naked capitalism

The SEC is pursuing a rather odd case, odd in the sense that while the media is getting very excited about it, it strikes me as having perilous little general applicability.

The broad strokes via the Financial Times:

The US Securities and Exchange Commission’s attempt to use – for the first time – a “clawback” law against an executive who is not accused of any wrongdoing marks a new hard-hitting approach at an agency under pressure to restore its reputation.

Until now, the SEC used the provision in the 2002 Sarbanes-Oxley law to go only after individuals it had accused of being involved in fraud and, even then, made its first settlement invoking that law some five years after it was adopted…

The clawback provision in Sarbanes-Oxley, passed in the wake of massive accounting frauds at Enron, Worldcom and other companies, requires executives to return performance-based pay and bonuses as well as stock sale profits if a company is forced to issue an accounting restatement “as a result of misconduct”.

Last week, the regulator asked a court to order the return of $4m (€2.82m, £2.43m) paid to Maynard Jenkins, former chief executive of CSK Auto, whose profits were allegedly inflated by accounting fraud committed by others: Mr Jenkins was not involved….

Yet it is far from clear whether the agency will be successful. The structure and language of the provision, known as Section 304, are ambiguous and have already prompted debate among lawyers.

Some questions, such as whether the provision could be used by private litigants, were partly resolved when courts ruled that only the SEC could enforce it. Private lawsuits invoking the provision have continued to be filed nonetheless.

“It has always been an open question whether the SEC would use this weapon against a CEO or CFO who did not personally engage in misconduct, and whether such an aggressive claim would be sustained in litigation,” wrote Wachtell, Lipton, the big Wall Street law firm, in a memo criticising the SEC action.

“They are basically going for the strict liability standard,” said Mr Salehi. The SEC has interpreted every ambiguity in the law in the “most aggressive way possible and saying this is the way the ambiguities are going to be resolved”.

OK, I hate to sound dense, but how often do you have fraud cases where the accounting was so distorted that the SEC could argue that a clawback was warranted (that is, the profits were boosted enough that it made a big difference in the bottom line, hence the CEO’s pay) AND the CEO was not in on it?

To put it another way, isn’t there another theory for going after the CEO? It strikes me he would have had to be pretty derelict in duty for a fraud to go on long enough to have a big impact and him not notice that something was amiss. He clearly failed in his duty of care to the corporation and its shareholders. And if his comp was inflated due to phony profits, there is a clear philosophical and policy reason to try to recoup the excesses. It’s a sign of how badly (or more accurately, CEO servingly) that incentive comp is structures that it fails to contemplate and address this possibiility.

Perhaps I am missing something, but I don’t see an SEC victory as significant, in terms of number of cases that there might be in the future like this.

Where this MAY be significant is that it shows that the SEC is willing to be very aggressive in how it reads ambiguities in the regs. But is this really the best use of SEC firepower? I’d much rather see them get creative about verbal misrepresentations in the selling of complex instruments. But many of those were derivatives and hence outside the SEC’s reach.

But the FT thinks otherwise, so perhaps I am wrong here:

“They are taking this tool and interpreting it aggressively. If they are successful, I expect to see them using it often and I bet it would change the way CEOs and CFOs behave when it comes to restatements, though it may also make people even more reluctant to take those jobs,” said Nader Salehi, a partner at Bingham, the law firm.

Yves again, Um, this is hardly a common type of restatement, and I love the notion that it’s hard to find people to take CEO jobs. Please. There are plenty of highly skilled division executives who’d make good CEOs. The problem is that boards (and the search firms that advise them, since a more difficult recruitment justifies the search firm fees) want CEOs from central casting, ideally someone who is a CEO somewhere else.