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January 26, 2005
Reigning In Raines on Bonuses Based on Earnings Before Restatements
    by William Baue

With restatements of financial earnings reaching record levels in 2004, the question arises whether executive bonuses based on incorrect earnings statements should be recalculated.

US Representative Richard Baker (R-LA), chair of the Capital Markets Subcommittee, wants Fannie Mae (ticker: FNM) executives to return bonuses based on "faulty and deeply flawed earnings statements" requiring restatement by an estimated $9 billion for the years 2001 to 2004. The day after the US Securities and Exchange Commission (SEC) ordered Fannie to restate its earnings in mid-December 2004, Rep. Baker asked the Office of Federal Housing Enterprise Oversight (OFHEO--which oversees Fannie) to "take action to recapture" such bonuses.

"OFHEO will take all actions appropriate to recapture excessive bonus payments, in addition to other amounts, that OFHEO finds were based upon false or misleading financial information or are otherwise excessive," wrote OFHEO Director Armando Falcon in a January 14, 2005 letter responding to Rep. Baker.

Rep. Baker is not alone. Wayne County Employees' Retirement System, a Michigan public pension fund, last week filed suit in the US District Court for the District of Columbia for a temporary restraining order on bonus payments to resigned CEO Franklin Raines and resigned CFO Timothy Howard.

The issue seems relatively straightforward: incentive-based executive compensation typically ties bonuses to earnings performance, so when errors are discovered that necessitate earnings restatements, bonuses should be recalculated to retain their correlation to actual earnings. While logic suggests that bonus reimbursement should be standard procedure, executives are rarely required to return the goods.

In fact, the same judge hearing the Wayne County-Fannie case ruled last year that OFHEO could not freeze pay and benefits to Fannie sibling Freddie Mac (FRE) executives while concurrently pursuing civil penalties for Freddie's $5 billion earnings restatements.

Compounding this problem is the increasing prevalence of restatements among public companies, according to a summary report released late last week by Chicago-based Huron Consulting Group (the full 2004 Annual Review of Financial Reporting Matters report is due out next month.) Amended SEC filings for quarterly and annual financial restatements due to accounting errors hit a record number of 414 in 2004, up by more than a quarter (28 percent) from the 323 identified the year before.

"There were several trends and events affecting financial reporting in 2004, but among the most significant was the impact of Sarbanes-Oxley Section 404 procedures," said Joseph Floyd, managing director and national practice leader of Huron's Disputes and Investigations practice.

Now that Sarbanes-Oxley requires CEOs to certify the accuracy of financial statements with their signatures, companies scrutinize earnings reports much more rigorously. Ironically, while CEOs now face increasing legal accountability for earnings statement accuracy, they do not face personal financial accountability regarding their earnings-based bonuses, which stay north even when restatements go south.

While restatements are more and more common, attempts to "claw back" or recoup executive compensation after the identification of accounting problems are relatively rare, and have met with mixed success. For example, Conseco (CNC) sued its former CEO Steve Hilbert and his family trusts to return $162 million in stock-related loans before his 2000 departure from the company, which filed for bankruptcy in 2002. In October 2004, a judge ordered the return of almost $63 million, representing the interest accrued loans. Although this case does not directly involve bonuses and restatements, it may serve as a precedent emboldening others to seek similar recompense.

On the other side of the coin, the Amalgamated Bank LongView Collective Investment Fund filed a shareowner resolution calling for Computer Associates (Computer Associates) to recoup performance-based executive compensation after restatements. The issue was far from moot at the company, which was embroiled in controversy over year 2000 restatements that led to the resignation of CEO Sanjay Kumar, who received performance-based bonuses of 80,000 shares of stock and $3.2 million that year. While the statement by an Amalgamated spokesperson introducing the resolution at the company's August 2004 annual meeting that "you shouldn't keep it if you didn't earn it" elicited applause from the audience, less than a quarter of voting shareowners supported the resolution.


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