Gregg J. Berman and Jaclyn Lisa Rabin
Broadly applying Section 304 of the Sarbanes-Oxley Act of 2002, the SEC filed a civil suit seeking to "claw back" compensation from Maynard L. Jenkins, the former CEO of CSK Auto Corp. (CSK), who has not yet been accused of a securities law violation. Ruling on defendant's motion to dismiss, the court sided with the SEC and held that the SEC need not allege wrongdoing when seeking disgorgement under the clawback provision of the Act. While the SEC has twice before attempted to use Section 304 in this manner—once in a Wells Notice and once in an SEC complaint, ultimately resulting in CEO reimbursement before trial—this is the first time a court has interpreted Section 304 to allow a claim against an individual who is not alleged to have otherwise violated the securities laws. The case is SEC v. Jenkins, D. Ariz., No. 2:09-cv-1510-GMS, 6/9/10.
Section 304 provides that if an issuer "is required to prepare an accounting restatement due to material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws," the CEO and CFO shall reimburse the issuer for any bonus or other incentive-based or equity-based compensation received, and any profits realized from the sale of the securities of the issuer, during the 12-month period following issuance of the original financial report.
The clawback authority does not specify whether the executives must be involved in wrongdoing. Previously, the SEC has only employed Section 304 in enforcement actions to obtain disgorgement where executives had themselves engaged in misconduct. For example, in 2007 the SEC reached an over $400 million settlement with the former CEO of a company accused of backdating options. In Jenkins, the SEC asked the U.S. District Court for the District of Arizona to order Jenkins to reimburse the company and its shareholders over $4 million received in bonuses and stock sale profits. These profits were received while the company was allegedly committing accounting fraud by intentionally failing to properly account for millions of dollars of uncollectible receivables under a vendor allowance program, and reporting greater pretax income than the company actually earned. The SEC sued after CSK was twice forced to restate financial results from fiscal years 2001 through 2005. Although Jenkins certified the company's inaccurate financial statements for those years, the complaint does not allege that Jenkins played any role in perpetuating the scheme. In fact, the SEC has filed both civil complaints and criminal indictments against other CSK officers, alleging that those officers concealed the scheme from Jenkins.
The CSK case raises questions of constitutional import. In his motion to dismiss, Jenkins argued that the SEC's interpretation of Section 304 would impose punishment on those who are innocent, violating both the constitutional guaranty of due process and its prohibition against excessive punishment. While the court noted that these constitutional issues may arise, "the facts necessary to decide these constitutional issues cannot be decided on a motion to dismiss." The court also rejected Jenkins' argument that because Delaware law requires CSK to indemnify Jenkins to the extent he acted in good faith, the SEC's interpretation of Section 304 would "create absurd results." The existence of a state statute, said the court, "does not alter the meaning of the federal statute."
Despite the potentially very harsh results and the potential availability of indemnification, the court's decision is likely to embolden the SEC. In addition, Senator Dodd's financial reform bill contained a provision that would require companies that filed a restatement to recover incentive-based compensation from executive officers, even if no one engaged in any misconduct. It is possible that such a provision will be contained in the bill that emerges from the conference committee.
Jenkins further increases the pressure on, and scrutiny of, executive officers. Financially, to avoid a Jenkins-like result, executives may seek to shift a greater portion of their compensation to guaranteed payments, such as salary, and away from incentive compensation. Of course, this runs contrary to current standards of corporate governance and proxy advisors would surely weigh in. While the blanket of corporate governance may not offer full protection, it is the best protection an executive officer has. A strong audit committee, a strong disclosure committee and ethical top-to-bottom leadership will go a long way in helping a company avoid a restatement and the pain of a Jenkins-like claw.
This article was prepared by Gregg Berman and Jaclyn Rabin from Fulbright's Securities Practice Group. If you have any questions about this Client Briefing please do not hesitate to contact the authors.
Gregg J. Berman
Jaclyn Lisa Rabin