Sunday, July 26, 2009

SOX § 304’s Clawback: Executive Fraud Not Required

Last week, the SEC filed a complaint in the District Court of Arizona to compel former CEO of CSK Auto Corporation, Maynard Jenkins, to disgorge over $ 4 million in bonuses and equity compensation. Since SOX's inception in 2002, § 304 has been used only a handful of times. This complaint is notable in that it marks the first time § 304 has been used to clawback executive compensation from a defendant who has no other securities fraud allegations pending against him. The move on the SEC's part is significant and warrants a background discussion.

Section 304 is subject to a number of significant limitations. The most substantial of which is the statute's broad language. For instance, the clawback function of § 304 disgorges executive compensation in the instance of "misconduct." Misconduct, however, is not defined by statute. Case law up to this point has provided a fairly narrow definition of what "misconduct" is. In SEC v. McGuire, former CEO and Chairman of UnitedHealth Group, William McGuire, settled with the SEC for $ 468 million to resolve allegations of personal involvement in a lengthy stock-option backdating scheme. In SEC v. Brooks, former CEO and Chairman of DHB Industries, David Brooks, was alleged to have overstated inventory values, falsified journal entries, and failed to charge obsolete inventory - all of which portrayed a false gross profit margin to the public. Brooks was also alleged to have misused corporate monies and to have engaged in insider trading. Apart from the factual allegations, both McGuire and Brooks involved a § 304 action to clawback executive compensation against an executive who had securities fraud allegations leveled against him personally. This is substantially different from the SEC's complaint last week against Jenkins.

There, in fact, are no personal allegations of securities fraud against Jenkins. The SEC has been chasing CSK's financial misconduct for several months. In March of this year, the SEC charged a number of officers with securities fraud. And again in May, the SEC instituted settled cease-and-desist proceedings against CSK for making public false financial statements. The SEC complaint last week against Jenkins compels disgorgement of his executive compensation for the periods of CSK's alleged financial fraud. A lay-instinct may be to indicate that Jenkins in fact signed CSK financial statements, and therefore despite not having allegations of securities fraud leveled against him, he is yet responsible to the extent of his SOX Certifications. It is widely held as consensus by the courts, however, that SOX Certifications alone do not constitute scienter. (n.1). The move on the SEC's part to try and clawback Jenkin's executive compensation despite and withal this, is fairly bold. I am sure I am not alone in wondering if this will be a secluded event.

Before closing, I want to briefly suggest to you other significant § 304 limitations.

  • It is insufficient for the "misconduct" to have merely occurred, or to even have been known of; a financial restatement must be publicly released (or, so says the case law).
  • It is only the executive compensation of a corporation's properly named CEO and CFO that is subject to the clawback provision.
  • Any bonus and equity compensation received one year following the "misconduct" is subject to clawback; salary excluded. Any profit earned from the sale of issuer securities sold one year following the "misconduct" is also subject to clawback.
  • Other vague statutory language, not yet resolved by the courts, includes: "required [to prepare]" (when must an issuer restate its financials: upon auditor suggestion? SEC opinion letter?); "material noncompliance" (as regards "misconduct"); "received" and "profits" (as regards when executive compensation is in fact received by the executive, and do you use the sale price or the acquisition price to determine stock sale profits?).
  • No private right of action.
  • No retroactive award (prior to SOX's 2002 enactment).
  • Disgorged proceeds are reimbursed to the corporate issuer, and not to any collection of shareholders, or other plaintiffs.

(n.1). In re Intelligroup Secs. Litig., 468 F. Supp. 2d 670, 707, complaint dismissed, 527 F. Supp. 2d 262 (D.N.J. 2007).

Hat tip: former Guest Blawger,
Allen Major.

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