Raises, Restatements, Reparations: The Effects of Sarbanes-Oxley

Part I: Raises

An article in the December 12 Wall Street Journal relates that “total compensation for CEOs at 1,522 big U.S. companies rose a median of 30% last year,” compared to a 15% rise in 2003. The most cited reason for the jump is to either retain or attract top-notch executives. Shareholders and regulators are now scrutinizing compensation packages and some workers are screaming as the bosses pay is going up while their’s is going down (see Delphi). In the same edition of the Journal, another article relates that compensation for CFOs is rising even faster than that for CEOs. The article states that this is due to the CFO’s “key role in implementing the Sarbanes-Oxley (SOX) corporate-overhaul law.” While this reason is not stated in regard to CEOs, it seems reasonable that CEOs should be offered more now that SOX regulation is in effect since it shifts more reporting responsibility onto the CEO and exposes them to more risk and liability. Although the SEC has long required certain disclosures pertaining to CEO and executive compensation, there is some talk that the requirements are lax (1). It seems the tradition has been to establish some sort of link between executive compensation and company performance. However, as companies struggle to compete (and sometimes to stay afloat) and as new regulations are rapidly changing the conduct of business, the competition for CEOs with just the right mix of ‘character and competence’ is bound to heat up, as well. These days, having a CEO who can avoid exposing the company to shareholder lawsuits and SEC scrutiny is worth its weight in gold.

(1) Executive Compensation Not Disclosed Correctly, Even After Sarbanes-Oxley

Part II: Restatements

Restatements run rampant!

Oh…Okay, maybe I’m exaggerating.

But… enter the search term effects+of+restatements into Google and you may get way more than you bargained for.

Here are just a few interesting trends I’ve come across in regard to restatements.

Even before the Sarbanes-Oxley Act of 2002 became effective on July 30 of the same year, a Government Accountability Office (GAO) report discloses that financial statement restatements increased 145 percent during the study period, which dates from January 1, 1997 to June 30, 2002. The restatements that were studied in the report were due to “accounting irregularities.” From my own experience, I am aware that irregularities can (and do) arise from misinterpretation and misapplication of GAAP rules or SEC regulations and guidelines. They are, for the most part, unintentional and could be attributed to confusing or unclear guidelines. However, in some instances, there are those who fully understand the regulations but will take advantage of any loopholes they can find when regulations are not clearly defined. Seems to me that these are the folks who invite stricter regulation to curtail their ‘creative accounting’ activities. More to come...

Interesting Bit of Trivia

According to this article, the word "integrity" is number one on Merriam-Webster's (online) list of the ten most looked-up words this year. Coming in tenth is the word "inept."

Quoting the article, "Ralph Whitehead, a journalism professor at the University of Massachusetts, said it may indicate the continuing discussion about American values and morality, or perhaps that integrity itself is becoming scarce so its definition is unfamiliar."

Interesting thoughts. Which do you think it is?

All I Want for Christmas is My Blacklist

An editorial in the November 22 edition of the New York Times, titled The Battle Against Fraud, states that Robert Stein, Jr., a former financial officer for the American occupation authority in Iraq, was recently charged in federal court for fraudulent and dishonest acts committed while handling $82 million of taxpayer funds that were to aid in the rebuilding of Iraq. The article states, “Mr. Stein accepted over $200,000 a month to steer contracts to an American businessman whose companies often did poor work and sometimes did no work at all.” The article goes on to say, “Officials at the Office of the Special Inspector General for Iraq Reconstruction…are pursuing fifty more [similar] cases and have already referred at least six more to prosecutors.” The editorial suggests applying the ‘lessons of Iraq’ to hurricane recovery here in the U.S. Unfortunately, that may be too late and now inspectors general are scrambling to review all of the questionable contracts that have been negotiated for post-Katrina reconstruction(1).

The editorial cries, “There must be accountability…,” and we would all probably agree that indeed there should be. Stein’s history includes a 1996 felony conviction relating to fraud and falsification of payroll records and invoices, which got him fired from a job in 2002, after which time the U.S. government sent him to Iraq to oversee construction projects. With his dubious background, how did our government see it fitting to entrust Stein with taxpayer dollars?

As it turns out, late in the days of the Clinton administration, a regulation was passed that addressed just this type of scenario. It was titled the Contractor Responsibility Rule, more affectionately known as the blacklisting rule. The rule would have required government contractors “to confirm that they had complied with tax, labor and employment, environmental, antitrust, and consumer protection laws in the three years before receiving a [government] contract (2).” A day after the rule went into effect on January 19, 2001, the Bush administration suspended its implementation ‘pending further review’ and in December of 2001, the rule was repealed altogether (3). Business groups strongly opposed the rule while the AFL-CIO firmly supported it and is quoted as saying, “By overturning these contractor responsibility rules, the Bush administration has made it easier for more corporate lawbreakers to rake in lucrative federal contracts in the future (4).” In the editorial, Preparing for the Next Enron, the author equates the failure to uphold the rule, which “had considerable potential to deter corporate crime,” to “paving the way for future Enron-level disasters.”

In light of the contracting fiascos in Iraq and in the hurricane-ravaged areas of the U.S., it appears that this obscure rule that got tossed out amidst the holiday bustle on December 27 of 2001 could have had the potential of saving us millions – perhaps billions – in taxpayer dollars.

1 No-Bid Contracts to Get Close Look
2 FAR Council rescinds the contractor blacklisting clause
3 Preparing for the Next Enron
4 Government contractors defeat federal blacklisting regulations

FASB Reacts

FASB Votes to Revise Pension Rules (Nov 10 WSJ, p. C3) a day after the House Ways and Means Committee approves H.R. 2830, the Pension Protection Act of 2005 (the Act), which now awaits a vote by the full House of Representatives. If passed, the Act will, among other things, “establish new minimum funding standards for…defined benefit pension plans,” increase some premiums paid to the PBGC, specify certain interest rate assumptions and calculations, and require “additional disclosures in annual reports and to plan participants and beneficiaries.” The Act would amend the Employee Retirement Income Security Act (ERISA) as well as the Code of the Internal Revenue Service. FASB’s proposed actions will enhance certain provisions of the Act. For instance, heightened disclosure of pension obligations would be facilitated by a FASB requirement that companies report ‘on their balance sheets the amounts by which their pension plans are over- or underfunded.’ This information has traditionally only been contained in footnotes to the financial statements. FASB reports that new rules, such as this one, may be in place by the end of next year and the board estimates that these simple revisions “would affect corporate balance sheets by hundreds of billions of dollars.”

However, the most sweeping changes to the pension accounting system will likely take several years to effect as FASB, in conjunction with the International Accounting Standards Board (IASB), ‘reconsider all elements of the current system.’ These changes will likely address how pension values are calculated at any given point in time (i.e. at fiscal year end), as well as how future obligations are determined.

It will be interesting to see how Wall Street reacts when the first phase of FASB’s approach is implemented next year.

PBGC Takes Stock in Big Industries

An article in the Nov. 3 Wall Street Journal relates that the Pension Benefit Guarantee Corporation (PBGC) is fast becoming a major shareholder in the flailing airline industry and may soon take stock (literally) in the auto industry as well. The article explains that when big corporations file for bankruptcy protection and turn their underfunded pension plans over to the PBGC, occasionally a federal bankruptcy court will award shares of a corporation’s stock to the PBGC in lieu of paying cash that the corporation doesn’t have. This practice is increasing as more and more corporations are using bankruptcy for reorganization versus complete liquidation of company assets. It’s estimated that the PBGC may receive as much as 35% of the stock of United Airlines when it emerges from 38 months of bankruptcy protection in February, as well as ‘sizable chunks’ of stock in Northwest and Delta Airlines and Delphi Corp., an auto parts manufacturer. Others in the auto industry, such as General Motors, Ford, and Dana, are currently struggling to stay afloat.

The upside to the PBGC as corporate stockholder is that if the stock increases in value, that would help erase the company’s current deficit, ‘forestalling the need for a taxpayer bailout.’ It sounds like a good idea and a good way for the PBGC to recoup some of its losses from the takeover of so many underfunded pensions. The downside is that we then have a government agency as a stockholder in private enterprise. Although, as the article states, the PBGC “doesn’t have the authority to involve itself in management decisions of bankrupt companies,” it still can’t be denied that an agency of the federal government now has a vested interest in these corporations, which are increasingly representative of entire industries (steel, airline, auto).

My concern is; how might this ‘vested interest’ shape the federal government’s policy-making and regulatory decisions? For example, at the same time that the PBGC stands to gain a big share of the airline industry, a related article states, “the White House signed off on new regulations aimed at easing strict limits on U.S. airlines’ access to foreign capital.” More accurately, the government will apply ‘looser interpretation’ to existing U.S. law, which currently “forbids foreigners from owning more than 25% of an airline’s voting shares and requires that carriers operate under the control of Americans.” While this may very well provide an influx of cash from foreigners for the struggling industry (thereby increasing stock value), it also sets a precedent for foreign ownership and control over other U.S. industries. Is this really what we want? (This proposed regulation will be open for public comment and should be published by November 28. It is sponsored by the U.S. Dept. of Transportation and the Office of Management and Budget.)

It’s not my intention to say that the decision to relax regulation of airline ownership is directly related to the PBGC’s interest in the industry, but if we look at a puzzle only in terms of each individual piece, we may never see the whole picture. Those in charge of running the federal government don’t want to be blamed that they’ve failed the American public and it would be shameful for a government agency, such as the PBGC, to have to rely on a bailout by American taxpayers. However, it’s important that we be wary of government actions that attempt to save its politicians from embarrassment or ridicule under the guise of doing what is best for American businesses and the general public. Wouldn’t a taxpayer bailout of the PBGC be of less consequence than foreign takeover of U.S. industry?

Bear in mind that politicians can (and do) fall under the same pressure to perform and succeed as do corporate officers and managers.