Executive Fallout

Raleigh, NC. Consider the recent resignations and/or terminations of high-profile corporate executives.  This includes a number of folks at Nortel, a handful of managers at AAIPharma, the Red Hat CFO, and so on.  Over the next couple of years court cases, lawsuits and SEC enforcement actions may serve to earmark one or more managers from one or all of these companies as guilty of fraud, misrepresentation, negligence, or other legal no-no’s.  Over the next couple of years many executives will also resign from their positions at Public Corporations to protect their personal assets, even when they  didn’t do anything fraudulent or illegal during their careers.

 Let us consider a hypothetical to illustrate this inevitability.

 The Scenario: Suppose company “A” was aggressive in its revenue recognition practices during the period 1999-2003.  Suppose they recognized revenue on forward-looking contracts faster than they should have.  That is, they sold a job or product in 2001 that called for performance over several years.  Under GAAP, they should have allocated the revenue over 2-5 years to coincide with their performance obligations (or liabilities), but suppose management chose to report the full contract (or a large part of it) as revenue in 2001 to plump their reported sales and profits in FY2001.  Suppose the company also paid their managers, salespersons, and executives bonuses in 2001 based on this accelerated, reported revenue. 

 Jump forward to 2002.  The Sarbanes-Oxley Act is passed in July, 2002.  Embedded in SarbOx, Section 304, is text that obligates the CEO and CFO to forfeit “any bonus or other incentive-based or equity-based compensation” that they received during the year subsequent to the filing of financial statements that are subsequently re-stated (lower).   The CEO and CFO must also forfeit any profits from their sale of securities of the issuer during the same twelve month period. 

 At the time of the Sarbanes-Oxley Act, Company A executives trivialized or under-estimated the likelihood that Company A would ever have to re-state earnings or that their internal controls systems would ever do them in.  Accordingly, it was unlikely that the §304 disgorgement provision would ever affect them.  And since Company A still had a pretty cushy relationship with its Public Auditor in mid-year 2002, it probably seemed far-fetched that the Auditor would ever advocate against Company A’s revenue recognition practices, especially since the Auditor had issued un-qualified opinions on Company A’s annual financial results for several years.

 Now, fast forward to July, 2004.  It has become clear that §304 has teeth.  Over the last year the SEC, State Attorneys-General, “ambulance-chasing” Attorneys pursuing class-action lawsuits, and affected companies, are serious about prosecuting wayward executives and forcing disgorgement (refund) of previously paid bonuses.

 The Quandary: Let us return to Company A in 2004 and/or 2005. Their Independent Auditor is now obligated to be “truly” Independent, courtesy of the PCAOB and SEC §404 Internal Control final rulemaking of March, 2004.  Company A’s Public Auditor must now identify and report problematic accounting practices, fraud, asset mis-management, GAAP accounting omissions, and other deficiencies in internal controls.  Else the Auditor runs the risk of losing its accreditation for public audits. Company A’s Auditor now tells Company A’s CEO and CFO that it can no longer support Company A’s aggressive revenue recognition practice, and by the way, it may be necessary to re-state revenues back to 1999 or 2000 because the recognition policy was not GAAP-compliant in each of those previous years.  While the Auditor is sorry that it okayed Company A’s practice from 1999-2003, it is a new day and they can’t do it anymore.

 All of a sudden Company A’s CEO and CFO are potentially liable for bonus and incentive refunds for one or more years of overstated revenues and earnings.  At the very least they are liable for refunds for any fiscal period after July, 2002, when the SarbOx Act was passed.  At this time it may be that they could be forced to refund bonuses/stock profits for FY2002, FY2003 and/or  FY2004.

 Reality Hits Hard: If the CEO and CFO stay with Company A beyond the financial restatements, it seems likely they will have to voluntarily pony up their prior period bonuses, as they will not have any room to argue.  They minute they sign the new §302 and §906 certifications for Company A’s 10Q and/or 10K filings (and/or amended 10Q or 10K filings for prior periods), they will be testifying, in effect, that their financials were previously reported wrong.  When the CEO and CFO acknowledge it was done wrong in prior periods, then how can either defend his/her entitlement to bonuses for those periods?

 It is decision time.  If the CEO and/or CFO leave Company A before the restatements are finalized, then one or both does not sign the restatement paperwork and/or certifications.  That is, one or both never formally acknowledge that any earnings misstatements ever took place on their “watch.”  On this basis one or both can then contend that they reported prior period financials in good faith, subject to their Auditor’s concurrence, in 2002, 2003, etc.  On this basis, they fully earned their bonuses and stock awards in those years, and should not be subject to disgorgement. For the CEO and/or CFO the previously banked bonus monies will now provide a legal war chest with which to defend the executive(s) against the lawsuits and disgorgement storm to come.

 Now let us look at an unfortunate parallel.  Suppose that executives at Company B did things entirely on the up and up, but because of an Auditor change in 2003 or 2004, or concern about a potential restatement, or an Auditor determination that an accounting practice needs to be tweaked, a totally honest CEO and/or CFO decides to resign to protect honestly-earned personal assets and bonus monies.  This is because in the current, litigious climate, they are concerned about “ambulance chasing” attorneys and/or other disgorgement actions that may be brought on shaky grounds, but which could cost them millions anyway.  ‘Tis better to leave than to be sued or prosecuted while the piranhas are swimming about.

 The implications: Going forward, when a senior corporate executive resigns, it may not be clear at the time  whether he/she was a “Company A” case jumping ship to avoid legitimate consequences for previous malfeasance, or whether he/she was a “Company B” case trying to minimize legal and financial fallout from the SarbOx feeding frenzy.  For the next couple of years we will probably see both occur with some regularity.  It will take from 1-3 years after the actual resignation to determine whether the “Case A” or “Case B” scenario drove the executive from the company.

 To mitigate the exodus, companies should commit to transparent financials at the earliest possible date.  This mitigates the likelihood and exposures connected with misstatements and/or the “appearance” of misdeeds.  This also stands to best protect the honest, “Case B” managers to the greatest extent.  After all, we want the honest, high-performance, Case B executives to stay the course and not resign from their positions.  As for the “Case A” executives, well, we “have no opinion.”

.VisageSolutions is a group of experienced operational executives focused on providing cost-effective, technology-based Sarbanes-Oxley solutions. By working carefully with their clients VisageSolutions provides customized solutions that focus on reducing the “operational cost” of sustained compliance through an optimum combination of existing and new technologies and tools, and business process integration.  See www.visagesolutions.com for more information and related links.