The U.S. Supreme Court handed a big victory to the Securities and Exchange Commission this month when it refused to review a lower court’s ruling that the Commission has broad power under the Sarbanes-Oxley Act to freeze “extraordinary payments” to company officers that are made when the SEC is investigating possible wrongdoing.

A three-judge panel of the San Francisco-based 9th Circuit Court of Appeals initially held in May 2004 that the SEC did not have the power under SOX to block $37.6 million in severance payments to the former chief executive officer and chief financial officer of Gemstar-TV Guide International.

But the full 9th Circuit upheld the Commission’s powers earlier this year, becoming the first federal appellate court in the nation to examine what constitutes “extraordinary payments” within the SEC’s reach under SOX. The court refused to set a bright-line test for determining when a payment is “extraordinary,” but said that proper considerations included whether the payment was connected to the suspected wrongdoing and whether it deviated from an “industry standard.”

On Oct. 11, the Supreme Court—without comment—let that decision stand, rejecting an appeal by Henry Yuen and Elsie Leung, the former CEO and CFO of Gemstar. (Yuen pleaded guilty on Oct. 4 to a charge of obstructing the SEC’s investigation of accounting irregularities at Gemstar. But the company has urged the judge to reject the plea agreement as too lenient. Sentencing is scheduled for December.)

No Surprises

Richard Humes, the SEC lawyer who handled the case for the Commission, says that the 9th Circuit’s decision put “teeth” into Section 1103 of Sarbanes-Oxley, the provision that gives the Commission the power to freeze extraordinary payments. “The Supreme Court has now ended the case,” he says.

Humes, an associate general counsel for the SEC in Washington, notes that there “shouldn’t be one formula for determining whether a payment was extraordinary.” Relevant factors to consider include “the size, the purpose and the circumstances under which the proposed payment was being made,” he says.

Hyatt

Clifford Hyatt, a partner with Pillsbury Winthrop Shaw Pittman in Los Angeles, told Compliance Week he isn’t surprised that the Supreme Court refused to review the case. “The Supreme Court really doesn’t take a whole lot of securities cases—one big one every couple of years. This particular case is pretty fact specific and is probably not the area they would go anyway.”

Hyatt says if the full 9th Circuit had upheld the original ruling limiting the SEC’s power and the Supreme Court then declined the case, “that would have been more surprising. If the SEC was not allowed to use this provision under these facts, its hands would have been tied to use this in the future.”

Because the high court won’t hear the appeal of Yuen and Leung, the case creates precedent only in the 9th Circuit and other federal circuits could conceivable interpret the Commission’s power to freeze extraordinary payments more narrowly, Hyatt notes. “If there are various decisions around this [issue], it’s more likely we would have review by the Supreme Court [at some point],” he says.

Nearly $40M For Departing Officers

The trouble for Gemstar, which publishes TV Guide and licenses technology for on-screen program guides, began on April 1, 2002, when the company filed its Form 10-K report for 2001. The filing reported that $107.6 million Gemstar had previously claimed as revenue had not actually been realized.

A few months later, Gemstar announced in an 8-K that it intended to restate its 2001 financial results and to reverse $20 million, plus make substantial corrections. Gemstar filed as exhibits to that Form 8-K sworn statements from CEO Yuen and CFO Leung, to the effect that they were not able to certify, as required by law, that some of Gemstar’s financial statements were accurate, and that they were not able to comply with written Commission orders to do so.

A month-and-a-half later, Gemstar filed another 8-K, confirming that it had been notified by NASDAQ that its securities were subject to delisting for failure timely to file a Form 10-Q for the quarter ending on June 30, 2002. The 8-K also stated that—because of an unresolved dispute between Gemstar and its independent auditor, KPMG—the company could not file its quarterly Form 10-Q report. KPMG itself was hit with a $10 million fine last November by the SEC for ignoring improper revenue statements from Gemstar.

As Gemstar was unraveling, Yuen and Leung cut a deal with the board of directors to resign as officers in return for a payment in cash. Yuen was to get $29.5 million and Leung $8.2 million, plus large shares of stock and options grants for both. After learning of the severance deal, the SEC commenced an investigation to determine whether Gemstar and its officers and directors had engaged in securities fraud by making materially false and misleading public statements regarding revenue, earnings and losses.

As part of the investigation, the Commission went to U.S. District Court and applied for an order freezing the payments to Yuen and Leung under Section 1103 of SOX. The law allows the SEC to petition a federal court to escrow payments when, during the course of an investigation of possible securities violations, it is “likely” that the company will make “extraordinary payments” to officers, directors or certain other individuals.

In upholding the trial judge’s decision to grant the SEC’s request for an escrow order, the 9th Circuit said that the judge “correctly focused on the nature, purpose, and circumstances of the payments and determined that they had nothing to do with Gemstar’s ordinary business.”

Compliance Week's original coverage of the Gemstar case is available in the box above, right.

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