Alison Frankel recently reported on a major new court decision on using clawbacks to punish executives under whose watch firms made financial misstatements:
The SEC is demanding that the Arthrocare officials, former CEO Michael Baker and former CFO Michael Gluk, return to the company the unspecified bonuses, stock options and stock-sale profits they received in 2006 and 2007 — even though Baker and Gluk were not involved in the accounting misconduct that forced Arthrocare to restate its financials in those years.
In upholding the SEC's claims, U.S. District Judge Sam Sparks of Austin, Texas, "all of the challenges, including constitutional arguments, that the former top officials of ... Arthrocare raised in the SEC’s so-called clawback suit under [Sarbanes-Oxley] Section 304."
As Kevin LaCroix noted:
... there have been prior rulings upholding the SEC”s right to pursue clawback actions under Section 304 even in the absence of allegations that the corporate executives from whom compensation clawback is sought were involved in or even aware of the misconduct that led to the restatement. However, Spark’s opinion provides a broad theoretical justification for the SEC’s use of the provision and may represent something of an encouragement to the agency to use its authority under the statute ...
Although I support 304, I'm not unsympathetic to LaCroix's concern that "that Section 304 represents part of a dangerous legal trend that tends to want to try to impose liability without culpability (as [he] discussed at length here)." Even so, Section 304 is on the book and whether the trend as a whole is a good idea, there are good policy reasons to impose liability without moral culpability in this context. As Frankel explains:
By demanding that they return bonuses and other incentive compensation to the company, the provision “creates an incentive for (officials) to be diligent in carrying out those (certification) duties,” the judge wrote, noting that Congress deliberately drafted the law to apply to officials who weren’t involved directly in cooking the books. “The absence of any requirement of personal misconduct is in furtherance of that purpose: It ensures corporate officers cannot simply keep their own hands clean, but must instead be vigilant in ensuring there are adequate controls to prevent misdeeds by underlings.”
Moreover, as LaCroix notes:
Section 304’s requirements are “crystal clear”; the Act “tells executives precisely what they must do to avoid reimbursement liability.” They must, Sparks noted, “ensure the issuer files accurate financial statements.” They are to do so by establishing and maintaining internal controls. Judge Sparks went further to find that there is a “reasonable relationship” between the conduct and the penalty; “where, as here …corporate officers are asleep on their watch,” they are liable for a penalty that is limited to the amounts of their bonus compensation.
Obviously, Section 304 applies only to corporate executives (and only to performance pay), but outgoing Securities and Exchange Commission Chair Mary Schapiro's announcement that she is stepping down raises the question of why she gets a free ride on precisely the same sort of conduct for which corporate executives are subject to having their pay clawed back.
During Schapiro's tenure, the Government Accountability Office has consistently found that the SEC's internal controls are seriously flawed. In a 2012 letter to Schapiro, for example, the GAO explained that:
In our audit of SEC’s fiscal years 2011 and 2010 financial statements, we identified four significant deficiencies in internal control as of September 30, 2011. These significant internal control deficiencies represent continuing deficiencies concerning controls over (1) information systems, (2) financial reporting and accounting processes, (3) budgetary resources, and (4) registrant deposits and filing fees. These significant control deficiencies may adversely affect the accuracy and completeness of information used and reported by SEC’s management.
Some of these deficiencies "resulted in misstatements in SEC’s liability balances."
And then there are the appalling "allegations of serious misconduct, failure of internal controls, and whistle blower retaliation" advanced by SEC whistleblower David Weber:
Weber’s titillating testimony turns its focus on other executives within the Commission, including the COO and chair Mary Schapiro. Weber’s charges of nepotism and a lack of meaningful internal controls expose the risks that the Commission presented in its daily management of operations and beyond that as well. One does not need to read very hard to understand Weber’s belief that the SEC’s COO utilized a “pay to play” practice. Additionally, in a scene fit for the classic movie Dumb and Dumber, Weber asserts that SEC representatives brought highly sensitive computer code and encryption data to monitor activity on our equity exchanges to a hacker’s conference in Las Vegas. You cannot make this stuff up, folks.
Saving some venom for Ms. Schapiro as well, Weber paints her as a “LIAR” for perjuring herself during a presentation before the House and Senate Oversight Committee regarding the SEC’s bungled attempt to move to new office quarters. Weber would not be the first to label Ms. Schapiro with the big L. Recall that Attorney Richard Greenfield did just the same in the case brought on behalf of Standard Chartered v FINRA, Mary Schapiro et al.
In sum, as Hester Pierce observes, under Schapiro's tenure there has been "a continuing embarrassment for the SEC" when the GAO annually identifies "new and continuing significant deficiencies in the SEC's internal controls over financial reporting."
At the very least, Mary Shapiro has been asleep at the switch while the SEC has continually failed to remediate serious internal control deficincies that the SEC would never tolerate in a private company. As the late Larry Ribstein once quipped:
Suppose a company or executive civilly or criminally charged with disclosure or internal control violations after a sudden market decline magnifies risks the company ignored tells the SEC or Justice: “we’re making significant strides on disclosure and we’ll do a better job the next time.” The SEC or Justice will tell the company: “We understand. You have to be looking around the next corner or beyond the next horizon, and that’s very hard. Just do the best you can.” Something like that.
If clawing back executive pay is necessary to give corporate executives "an incentive for (officials) to be diligent in carrying out" their duties over corporate internal controls, maybe clawing back government official pay when they "are asleep on their watch,” would give future SEC chairs the necessary incentive to avoid Schapiro's manifold failures to fix the SEC's internal problems.