Accountants guard their profession from accusations of excitement with euphemism. Doctoring results is "earnings management," an auditor's F is a "qualified opinion," and if a firm must fix its screwed up figures, that's a "restatement."
Somehow, the graphic term "claw back" has infiltrated the staid industry's lexicon. Whether or not this will help reform errant companies, the clarity is refreshing.
Now open for public comment, the Securities and Exchange Commission (SEC) has proposed a rule that requires companies to claw back incentive-based compensation when there is a restatement. Visualize: a metal claw reaching into a bank account and scratching out wads of cash.
The claw back rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This law followed the financial crash of 2008, when bankers cashed bonuses from a housing finance business that proved to be an illusory bubble. The massive "restatement" caused America to revalue itself by a negative $12 trillion as millions lost their jobs, their homes, their savings.
Even as major firms at the center of this bursting bubble went bust, such as Bear Stearns and Lehman Brothers, their executives pocketed billions in compensation. Harvard Prof Lucian Bebchuck in "The Wages of Failure" provides what amounts to compensation accounting porn.
No one argues that compensation based on figures that prove false should be retained. But until the accounting frauds of Enron, WorldCom and others led Congress to the Sarbanes Oxley Public Company Accounting Reform and Investor Protection Act in 2002, few companies published claw back policies. Now, most companies do. Still, the Sarbanes Oxley law left it to the SEC to enforce these policies. The numbers suggest this agency hasn't been zealous. For the last decade, there have been between 700 and 1,500 account restatements by America's public corporations annually. But the SEC didn't bring its first enforcement case until 2007. Through 2011, the SEC brought only 3 enforcement cases.
The 2010 Wall Street Reform Act empowers the stock exchanges to enforce the claw backs, as firms that fail to comply would be delisted.
Ideally, a strong claw back policy will serve as a prophylactic. Managers will have little incentive to fiddle with the books to goose their compensation if they know they must repay the money.
In the real world, problems remain. Some firms may not issue restatements even when they should. Fewer banks issued restatements in the three years following the financial crash of 2008 than in the three years before then. IndyMac, Washington Mutual and Lehman Brothers, all of whom failed, all of whom received "unqualified" opinions from their auditors, all issued no restatement.
Others worry that firms will restructure compensation so that it's not based on accounting numbers. That is, they'll simply raise the amount of cash-based compensation. That may be cynical thinking, but the rise in executive compensation in the last quarter century has been inexorable, in good times and bad, following good performance and bad.
Public Citizen joined other members of the umbrella group Americans for Financial Reform to urge the SEC to propose and finalize a strong claw back rule. We are generally pleased with the contours of the SEC's proposal. The SEC can strengthen the proposal by including "revisions," which is the even softer form for "restatements." The SEC also allows some managers to retain their compensation even after a restatement if the cost of recovery exceeds what's being recovered, although it must name those managers.
Public Citizen also supports parallel reforms. Senior banker pay should be deferred in a pool for 10 years and used to pay penalties for violations such as fraud. Currently, penalties are paid by shareholders, who are hardly accomplices to fraud. Such a penalty pool would motivate managers to keep one another honest.
In Mel Brooks' The Producers, hucksters sell one-fourth shares of a proposed Broadway musical to more than four investors. They count on a flop so they needn't repay any proceeds. They call their scam "creative accounting," a common term now but first coined for the play in 1968 by writer Brooks. The jurors don't buy this euphemism. They find the defendants "incredibly guilty."
Would that the producers of the SEC's new claw back rule finalize a rule that achieves similar justice at America's public companies.