Four months before signing the Sarbanes-Oxley Act, President Bush offered a preview of the impending law’s broad effect on the activities and livelihoods of CFOs. Not only would they have to certify their financial filings, they would also risk revocation of their compensation if something went amiss.
“If a financial statement turns out be grossly inaccurate, or the result of serious misconduct, [executives'] bonuses should be returned to the company’s treasury on behalf of its shareholders,” Bush said at an awards ceremony in March 2002.
Six years later, CFOs have, for the most part, adjusted to life under Sarbox. But the courts are just beginning to actually test certain aspects of the law. Most recently, the “clawback” concept cited by the president was put before a federal judge in a stock-option- backdating case filed by the Securities and Exchange Commission. The verdict: CEOs and CFOs are exempt from disgorging their compensation if their company didn’t restate their financial results — even if a restatement should have been filed.
“It’s a relatively unusual case in which a court has interpreted the text of Sarbanes-Oxley,” notes Russell Ryan, a partner at King & Spalding who spent a decade in SEC enforcement. He predicts the judge’s ruling could discourage the commission from using Sarbox’s clawback provision in similar cases.
U.S. District Judge Jean Hamilton’s opinion filed earlier this month suggests the language in the provision, Section 304, is vague enough to wipe the clawback request by the SEC from its case against Michael Shanahan, the founder and former CEO of Engineered Support Systems. Shanahan had pleaded guilty to falsifying records in the criminal case against him. “If an issuer is required to prepare an accounting restatement due to material noncompliance of the issuer, as a result of misconduct,” the top executives should give their companies back any bonuses or stock profits realized within the year of the misstated financial statements, the 2002 law says.
Hamilton interpreted Section 304′s wording to mean that “before penalties may be imposed, an issuer must be compelled or ordered to prepare a financial restatement, and must actually file the restatement.”
In its suit against Shanahan and other executives at ESSI, the SEC charged that the company overstated its pretax operating income by 25 percent by backdating the measurement dates of stock-option grants on at least 10 occasions from 1997 to 2002. Although that error warranted a restatement under generally accepted accounting principles, in the SEC’s view, none was filed. DRS Technologies bought ESSI in January 2006, more than a year before the SEC sued ESSI’s former executives. Shanahan’s attorney did not respond to CFO.com’s request for comment.
The SEC has alleged that Shanahan, aided by his son, Michael Shanahan Jr., who was a member of ESSI’s compensation committee, profited by $8.9 million by approving misdated stock option grants. Gary Gerhardt, ESSI’s former finance chief, was also involved in the scheme and gained $1.9 million, along with a controller, according to the commission.
In the criminal case against the former officers, they have received various sentences for their backdating roles. Gerhardt is scheduled to serve 15 months behind bars, plus two years on probation, Shanahan Sr. received three years of probation, and his son received one year probation. An attorney for Shanahan Jr. did not return CFO.com’s request for comment. Eugene Goldman,Gerhardt’s attorney, declined to comment.
Hamilton ordered Shanahan Sr. to pay a $40,000 fine and $7.9 million in restitution in the criminal case. As the civil case that Hamilton also oversees continues, Shanahan could have had to repay as much as $35 million if Hamilton had agreed with the SEC’s interpretation of the Sarbox clawback provision.
But by agreeing with Shanahan, the judge could “undermine the remedial purposes of the statute, by enabling chief executive officers and chief financial officers to shield themselves from Section 304 liability simply by refusing to restate financial statements and continuing to conceal their misconduct,” predicted SEC attorney Robert Moye in his response to Shanahan’s request to dismiss some of the SEC’s charges against him.
Section 304, like other provisions of Sarbox, has not been thoroughly tested by the courts because of the law’s newness and for the tendency of such cases to be settled, Ryan notes. Three years ago, a federal judge determined that shareholders could not file derivative lawsuits under the provision and that only the SEC could bring action.