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.