Public companies whose quarterly reports show a distinct absence of the number “4” in their financial statements may get a knock on the door from the SEC, which is stepping up enforcement against companies that it finds are rounding up in order to manipulate higher earnings-per-share (EPS) ratios.
The enforcement effort, known as the EPS Initiative, was launched a few years ago and is going into higher gear under the leadership of SEC Chair Gary Gensler, who has promised robust action against potential violators.
The SEC’s EPS Initiative was launched based on the findings in a 2009 academic paper that examined what researchers believed was an unusually high absence of the number “4” in company financial statements.
The academics said that statistically, each number should appear in the tenth place of a company’s unrounded EPS ten percent of the time. If the number “4” appears less than that, the researchers said there’s an increased chance that the companies were improperly rounding up. If a company reports that figure at “5” or more, it allows it to round up its earnings per share to the next cent.
Companies have a great incentive to report higher EPS numbers, especially if they are followed by Wall Street analysts, who use quarterly forecasts to gauge company performance. Investors are more likely to buy shares of companies which beat analyst expectations, as they are to sell shares of those which miss the forecast.
To identify potential violators, the SEC has built and maintains a database of quarterly reports for the majority of US publicly traded companies dating back a dozen years. In 2020, in order to assess whether companies were rounding up numbers, the regulatory agency began comparing a company’s recent quarterly report against the database, using the number “4” as a benchmark.
Over the last year, the SEC has charged three companies with EPS manipulation. The Wall Street Journal is reporting that more cases are likely to be filed, as the SEC uses its analytics tools to comb through company filings.
Proposed Rule to Expand Pay Clawbacks
The SEC is once again asking public feedback on a rule that would force executives to return performance-based compensation if their company has to file material financial restatements.
The rule was proposed in 2015 but was withdrawn amid dissent from some SEC commissioners. The SEC already requires executives to return pay if the performance-based compensation was based on numbers that were achieved through misconduct. This new rule, if adopted, would extend clawbacks to include material misstatements stemming from errors without misconduct.
The proposal doesn’t describe what types of accounting errors would be considered “material” to investors. Restatements that address minor problems, such as misclassifications of cash flows, and which would be corrected in subsequent financial statements, would not trigger a clawback.
This proposed clawback rule stems from the 2010 Dodd-Frank law, which was passed after the 2008 financial crisis.
If adopted, it would require stock exchanges, including the New York Stock Exchange and NASDAQ, to force listed companies to both disclose and apply clawback policies. Those that don’t would be delisted. Additionally, the clawback would apply to both current and former executives going back three years prior to restatement.
According to Audit Analytics, US-based public companies filed 325 material restatements in 2020, down 60 percent from ten years ago. The research firm is reporting that 75 percent of restatements in recent years are minor, or immaterial, restatements.
The SEC reports that over 2,000 of the 5,500 companies listed on US exchanges already have adopted clawback provisions. That’s up from 1,320 in 2018 and fewer than 1,000 in 2015, when the rule was originally proposed.
The SEC will make its final determination following a 30-day comment period, which began October 14.
Regulating Crypto a Priority for New General Counsel
Dan Berkovitz, recognized as one of the top U.S. derivatives regulators, will join the SEC as its top lawyer beginning November 1.
He joins the SEC from the Commodities Futures Trading Commission (CFTC), where he currently serves as a commissioner. Earlier, from 2009 to 2013, Berkovitz served as the CFTC’s general counsel, during the time when SEC Chair Gary Gensler served as the CFTC’s Chair.
In June while speaking at the 2021 Asset Management Derivatives Forum, Fortune Magazine reported that Berkovitz criticized decentralized finance, commonly known as DeFi, saying, “Not only do I think that unlicensed DeFi markets for derivative instruments are a bad idea, I also do not see how they are legal under the Commodity Exchange Act.” He added that the CFTC “together with other regulators, needs to focus more attention on this growing area of concern and address regulatory violations appropriately.”
Berkovitz joins at a time when the SEC is embarking on a comprehensive rule-making agenda. In June the SEC disclosed a list of 49 proposed rule changes to be addressed this year.
Along with new proposed rules relating to climate risk, and changing the underlying rules of the US stock market, both Gensler and Berkovitz have expressed a need to establish stronger regulations for cryptocurrencies.
Berkovitz succeeds current general counsel John Coates, who will be returning to teaching at Harvard University.
SEC Comment Letters Continue Decline
The downward trend in the number of SEC comment letters has continued, with a total of 769 comment letters being issued in the first half of 2021, according to Audit Analytics.
For the first two quarters of 2021, the research firm reported that comment letters referencing 10-Ks, 10-Qs, or 8Ks are on pace to decline by about 15% compared to 2020.
These types of comment letters declined by 11% in 2019 and by 35% in 2018.
For 2021, discussions about non-GAAP measures again ranked highest among regulators, followed by Management Discussion and Analysis (MD&A). Questions about revenue recognition fell to 5th place.
Audit Analytics speculated that the decline in comment letters relating to 10-Ks, 10-Qs and 8-Ks may be due to the increase in both IPOs and M&As in recent years. Although the SEC’s Division of Corporate Finance is required to review public company filings at least once every three years, limited staff instead may have been busy working on initial public offerings and merger activity.