, Beckstead and Watts. In September 2005, the PCAOB disclosed that it was investigating the firm and that it had found "deficiencies" eight of sixteen of the firm’s audits. In response, the firm sued the PCAOB and the federal government, seeking an order blocking the PCAOB from taking any further action. The firm was joined in the action by the Free Enterprise Fund, which according to its website, is a nonprofit advocacy group "dedicated to fighting the so-called Sarbanes-Oxley law."

The plaintiffs contended that in creating the PCAOB in the Sarbanes Oxley Act, Congress set up a private corporation that exercised governmental authority. The plaintiffs argued that this arrangement and in particular SOX’s statutory provision for the SEC’s appointment of the PCAOB’s five members, and more particularly specifying that the members can only be removed by the Commission for just cause, contravened the separation of powers in the U.S. Constitution by conferring wide-ranging executive power on Board members without subjecting them to Presidential control.

In a March 21, 2007 decision, Judge James Robertson of the District Court for the District of Columbia rejected the plaintiffs’ arguments, and on August 22, 2008, the D.C. Circuit Court affirmed the lower court’s dismissal. The Circuit Court later denied an en banc review, and the plaintiffs filed a petition for a writ of certiorari to the Supreme Court, which the Court granted.

An excellent summary of the background regarding the case and the parties’ arguments can be found on the SCOTUSWiki site, here. My prior post about the case can be found here.

The Supreme Court’s Opinion

In a 5-4 majority opinion written by Chief Justice John Roberts, the Court focused on the Sarbanes Oxley’s Act’s provisions for the removal of the PCAOB members. The removal provision provides that members can only be removed by the SEC Commissioners for good cause shown and then only pursuant to rigorous procedural requirements. The Court said the arrangement "not only protects Board members from removal except for good cause, but withdraws from the President any decision on whether that good cause exists."

The result of what the Court described as "a second level of tenure protection," in the form of the procedural requirements, is that the Commission "cannot remove a Board member at will" and the President therefore "cannot hold the Commission fully accountable." This arrangement, the majority found, is "contrary to Article II’s vesting of the executive power in the President." The majority opinion added:

By granting the Board executive power without the Executive’s oversight, this Act subverts the President’s ability to ensure that the laws are faithfully executed – as well as the public’s ability to pass judgment on his efforts. The Act’s restrictions are incompatible with the Constitution’s separation of powers.

However, having found a provision of Sarbanes Oxley Act to be unconstitutional, the majority drew back from finding either the entire Act or the PCAOB itself to be unconstitutional. The Court found that the "unconstitutional tenure provisions are severable from the remainder of the statute" and that even if board removal provisions violate the Constitution, the "existence of the Board does not." The Act itself "remains fully operative as a law with these tenure restrictions excised," since the "remaining provisions are "not incapable of functioning independently."

The majority opinion reversed the Court of Appeals opinion in part and remanded the case for further proceedings.

A dissenting opinion written by Justice Breyer asserted that the removal provisions violated no separation of power principles and contended that the majority’s ruling "threatens to disrupt severely the fair and efficient administration of the laws" because it is inconsistent with the structure of many administrative agencies.

Discussion

Though the majority found a portion of the Sarbanes Oxley Act to be unconstitutional, its holding was about as limited and as nondisruptive (at least as to the continued operation of the Act) as might be hoped for, given the finding of constitutionality. Certainly the finding that Act remains otherwise fully operational fell well short of the plaintiffs’ objective so trying to have the entire Act set aside.

Indeed the relief provided seems like pretty weak beer. The majority said only that "petitioners are not entitled to broad injunctive relief against the Board’s continued operations. But they are entitled to declaratory relief sufficient to ensure that the reporting requirements and auditing standards to which they are subject will be enforced only by a constitutional agency accountable to the Executive."

The Court’s refusal to declare the entire Act unconstitutional, despite finding one part to be unconstitutional, might have surprised and disappointed some advocates and Court watchers, who, as discussed here, had contended that the absence from the Act of a "savings clause" preserving the rest of the statute if one part was disallowed, should have required the entire Act to be found improper. The Court clearly strained to avoid this result, relying on prudential and precedential principles to steer clear of a disruptive result that arguably might otherwise have been required by absence of a statutory savings clause.

As the Conglomerate blog commented, the majority opinion "illustrated how to hold an agency to be unconstitutional without really doing anything important at all." CFO.com quotes one commentator as saying that the decision against the PCAOB "was about as gentle a finding as you could expect." The Volokh Conspiracy blog said "The Court drew a line in the sand to safeguard executive power and ensure greater accountability, but did so without picking much of a fight."

The net effect of the Court’s holding is that the SEC now may remove the PCAOB board members at will, rather than having to go through the removal procedures that had been defined in the Sarbanes Oxley Act. The SEC issued a statement after the opinion was published in which the SEC said that "the Act ‘remains fully operative as a law’ with the for-cause restrictions excised, leaving the members of the PCAOB subject to removal by the Commission without restriction. The opinion does not call into question any action taken by the PCAOB since its inception." 

Professor Stephen Bainbridge has an interesting commentary on his eponymous blog (here) commenting that he is "unpersuaded" by the majority opinion, agreeing with the dissent that there is nothing about the effective result of the Court’s ruling that actually validates the President’s actual right or authority to oversee the PCAOB.

In a nice piece of ironic timing, the Court released its opinion in the case on the first day of the Senate Judiciary Committee confirmation hearings for Supreme Court nominee Elena Kagan. The Court’s ruling represents a defeat for Kagan, who as Solicitor General had argued the case for the government. (A transcript of the oral argument in the case can be found here.)

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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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Both the number of restatements and the number of companies reporting restatements are declining according to a new study. The number of restatements has been declining for three years now, and the number has declined materially since the figures peaked in 2006, both because of better controls and changing standards.

The study, by Audit Analytics, is not yet available online, but it has been widely reviewed, including in a March 4, 2010 CFO.com article (here) and a March 1, 2010 article by Matt Kelly of Compliance Week (here).

As reflected in this article, the study shows that there were just 630 companies reporting 674 accounting restatements in 2009. There were 24% fewer restatements in 2009 compared to the prior year, when there were 923. The 2009 figures represent the lowest number of restatements since 2001 (when accounting scandals dominated the headlines).

The number of restatements has actually declined for three years in a row since they reached their peak in 2006, when 1,564 companies filed 1,796 restatements. In other works, the number of restatements in 2009 was 62 percent less than the number in 2006.

In addition to the declining number of restatements, accounting errors requiring a restatement are now being caught sooner. The average restatement in 2009 covers a period of 476 days, compared to 716 days in 2006.

Restatements also reduced earnings by smaller amounts. 2009 restatements on average reduced earnings by $4.6 million, compared to $7.2 million in 2008 and $23.5 million in 2006.

The CFO.com article reports that the study’s authors attribute the decline to two factors: improved internal controls as a result of Section 404 of the Sarbanes Oxley Act, and a 2008 recommendation by the SEC’s Advisory Committee on Improvements to Financial Reporting that the SEC “relax its requirements on what types of errors should trigger restatements.”

One circumstance supporting the suggestion that SOX may be contributing to the reduced number of restatements is the fact that the majority of U.S.-based companies issuing 2009 restatements (374 out of 522) were “nonaccelerated filers,” meaning that Section 404’s requirements do not yet apply to them. Of course, there are, in fact, more nonaccelerated filers than accelerated filers in the first place, so the raw numbers alone may not tell the whole story. In addition, the smaller nonaccelerated filers simply may be more likely to have problems due to their small staffs and fewer tools.

On his Compliance Week blog, Kelly points out that the number of restatements by accelerated filers grew between 2002 and 2005, the year they had to comply with Section 404, but they have declined since that time. Kelly concludes that, despite all of the criticism of the provision, Section 404 may be working.

To those who say we had a crisis in 2008 notwithstanding Section 404, Kelly points out that the most recent crisis “has largely been a crisis of flawed assumptions and reckless risk management coming home to roost – not accounting fraud.” Kelly concludes that whatever financial reform Congress might conjure up in response to the current crisis, it is not time to “start rewriting Sarbanes-Oxley wholesale,” as “the law is working just fine.”

The suggestion that the declining number of restatements is due to SOX reforms brings to mind the long-standing question whether the changes in the number of securities class action filings are also attributable to improved company behavior as a result of SOX.

However, though the number of restatements has declined steadily, the number of lawsuits has fluctuated from year to year. Indeed, the most recent year with the highest numbers of restatements, 2006, when there were almost three times as many restatements as in 2009, there were fewer class action lawsuit filings (116) than in any year since 1996, and certainly significantly fewer filings than in 2009, when there were (depending on whose count you are using) at least 178 filings.

So there may well be fewer restatements as a result of Sarbanes Oxley, but that alone does not explain what has been happening with fluctuating securities class action lawsuit filings. Changed corporate behavior as a result of Sarbanes Oxley, even if it has occurred, is not a sufficient explanation for lawsuit filing levels. There may simply be too many other areas of corporate activity, beyond those addressed in Sarbanes Oxley, that continue to attract the unwanted attention of the plaintiff’ class action securities lawsuits.

The bottom line seems to be that as good as the news is that the number of restatements is declining, that does not necessarily mean as a general matter that companies are necessarily less likely to be sued.

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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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