Remember the clawback provision of SOX 304? That provision provides a reimbursement remedy against CEOs and CFOs when the issuer has restated its financial statements as a result of misconduct. Although the provision was enacted in 2002, it wasn't until 2007 that an executive was successfully hit with a clawback claim (and a big one it was—the executive returned approximately $600 million in cash and options). And since then, SOX 304 hasn't gotten all that much of a workout. As reflected in this Order, the SEC has just brought settled charges against the former CEO and CFO of WageWorks Inc., alleging that they made false and misleading statements and omissions, including to the company's outside audit firm, that led to improper revenue recognition and ultimately resulted in a financial restatement. The settlements with both former executives included reimbursement of incentive-based compensation under SOX 304.
SOX 304 provides that, if
"an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for—
(1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and
(2) any profits realized from the sale of securities of the issuer during that 12-month period."
SideBar
What if the CEO and CFO were not the malefactors in the case? In the early years after SOX was initially adopted, there was some question as to whether the SEC would even seek to enforce SOX 304 against non-perps. It wasn't until 2009 that the SEC brought its first case against executives seeking disgorgement of compensation under SOX 304 because of a restatement involving alleged accounting fraud, notwithstanding the absence of allegations of misconduct against those executives. Then, in 2011, the SEC announced another settlement to recover bonus compensation and stock sale profits from a CFO under SOX 304, even though there were no charges of personal misconduct by the CFO. In 2016, the 9th Circuit, in SEC v. Jensen, became the first circuit court case to confirm the SEC's position that the "clawback" provisions of SOX 304 provide for a disgorgement remedy against CEOs and CFOs when the issuer has restated its financial statements as a result of misconduct, even if the CEO and CFO were not alleged to have engaged in the misconduct themselves. (See this PubCo post.) So apparently, the book is closed on that question: the SEC takes the broader view that, under SOX, the CEO and CFO are required to "take affirmative steps to prevent fraudulent accounting schemes from occurring on their watch," and, if they receive substantial incentive compensation and stock sale profits while their company is misleading investors and committing accounting fraud, those amounts should be forfeited.
According to the Order, in March 2016, WageWorks, a provider of Flexible Spending Accounts and other employee benefit services, entered into a contract with a significant client to provide FSA services for certain public-sector employees. The services were to begin September 1, but the company needed to perform development and transition work between March 1 and September 1, referred to as "Base Year 1." There was a dispute, however, as to whether the client would pay for the work performed during Base Year 1. In June, the client advised the company that it did not intend to pay for work during that period, and that information was conveyed to the CEO and CFO. Repeatedly, however, during 2016, the CFO falsely told the company's internal accounting staff as well as its outside audit firm partners that the client had agreed to pay and did not advise them that the client had at least twice indicated that it was not going to pay for Base Year 1. The CEO and CFO both signed management representation letters stating that management had continually assessed the collectability of the amounts owned by the client, included amounts related to Base Year 1, and determined that they were reasonably assured of collection. In its 10-K for 2016, the company recognized revenue related to Base Year 1 of $3.6 million. Consistent with GAAP, WageWorks stated that it recognized revenue when, among other things, collectability was reasonably assured and persuasive evidence of an arrangement existed. Even though the CEO and CFO believed that the company was entitled to be paid for Base Year 1, the Order stated, recognition of revenue for Base Year 1 was improper under GAAP: because the client had indicated that it was not going to pay for Base Year 1, the revenue "was not realizable or reasonably assured." After filing its 10-K, the company's stock price rose and the CEO and CFO earned bonuses based on the company's financial performance.
In 2017, the dispute between WageWorks and the client escalated, but the executives continued to dissemble to the internal staff and the outside auditors, indicating that the they were in discussion with the client or working on collection and even that the client hadn't paid because the invoice was in the wrong format, and that WageWorks expected to be paid after it resubmitted its invoice. Even after the company submitted to the client a "certified claim," a necessary precursor to litigation, the CEO and CFO did not advise the outside auditors, instead maintaining that they expected to be paid by year end. Nor did they advise the audit committee that the client had expressly denied that it owed payment. The company continued to recognize revenue from the client for Base Year 1.
In mid-2017, the company conducted a public offering.
Not until January 2018 did the CFO and other management fess up to the outside auditors and the company's internal accounting staff about WageWorks' certified claim and the client's rejection of that claim. Finally, in March 2018, the company announced a 10-K filing delay and investigation into its revenue recognition practices. Its stock price dropped 9%. In mid-March, the company restated its 2016 annual financials and its quarterly financials for the second and third quarters of 2017, reversing all revenue from the client attributable to Base Year 1.
The SEC charged the CEO and CFO with a number of violations, including obtaining money or property by means of any untrue statement or omission and engaging in a fraudulent or deceitful transaction, practice or course of business under Sections 17(a)(2) and 17(a)(3) of the Securities Act (which do not require scienter), falsifying books and records under Rule 13b2-1 of the Exchange Act, false certifications under Rule 13a-14 of the Exchange Act (certifications filed with each periodic report as to, among other things, the accuracy of the financial statements and the effectiveness of disclosure controls and internal controls), and failure to reimburse the company under SOX 304. Interestingly, even though the Order includes a number of allegations against the CEO and CFO, the Order adds that SOX 304 "does not require that a chief executive officer or chief financial officer engage in misconduct to trigger the reimbursement requirement." The CEO and CFO were also charged with violations of Rule 13b2- 2, which prohibits any director or officer from (a) making materially false or misleading statements or omissions
"to an accountant in connection with financial statement audits, reviews, or examinations or the preparation or filing of any document or report required to be filed with the Commission and (b) taking any action to coerce, manipulate, mislead, or fraudulently influence any independent public or certified public accountant engaged in the performance of an audit or review of the financial statements of that issuer that are required to be filed with the Commission pursuant to this subpart or otherwise if that person knew or should have known that such action, if successful, could result in rendering the issuer's financial statements materially misleading."
The CEO and CFO were also charged with causing the company to file false current and periodic reports in violation of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder; to keep false books and records in violation of Section 13(b)(2)(A) of the Exchange Act; and to maintain inadequate internal accounting controls in violation of Section 13(b)(2)(A) of the Exchange Act.
The CEO was required to reimburse WageWorks for approximately $1.9 million and pay a civil penalty of $75,000, and the CFO was required to reimburse WageWorks for approximately $157,000 and pay a civil penalty of $100,000.
SideBar
One reason that violations of SOX 304 are not frequently charged might be the absence of "misconduct." Could another be that companies are filing fewer restatements, with many instead opting for the less draconian "revision"? According to Bloomberg, since "2014, roughly three-fourths of all corrections were reported as a revision, according to data compiled by Audit Analytics. Companies reported 383 revisions [in 2019], whereas full restatements hit a 15-year low of just 83, based on a preliminary analysis of 2019 disclosures by Audit Analytics." (Note that the volume of revisions reflecting immaterial accounting errors also declined over the past decade but at a slower rate than restatements.) While some contend that the "steady flow of revisions is a sign that auditors are doing what they're supposed to under the 2002 Sarbanes-Oxley Act, catching mistakes before they balloon into market-moving problems," others wonder whether auditors are being sufficiently skeptical. A study from the University of Texas at El Paso of about 1,500 "revisions and restatements issued from 2004 to 2015 found that 45 percent of the revisions met at least one of the SEC's materiality criteria."
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