Member Article

In a decision of first impression, a federal district court has held that the “clawback” provision of Sarbanes-Oxley permits the SEC to seek reimbursement of incentive-based compensation from CEOs and CFOs of companies that restate their financial statements as a result of misconduct, even if the CEO and CFO had no personal involvement in such misconduct. This decision, coupled with other recent SEC actions, suggests that clawback actions against executives who are not accused of wrongdoing may become a regular part of the SEC’s enforcement arsenal in restatement cases.

Sarbanes-Oxley’s Clawback Provision

Passed in 2002 in reaction to revelations of corporate misconduct, the Sarbanes-Oxley Act mandated procedures and rules designed to enhance corporate responsibility and financial disclosures and prevent corporate and accounting fraud.

Section 304 of Sarbanes-Oxley, the so-called “clawback” provision, provides that if an issuer is required to prepare an accounting restatement, “as a result of misconduct,” the CEO and CFO “shall reimburse the issuer” for any bonus or incentive-based compensation received during the 12 months after the publication of the misstated financial filing, and any profits from the sale of company stock during the same period.

The SEC first used this clawback provision in December 2007 as part of a settled options backdating case against the former CEO of UnitedHealth Group. It subsequently used or sought to use the provision in other options backdating cases in which the SEC viewed the relevant executive as having participated in the alleged wrongdoing.

The Jenkins Case and Decision

In July of 2009, the SEC for the first time sought to use Section 304 to claw back compensation from an executive whom the SEC did not allege engaged in the underlying financial wrongdoing. The case, SEC v. Jenkins, was filed against Maynard L. Jenkins, the former CEO of CSK Auto Corporation, seeking a return of more than $4 million received in bonuses and stock sales while the company was allegedly committing accounting fraud. The SEC did not allege that Jenkins knew of or participated in any way in the alleged accounting fraud. To the contrary, in complaints against other CSK officers the SEC alleged that the scheme was concealed from Jenkins.

Jenkins moved to dismiss the complaint, arguing that Section 304 would raise serious constitutional questions if interpreted to require clawbacks from executives who are innocent of any wrongdoing and that Section 304 should be interpreted as a remedial provision requiring proof of wrongdoing by the defendant from whom relief is sought.

On June 9, 2010, Judge Snow of the District of Arizona denied Jenkins’s motion and agreed with the SEC that Section 304 is applicable to CEOs and CFOs who are not alleged to have engaged in any wrongdoing. The court’s decision was based primarily on the plain language of the statute, which requires misconduct on the part of the issuer company but not necessarily misconduct on the part of the CEO or CFO. The court viewed the legislative history as confirming that reading of the statute. The court also looked to the larger statutory context of Sarbanes-Oxley, particularly the requirement that CEOs and CFOs sign certifications in connection with issuers’ annual and quarterly reports, and noted that “Section 304 provides an incentive for CEOs and CFOs to be rigorous in their creation and certification of internal controls.”

Turning to Jenkins’s constitutional challenge to clawbacks from innocent executives, the court appeared to agree that constitutional issues might arise in particular cases if the recovery sought by the SEC results in a clawback that is severe, unjustified or grossly disproportionate. But the court held that the nature and amount of the specific recovery sought by the SEC would be ascertained through discovery and the constitutional issue could not be decided at the pleading stage. The court also held that the potential conflict with CSK’s indemnification obligations to Jenkins under Delaware law did not impact the plain meaning of Section 304.

Implications for the SEC’s Use of Clawback Actions

While the Jenkins case was the first of its kind, it cannot be viewed as an anomaly. Since filing the Jenkins case, the SEC has at least twice demonstrated an intention to use Section 304 in other cases involving executives who are not alleged to have engaged in any wrongdoing. In a November 2009 SEC filing, Beazer Homes, USA, Inc. disclosed that its CEO, who has not been accused of any wrongdoing, received a Wells Notice stating that SEC staff had preliminarily recommended the SEC bring a civil action against him under Section 304. And on June 2, just a week prior to the Jenkins decision, the SEC announced that Diebold Inc.’s former CEO, Walden O’Dell, agreed to reimburse Diebold for cash bonuses, stock, and stock options due under Section 304. The SEC’s complaint did not claim O’Dell was involved in the alleged fraud.

The SEC’s success in Jenkins in obtaining a favorable judicial interpretation of Section 304 likely will result in more demands by the SEC and its staff that a non-culpable executive reimburse an issuer for bonuses and stock sales profits. Moreover, the decision likely will impact the parties’ leverage in settlement discussions. Coupled with its other recent uses of Section 304, Jenkins strongly suggests that Section 304 clawback actions against executives who are not accused of wrongdoing will become a more frequently used and important tool in the SEC’s enforcement arsenal in restatement cases.

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