May 16, 2012
How Often Might Dodd-Frank Clawbacks Be Invoked?
– Broc Romanek, CompensationStandards.com
Towers Watson’s Steve Seeling recently blogged about this restatement study that I blogged about last month:
As we wait for the SEC to propose regulations (still on the SEC agenda for the first half of this year), there’s been a lot of discussion about how the SEC might answer many of the open questions about Dodd-Frank clawbacks. But relatively few compensation professionals have yet focused on the reality of how often financial restatements triggering clawbacks might actually arise. Two recent reports from Audit Analytics found there are more restatements taking place each year than you may have thought.
In a report entitled A Restatement Analysis of the Russell 1000 Companies, Audit Analytics found that from 2006 to 2011, 291 of the 1,355 companies that were part of the Russell 1000 during those years disclosed an annual restatement, defined as a restatement with a restated period of greater than 368 days.That would mean that for each year, an average of almost 4% of companies in the Russell 1000 (48.5 per year) decided a restatement of financials was in order. The data does not mention the percentage of companies that had restatements in different years or those that had to revisit the same issue in a later year, but the sobering possibility is that over the six years of analysis, the percentage of companies with restatements was somewhere in the teens.
In a separate report entitled 2010 Financial Restatements: A Ten Year Comparison, Audit Analytics found that for over 7,000 SEC public registrants, the trend has been for a decline in the number of restatements, from 1,566 in 2006 down to 699 in 2010 (almost 10% of companies). Of course, the salient issue for companies faced with a Dodd-Frank clawback will be how often these restatements rise to the level of meeting the statutory requirement: “an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws.”
Taken at face value, this could encompass all of those restatements detailed in the Audit Analytics research, or some higher threshold to be determined by the SEC. For example, it might be possible that the SEC could define a “material misstatement” to include only those that had an impact on earnings. The Audit Analytics report on 2010 restatements found that, for companies trading on Amex, NASDAQ or NYSE, approximately 40% of the restatements disclosed had no impact on earnings, so this higher threshold would reduce the number of companies potentially subject to clawbacks.
On the other hand, the SEC might decide to leave the question of “material noncompliance” to companies and their audit firms. If the SEC takes this path, the number of companies subject to clawbacks might be larger than if the SEC chooses the standard. The theory would be that if “material noncompliance” was determined to be the same standard as used by auditors when requiring an annual restatement, this standard would mean more restatements would prompt a clawback.
While the issue of when companies must restate financials is one that will be out of the hands of those who design corporate executive compensation programs, this does not mean that a restatement’s impact on the financials themselves can be ignored. Continuing the above example, if only restatements that impact earnings are deemed material, would this mean companies would turn away from earnings metrics in their annual and long-term incentive plans on the theory that non-earnings-based metrics might not trigger clawbacks? Similarly, if the data suggest that most restatements take place within, say, two years of the original financials, will this make companies more likely to hold back bonus payments until that period has passed?
Whichever direction the SEC takes, the wager here is that the forthcoming Dodd-Frank clawback rules will factor into ongoing discussions about whether incentive compensation program metrics are appropriate to support company business strategies, balanced against the risk that clawbacks may be invoked.