The SEC’s AgFeed Complaint: No Restatement Means No Sarbanes-Oxley Clawback

The Securities and Exchange Commission says it’s stepping up scrutiny of corporate accounting and disclosure fraud. That means going after gatekeepers like auditors, lawyers, and directors under an aptly named initiative Operation Broken Gate. The AgFeed case is the mother lode for an SEC that says it’s ready to rack up some accounting fraud enforcement points and, perhaps, pursue a more aggressive enforcement approach to sparsely utilized Sarbanes-Oxley provisions like Section 304, compensation clawbacks.

AgFeed has everything a reinvigorated corporate fraud fighting and broken gate fixing SEC could want. My recent three part series on this Chinese reverse merger gone bad and bankrupt was published before the SEC recently filed a complaint against AgFeed and six executives. The SEC complaint includes fifteen allegations that cover a wide range of federal securities laws including Sarbanes-Oxley law.

I previously wrote about the Audit Committee member, Milton Webster, who was a whistleblower. The complaint alleges another guy, an Audit Committee Chairman, “engaged in a scheme to avoid or delay disclosure of the fraud.”

I previously wrote about the two audit firms that missed the fraud, Goldman Parks Kurland Mohidin LLP and McGladrey & Pullen LLP, defendants in private shareholder class action litigation alleging malpractice. The SEC’s complaint says AgFeed executives deceived the auditors, a violation of Rule 13b2-2 or Section 303(a) of the Sarbanes-Oxley Act. (The SEC has, in the interest of strengthening its own case against the executives, given the audit firms a big SEC-supported leg up in defending themselves against private litigation for malpractice.)

The SEC’s complaint “anonymizes” two trusted advisors, a firm and an individual, and credits them with trying to do the right thing and warning executives about the potential for fraud. I wrote about Fred Rittereiser, an advisor to the board that Milton Webster referred to in his deposition as a “consiglieri”, and not the upstanding, law abiding kind. I also wrote about Protiviti, a consulting firm with close ties to the Audit Committee Chairman and, later, AgFeed CEO and Chairman Van Gothner. Protiviti helped AgFeed management prepare its Sarbanes-Oxley internal controls assessments starting in 2008, respond in March of 2012 to initial SEC investigative inquiries and then doubled down in early 2013, after the fraud was well-known, to be the company’s internal audit service provider.

The SEC complaint does not even mention law firm Latham & Watkins, since the agency chose to focus only on the fraud in the Chinese operations of AgFeed that allegedly occurred from 2008 until the end of June 2011. I wrote about Latham & Watkins, the firm that began representing AgFeed and its officers and directors shortly they disclosed the Chinese fraud and shareholders sued them. Latham continues to represent the company and some executives. Latham & Watkins was hired as counsel to a special investigative committee at the end of 2011 and the law firm hired consulting firm FTI to act as forensic accountants under its direction. A derivative suit was eliminated by the bankruptcy in July of 2013. Latham also now serves as special counsel to the company in bankruptcy.

The SEC complaint includes a claim against the former Chinese CEO and CFO and the subsequent US CFO for “failure to reimburse”, a violation of Section 304(a) of the Sarbanes-Oxley Act of 2002. The Section 304 claim hits all the highlights of the law:

“As a result of the misconduct described above, AgFeed filed reports that were in material non-compliance with its financial reporting requirements under the federal securities laws. AgFeed’s material non-compliance with its financial reporting requirements resulting from the misconduct required the company to prepare accounting restatements.”  But the SEC admits “the company prepared a draft restatement but never completed it because on July 15, 2013, the company filed for protection under the United States Bankruptcy Code.”

The SEC then makes a calculation of the impact of the restatement that should have been, if only the AgFeed executives had completed and filed it.

“Based on the company’s draft restatement work, the fraud caused AgFeed’s publicly-reported revenues to be overstated by approximately $239 million over a three-and-a-half year period. On an annual basis, for 2008, 2009, and 2010, the fraud caused revenue inflation ranging from approximately 71% to approximately 103% and gross profit inflation ranging from approximately 98% to approximately 153%.”

On March 7, 2014 AgFeed filed an 8-K to, among other things, announce “the Company has not completed, and is not working on, its financial statements for the years ended 2013, 2012 or 2011, or its restated financial statements for the year ended December 31, 2010.” The company’s auditor, McGladrey LLP, also resigned on March 7.

(The company had previously disclosed that, based on the completion of the special committee investigation into certain accounting issues in the Company’s animal nutrition and legacy farm hog operations in China, “investors and others should not rely on the Company’s (1) audited financial statements for the year ended December 31, 2010, which were audited by McGladrey, (2) audited financial statements for the years ended December 31, 2009, 2008 and 2007, which were audited by another registered accounting firm and not McGladrey, and (3) unaudited financial statements for all quarters within those years and the first two quarters of 2011.”)

The SEC’s fifteenth and final claim against AgFeed and its executives, “Failure to Reimburse – Violation of Section 304(a) of the Sarbanes-Oxley Act of 2002 [15 U.S.C. § 7243(a)]” is a huge prosecutorial stretch given the law and the agency’s track record, if you can call it that, for enforcing Section 304.

Here’s why…

It’s hard enough to enforce Section 304 when all the legal requirements are met:

• A restatement is “required”,
• There’s been material non-compliance with any financial reporting requirements under the securities laws,
• The non-compliance is the result of “misconduct”, and
• The Commission did not exempt any person—the law only applies to CEO and CFO compensation— from the application of subsection, as it has the authority to do. (The SEC has never formally exempted any executives from application of the subsection even though it has chosen, in many cases, not to enforce it.)

The “misconduct” requirement has been litigated and the current assumption, after Jenkins, is that the SEC will go after “innocent” CEOs and CFOs. There’s also been plenty of litigation about whether the SEC has exclusive enforcement authority or if there is a private right of action. There is not.

The one necessary component that hasn’t been discussed much recently is the one that says a restatement must be “required”. That’s the one the SEC may be trying to put on the boards with some case law. Unfortunately, AgFeed doesn’t fit as well as many others the agency could and should pursue.

Gretchen Morgenson at the New York Times has spit out a lot of pixels discussing “clawbacks” that haven’t happened. First she, like many other journalists, takes the SEC’s word for how many cases there’s been by counting actions filed rather than settled or litigated still holding a Section 304 claim. The SEC likes to take credit in its enforcement statistics for swinging sticks but thinks no one will check back to see how the match ended.

Turns out Section 304 claims are often dropped when the SEC settles with the scoundrels and only a dribble of 304 cases have been litigated since 2002. The Section 304 claim is dropped because the cases are missing, like New Century—one Morgenson included in her article—a crucial element. There was no Section 304 clawback in the New Century case because there was no restatement ever made. The company went bankrupt first, like AgFeed.

Cadwalader attorney Brad Bondi, in a recent article describes the landscape:

“…section 304 is far from a settled area of law. Despite the SEC’s wins in Baker and Jenkins, case law in this area is sparse and, in some cases, conflicting.”

Recently Morgenson lamented another case that could have been, Fifth Third, even though it would have never qualified for Section 304 treatment. It too was missing that basic element, a restatement. (She mentions New Century again, even though we already know there was no Section 304 clawback. It may be because she keeps talking about compensation disgorgement. That may be because the SEC continues to conflate clawbacks under Section 304 and disgorgements, an equitable remedy under a different law, in its statistics.)

Rather than cry over cases that coulda/shoulda been if only they’d met the requirements, why not look at the number of cases that met all the requirements and were never brought? That can tell us more about the SEC’s enforcement philosophy for Section 304. In my opinion it’s conservative, selective, inconsistent at best, and haphazard at worst.

The element of “materiality” plays a big role in whether a Section 304 case makes it through and maintains its Section 304 character. If the non-compliance with financial reporting requirements was not material, there will be no restatement. Case closed. A good example of the absence of Section 304 enforcement where you would think, based on the criteria, there would be is Huron Consulting.

I wrote about it here.

On Friday July 20, 2012 the SEC announced it had settled charges against Huron, its CFO Burge and its Controller Lipski in return for fines and promises to be good in the future with no admissions of guilt by any of the parties. Huron paid a $1 million penalty and the CFO and Controller will pay a total of about $300,000 in fines and restitution. Fines paid by the CFO are labeled a disgorgement, not Sarbanes-Oxley Section 304 clawbacks, in spite of the fact Huron restated several years of financial statements as a result of the “misreported costs”. Huron indemnified the former executives for defense costs, but it is not obligated to reimburse them for monetary penalties.

Chicago’s own Thomas Cimino at Vedder Price, attorney to former Huron CEO Gary Holdren, also announced on July 20, that the SEC had, “terminated its case against Mr. Holdren and determined not to pursue what have become known as “innocent executive” clawback claims against him in this matter.”

That means no “Jenkins” treatment or any Section 304 clawbacks of incentive compensation related to the Huron Consulting “misreported costs.”

…The other side of the expertise coin is the winning position taken by Holdren’s attorney, Thomas Cimino and, apparently, the SEC. Cimino told me this morning that the SEC “did not assert any allegations of wrongdoing against Gary Holdren. The SEC also determined to drop any claim against Mr. Holdren for clawbacks of incentive-based bonuses, stock awards or stock sale profits.” While Huron touted itself as having a number of consulting experts in the area of technical accounting standards, Cimino articulated Holdren’s position that the restatement “was the result of a single accounting mistake on a very complicated issue at a company with an otherwise perfect record.”

The SEC must have decided that an unintentional mistake occurred given the fairly light sanctions imposed on CFO Burges and Controller Lipski. The SEC’s decided to make the charges against Lipski, Burge and Huron a “books and records” violation using Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the 1934 Exchange Act rather than associating the material, multiyear accounting misstatement with a Section 10b-5 fraud charge.

Huron restated, actually went back and recalculated and reissued financial statements for, 2006, 2007, 2008 and the first quarter of 2009, because of incorrect accounting related to the acquisition of four businesses between 2005 and 2007. The “adjustments” reduced net income from 2006 through the first quarter of 2009 by about $56 million but were characterized everywhere, including by the SEC, as “misreported costs”. I think the decision not to pursue Section 304 clawbacks was supported by characterizing these restatements, appropriately or not, as “nice to have” but not material and, therefore, not “required”. It had nothing to do with whether CEO Holdren was “innocent” or not.

Another recent example of non-pursuit by the SEC of CEO and CFO reimbursement to a company is the restatement by JPMorgan as a result of the “London whale” scandal.

I wrote about it here.

The Wall Street Journal reported that Achilles Macris, Javier Martin-Artajo and Bruno Iksil were terminated with no severance pay. Martin-Artajo  and another trader, Julien Grout, have now been indicted for the mismarking of the trades that led to JPM’s  restatement of its 1Q 2012 results. JPM said the amount clawed back, under bank policies, from each person represents about two years of total annual compensation. The recovered sums include restricted stock and canceled stock options grants.

Ina Drew “offered” to give up “a significant amount of past compensation”, according to the WSJ who quoted Jamie Dimon at the time. Dimon said it is equivalent to the maximum clawback allowable under the bank’s policies.

Dimon and Braunstein, however, have not given back any 2012, 2011 or 2010 incentive compensation and the SEC hasn’t yet forced them to do so. A recent indictment of two of the two traders implies there was misconduct.

At a minimum, under Sarbanes-Oxley Section 304, the CEO and CFO, whether “blameless” or not, must reimburse the company for any bonus or other incentive-based or equity-based compensation received during the 12-month period following the first public issuance or filing and any profits realized from the sale of securities of the issuer during that 12-month period if the company is required to prepare an accounting restatement, due to material noncompliance as a result of misconduct.

JP Morgan formally restated its 1Q results in the 2^nd Q, lowering its previously-reported profit by $459 million. You can argue if that amount was material but that discussion is trumped by the fact that, like at Huron, the bank believed there was a requirement to restate and did so. Certainly there was misconduct. The traders involved were indicted and face civil and criminal charges. The CFO, Doug Braunstein, was sent back to investment banking. The bank was sanctioned by the OCC and is under a consent decree requiring improvement of internal controls and other risk management policies and procedures as a result. And yet JPMorgan did not require reimbursement of incentive compensation by CEO Jamie Dimon and Braunstein and the SEC has not filed a Section 304 claim against them for failure to reimburse.

When is a restatement required?

Scott Taub, a former deputy chief accountant of the Securities and Exchange Commission under Arthur Levitt wrote in Compliance Week in 2012 that authoritative literature and SEC regulations on restatements are straightforward:

• The Accounting Standards Codification Master Glossary defines restatement as “the process of revising previously issued financial statements to reflect the correction of an error in those financial statements.”
• ASC 250, Accounting Changes and Error Corrections, states, “Any error in the financial statements of a prior period discovered after the financial statements are issued shall be reported as an error correction, by restating the prior-period financial statements.”
• ASC 105, Generally Accepted Accounting Principles, notes that the provisions of GAAP apply only to material items. Read in conjunction ASC 250, this means that restatement is required only for material errors.
• AU Section 508 requires that auditors’ make reference to the correction of a material misstatement in the auditors’ report the first time the corrected statements are issued.
• SEC regulations require that correction of a material error in a previously filed form 10-K or 10-Q be reported by amending the previous filing.
• SEC regulations require a Form 8-K Filing if the company concludes that previously issued financial statements should not be relied upon because of an error.

But what does Section 304 mean when it says reimbursement must be made when a “restatement is required”? That law does not define the term “required”.

In 2002 the law firm Alston & Bird told its clients that “a reasonable interpretation of this term would be that a restatement is required when the company’s independent accounting firm cannot complete its interim review or deliver its audit opinion unless the restatement is made”.

In 2004 law firm Gibson & Dunn said “one could also argue that a restatement is “required” when the SEC will not declare a registration statement effective under the Securities Act of 1933 without a restatement of an issuer’s financial statements, or indicates that an issuer may be subject to an enforcement action if it does not restate its financials.”

The Agfeed case does not qualify for a Section 304 reimbursement claim under either of these assumptions. There is no more auditor waiting to sign an opinion. McGladrey resigned, AgFeed is in bankruptcy and said recently it will not prepare the restatements. The SEC has also deregistered the company. There is no registration statement that is ineffective without the restatement.

What if the SEC is trying to make a point—a worthy one— here. Maybe the SEC believes, as I do, that executives should not be able to dodge forfeiture under Section 304 by weaseling out of making “required” restatements.

I’ve written about the growth of “stealth” or revision restatements that avoid the 8-K notice and refiling of previous reports by downplaying materiality. (Research firm Audit Analytics noted my skepticism about this trend in a recent blog post.) Corrections are made for what are deemed, by executives with auditors’ acquiescence, innocent errors and the company moves on. No “required” restatement, non-material errors corrected in current period means no clear cut Section 304 clawback eligibility.

Maybe the SEC thinks CEOs and CFOs should not be allowed to dodge forfeiture of undeserved incentive compensation through bankruptcy and delisting/deregistration. In particular, when there’s fraud that caused the material misstatements, Chapter 11 should not provide cover for keeping what you stole.

But maybe disgorgement is the best there is. The SEC has sought disgorgement in numerous cases, an equitable remedy under Section 21(e) of the Exchange Act that empowers the SEC to obtain injunctive relief, rather than Section 304, to recover ‘the gains of wrongful conduct’ from defendants. That’s what most of the Section 304 initial claims end up as when they are settled many years later.

The SEC has already lost at least one case where there was no restatement, even though the agency claimed there should have been one. That’s the point the defendant argued – and won – in SEC v. Shanahan. U.S. District Judge Jean Hamilton (E.D. Mo.) ruled on December 12, 2008, that the “clawback” provision of Section 304 of the Sarbanes-Oxley Act of 2002 only applies where an accounting restatement is filed.

It is also necessary for me to note here that the SEC has been selective in its claim for reimbursements under Section 304 in the AgFeed case. Two of the three executives named, the CEO and CFO of the company while it was based in China, are Chinese nationals. The likelihood of anything but a default judgment against them is low. Even Reuters couldn’t find them or their lawyers.  The third executive charged, the US CFO, was CFO of the company for a short time, less than a year, November 2010 until July 15, 2011.

In the interest of filing charges against an Audit Committee Chairman, quite a coup for its Operation Broken Gate initiative and quite unusual, the agency neglected to mention that Van Gothner became the company’s Chairman and CEO later. He allegedly presided over a second round of frauds, according to private litigation, in the US operation.

AgFeed’s former chairman and interim CEO during the Chinese fraud period, John A. Stadler, separately consented to an SEC order barring him from acting as an officer or director and requiring him to pay a $100,000 penalty. AgFeed’s former CFO Clayton T. Marshall, who replaced Pazdro, entered into a cooperation agreement with the SEC. Whether a financial penalty should be imposed against Marshall will be determined at a later date. There was no Section 304 reimbursement claim for either.