Tag: Restatements

SEC Proposes Compensation Clawback Rules

Holly J. Gregory is a partner and co-global coordinator of the Corporate Governance and Executive Compensation group at Sidley Austin LLP. The following post is based on a Sidley update. Related research from the Program on Corporate Governance includes Excess-Pay Clawbacks by Jesse Fried and Nitzan Shilon (discussed on the Forum here).

On July 1, 2015, the Securities and Exchange Commission (SEC), by a 3-2 vote, proposed long-awaited rules [1] mandated by Section 954 of the Dodd-Frank Act that would direct the national securities exchanges and associations to establish listing standards that would require any company to adopt, disclose and comply with a compensation clawback policy as a condition to listing securities on a national securities exchange or association. With the proposal of the clawback rules, the SEC has now proposed or adopted rules to implement all of the Dodd-Frank Act provisions relating to executive compensation.

The clawback policy would be required to provide that, in the event that the company is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, the company would recover from any of its current or former executive officers (not just named executive officers) who received incentive-based compensation during the preceding three-year period based on the erroneous data, any such compensation in excess of what would have been paid under the accounting restatement. In addition to requiring that a company file its clawback policy as an exhibit to its annual report on Form 10-K or 20-F, as applicable, the proposed rules would require proxy statement disclosure of certain actions taken pursuant to the clawback policy.

SEC Proposes Rules on Mandatory Clawback Policies

Renata J. Ferrari is partner tax & benefits department at Ropes & Gray LLP. This post is based on a Ropes & Gray Alert.

On July 1, 2015, the Securities and Exchange Commission proposed rules to require issuers of securities listed on U.S. stock exchanges to adopt and enforce clawback policies applicable to incentive-based compensation received by current and former executives in the three-year period preceding the date the issuer is required to prepare an accounting restatement due to material noncompliance with financial reporting requirements. The proposed rules would implement the “no fault” clawback rule requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Section 10D of the Securities Exchange Act of 1934, as amended).


Making Executive Compensation More Accountable

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at a recent open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. Related research from the Program on Corporate Governance about CEO pay includes Paying for Long-Term Performance (discussed on the Forum here) and the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, both by Lucian Bebchuk and Jesse Fried.

When it comes to compensation, Americans believe you should earn your money. They also believe, just as strongly, that you should not keep what you did not earn. It’s fundamental to our values. However, when companies have to restate their financial statements because they violated applicable reporting requirements, their executives may not be required to reimburse any incentive-based compensation that was erroneously paid. In other words, they get to keep what they never should have received in the first place.

And, quite often, we are talking about very large amounts. In today’s corporate world, many executives are earning eye-catching sums. Much of the increase in executive compensation is commonly attributed to the impact of incentive-based compensation, including equity and other performance-based compensation plans.

Incentive-based compensation plans are intended to align the interests of company managers and shareholders. However, when a company is required to issue a restatement, and when its executives have been paid compensation based on inflated financial results, this alignment disappears. In such cases, it is only fair that these erroneously awarded payments be recovered.


The Efficacy of Shareholder Voting in Staggered and Non-Staggered Boards

The following post comes to us from Ronen Gal-Or and Udi Hoitash, both of the Department of Accounting at Northeastern University, and Rani Hoitash of the Department of Accountancy at Bentley University. Recent work from the Program on Corporate Governance about staggered boards includes: How Do Staggered Boards Affect Shareholder Value? Evidence from a Natural Experiment (discussed on the Forum here).

In our paper, The Efficacy of Shareholder Voting in Staggered and Non-Staggered Boards: The Case of Audit Committee Elections, which was recently made available on SSRN, we study the efficacy of audit committee member elections in staggered and non-staggered boards.

Voting in director elections and auditor ratifications is a primary mechanism shareholders can use to voice their opinion. Past research shows that shareholders cast votes against directors that exhibit poor performance, and these votes, in turn, are associated with subsequent board reaction. However, because a significant number of U.S. public companies have staggered boards, not all directors are up for election every year. Therefore, the efficacy of shareholder votes may not be uniform. Under the staggered board voting regime, shareholders and proxy advising firms can typically voice their opinion on any given director only once every three years. This election structure may increase the likelihood that directors who are not up for election following poor performance will be insulated from the scrutiny of shareholders and proxy advisors. In turn, this may influence the accountability of staggered directors and the overall efficacy of shareholder votes.


What Happens in Nevada? Self-Selecting into Lax Law

The following post comes to us from Michal Barzuza, Professor of Law at the University of Virginia School of Law, and David Smith, Professor of Finance at the University of Virginia.

In our paper, What Happens in Nevada? Self-Selecting into Lax Law, forthcoming in the Review of Financial Studies, we study the financial reporting behavior of firms that incorporate in Nevada, the second most popular state for out-of-state incorporations, after Delaware. Compared to Delaware, Nevada law has weak fiduciary requirements for corporate managers and board members. We find evidence consistent with the idea that lax shareholder protection under Nevada law induces firms prone to financial reporting errors to incorporate in Nevada, and that lax Nevada law may also cause firms to engage in risky reporting behavior. [1] In particular, we find that Nevada-incorporated firms are 30 – 40% more likely to report financial results that later require restatement than firms incorporated in other states, including Delaware. These results hold when we narrow our set of restatements to more serious infractions, including restatements that reduce reported earnings, and to restatements that raise suspicions of fraud or lead to regulatory investigations.


A New Tool to Detect Financial Reporting Irregularities

The following post comes to us from Dan Amiram and Ethan Rouen, both of the Accounting Division at Columbia University, and Zahn Bozanic of the Department of Accounting and MIS at Ohio State University.

Irregularities in financial statements lead to inefficiencies in capital allocation and can become costly to investors, regulators, and potentially taxpayers if left unchecked. Finding an effective way to detect accounting irregularities has been challenging for academics and regulators. Responding to this challenge, we rely on a peculiar mathematical property known as Benford’s Law to create a summary red-flag measure to capture the likelihood that a company may be manipulating its financial statement numbers.


Regulating the Timing of Disclosure

The following post comes to us from Lisa Bryant-Kutcher of the Department of Accounting at Colorado State University, Emma Peng of the Accounting Area at Fordham, and David Weber of the Department of Accounting at the University of Connecticut.

In our paper, Regulating the Timing of Disclosure: Insights from the Acceleration of 10-K Filing Deadlines, forthcoming in the Journal of Accounting and Public Policy, we examine how regulatory reforms that accelerate 10-K filing deadlines in 2003 affect the reliability of accounting information. The intended purpose of the new deadlines is to improve the efficiency of capital markets by making accounting information available to market participants more quickly. However, accelerating filing deadlines compresses the time available for firms and their auditors to prepare, review, and audit accounting reports, suggesting potential costs in the form of increased misstatements and lower reliability. We provide empirical evidence on the effects of accelerating deadlines by comparing the likelihood of restatement of 10-K filings before and after the rule change.


The Effect of Audit Committee Expertise on Monitoring Financial Reporting

The following post comes to us from Udi Hoitash, Ganesh Krishnamoorthy, and Arnold Wright, all of the Accounting Group at Northeastern University, and Jeffrey Cohen, Professor of Accounting at Boston College.

In our paper, The Effect of Audit Committee Industry Expertise on Monitoring the Financial Reporting Process, forthcoming in The Accounting Review, we examine the impact of audit committee (AC) industry expertise on the AC’s effectiveness in monitoring the financial reporting process. Despite the increased responsibilities, authority, independence, and financial expertise requirements placed on ACs by the Sarbanes-Oxley Act (SOX), ACs may, nonetheless, lack sufficient industry expertise to understand and thus properly monitor complex industry specific accounting issues. For instance, expertise in the retail industry may assist ACs to ensure that companies take an adequate write-down of inventory when their products face potential obsolescence. Similarly, revenue recognition, a prominent area of accounting manipulation (Beasley et al. 2000, 2010), entails an evaluation and understanding of the earnings process, which is tied to a company’s business processes that are often industry specific.


Measuring Intentional Manipulation: A Structural Approach

The following post comes to us from Anastasia Zakolyukina of the University of Chicago Booth School of Business.

In the paper, Measuring Intentional Manipulation: A Structural Approach, which was recently made publicly available on SSRN, I suggest a structural model of a manager’s manipulation decision that allows me to estimate his costs of manipulation and to infer the amount of undetected intentional manipulation for each executive in my sample. The model follows the economic approach to crime (Becker, 1968) and incorporates the costs and benefits of manipulation decisions. The model is a dynamic finite-horizon problem in which the risk-averse manager maximizes his terminal wealth. The manager’s total wealth depends on his equity holdings in the firm and his cash wealth. The model yields three predictions. First, according to the wealth effect, managers having greater wealth manipulate less. Second, according to the valuation effect, the current-period bias in net assets increases in the existing bias. Third, the manager’s risk aversion, the linearity of his terminal wealth in reported earnings, and the stochastic evolution of the firm’s intrinsic value produce income smoothing. Furthermore, the structural approach allows partial observability of manipulation decisions in the data; hence, I am able to estimate the probability of detection as well as the loss in the manager’s wealth using the data on detected misstatements (i.e., financial restatements).


Accounting and Litigation Risk

The following post comes to us from Zhiyan Cao, Assistant Professor of Accountancy at the University of Washington Tacoma, and Ganapathi S. Narayanamoorthy, Assistant Professor of Accountancy at the University of Illinois at Urbana-Champaign.

In our paper, Accounting and Litigation Risk: Evidence from Directors’ & Officers’ Insurance Pricing, forthcoming in the Review of Accounting Studies, we study whether and how financial reporting concerns and traditional measures of corporate governance are priced by insurers that sell Directors’ and Officers’ (D&O) insurance to public firms. As D&O insurers typically assume the liabilities arising from shareholder litigation, the insurance premiums they charge for D&O coverage reflect their assessment of a company’s litigation risk.

Estimation of ex-ante litigation risk has always been a challenge for empirical research. Past studies employ ex-post lawsuits to derive an ex-ante measure of litigation risk. In such studies, a litigation risk prediction model is first estimated with the dependent variable being whether the firm got sued ex-post. The predicted values of the probability of getting sued are then used as ex-ante measures of litigation risk in an empirical model. Such measures ignore lawsuits filed in other jurisdictions and also cannot distinguish between frivolous and serious lawsuits. We employ a market-based measure of ex-ante litigation risk; that is, the D&O liability insurance premium, which incorporates the ex-ante expectation of both the likelihood of lawsuits and the magnitude of damages. In the U.S., public firms routinely purchase D&O insurance coverage for their directors and officers for reimbursement of defense costs and settlements arising from shareholder litigation. Most shareholder litigation is settled within policy limits, with the D&O insurers primarily footing the bill. Therefore, we expect the D&O insurers to price financial reporting risk and corporate governance risk efficiently in order to compensate for their expected payout obligations in the case of lawsuits.


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