CEOs And CFOs Beware: Court Endorses SEC's Aggressive Use Of Section 304 Of Sarbanes-Oxley To Clawback Compensation Of Executives Who Did Not Engage In Misconduct

Introduction

Executive pay is under fire again. According to a recent district court decision in the Western District of Texas interpreting section 304 of the Sarbanes-Oxley Act of 2002,1 corporate executives could lose their bonuses and other incentive compensation if their company is required to revise its financial statements as a result of misconduct, even when the executives did nothing improper. On November 13, 2012, the court in SEC v. Baker, No. A-12-CA-285-SS, 2012, WL 5499497 (W.D. Tex. Nov. 13, 2012), agreed with the Securities and Exchange Commission's view that section 304 requires chief executive officers and chief financial officers to return bonuses and certain other compensation received in years in which the corporation restated its financials, even in the absence of misconduct by the executive. This decision and the SEC's continued, aggressive enforcement of section 304 against innocent executives raises the stakes yet again for executives who fail to detect or prevent misconduct on their watch.

Section 304 of Sarbanes-Oxley

Entitled "Forfeiture of Certain Bonuses and Profits," section 304 of Sarbanes-Oxley was intended to prevent executives from profiting from corporate misconduct.2 Section 304 empowers the SEC to force CEOs and CFOs of public companies to reimburse their company for certain compensation received in years for which the issuer undertook an accounting restatement due to the issuer's "material noncompliance" with any financial reporting requirement under the securities laws.3 Such noncompliance specifically must be the result of "misconduct," although misconduct is not defined within the statute. Under section 304, CEOs and CFOs must repay bonuses, incentive or equity-based compensation, and profits realized from the sale of the issuer's securities if such compensation was received or realized by the executive during the twelve-month period following the issuer's first noncompliant filing with the SEC.4 Any compensation that the SEC obtains from the executives pursuant to section 304 goes directly to the company, regardless of whether the company (and its shareholders) want the money back, and companies may not indemnify the executives for the amount they were forced to relinquish pursuant to section 304.-

Only the SEC may enforce section 304. Courts in several circuits have determined that section 304 does not contain an express or implied private right of action, so shareholders may not bring suit under the provision.6 In cases examining this question, courts contrasted the absence of any reference to private litigation in section 304 with the explicit authorization of such litigation in other sections of Sarbanes-Oxley. Instead, section 304 refers only to the SEC's ability to exempt persons from enforcement.7

Congress broadly empowered the SEC in section 304(b) to exempt any person from the provision, "as it deems necessary and appropriate."8 Indeed, Congress appears to have recognized that prosecutorial discretion, particularly where the company is not seeking a clawback of compensation, should accompany such a draconian provision as section 304(a). Unfortunately, the SEC has not provided any meaningful guidance to date on the factors it would consider in granting such an exemption or even the process that companies should follow to seek an exemption. And, as discussed below, the SEC does not appear to have applied section 304(a) in a consistent manner from which anyone could glean any guidance – choosing to pursue zealously the compensation of some clearly non-culpable executives while giving a pass to other, equally non-culpable executives. The result has been a hodge-podge enforcement of section 304.

SEC Enforcement Actions between 2009 and 2011

Although a decade has passed since Sarbanes-Oxley became law, the SEC has brought only a few actions under section 304. Until 2009, all of these enforcement actions had been in cases where the executives participated in the misconduct at issue.9 In those circumstances, the SEC used section 304(a) as an additional mechanism to disgorge compensation from allegedly culpable executives who participated in misconduct. It is hard to quarrel with such application.

In 2009, however, the SEC deviated from its practice of using section 304(a) as a means to disgorge the compensation of CEOs and CFOs who engaged in wrongdoing. In an unexplained and surprising volte-face, the SEC in 2009 decided to bring a stand-alone section 304(a) action against Maynard Jenkins, the former CEO of CSK Auto Corporation. In an enforcement action filed on July 22, 2009 in the U.S. District Court for the District of Arizona, the SEC sought reimbursement from Jenkins of approximately $2 million in bonuses and $2 million in security sale profits – representing all of his discretionary compensation, even compensation that was unconnected with the alleged misconduct that formed the basis for the restatement.10 At issue were restatements required to correct misstatements made by CSK as a result of accounting fraud committed by CSK's CFO, Chief Operating Officer, and other finance and accounting department employees.11

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