SEC Clawback Action Sets Off Alarms

Well, it’s finally happened: The Securities and Exchange Commission has decided to claw back money from a chief executive that it believes the CEO should never have received.

The Commission filed a civil action on July 22 against Maynard Jenkins, former CEO of CSK Auto Corp., seeking to recoup more than $4 million in bonuses and profits Jenkins received while the company was committing accounting fraud. The move comes seven full years after the Sarbanes-Oxley Act first granted the SEC such powers under Section 304 of the law.

The enforcement action has corporate governance circles buzzing for another reason, too: While the SEC does want Jenkins to pay back what it sees as ill-gotten compensation, the agency is not accusing Jenkins himself of any misconduct.

Salehi

“The SEC here has interpreted statute in the most aggressive way possible,” says Nader Salehi, a partner at the law firm Bingham McCutchen. “It remains to be seen whether the courts agree with their interpretation.”

Section 304 requires the forfeiture of certain bonuses paid to the CEO and chief financial officer of public companies that are later forced to restate their financials due to misconduct. The SEC has actually exercised Section 304’s clawback powers 10 other times since 2002, but always in the context of executives accused of breaking other securities law while backdating stock options.

Lawyers have taken a sharp interest in the Jenkins action, because it will illuminate SEC thinking about the little-understood Section 304. The statute has been criticized for its limited usefulness (private litigants cannot sue under 304, although they have tried) and for its vagueness. No court has ever ruled whether a defendant could be found liable under the provision for mis-stated financial results, particularly when the executive didn’t know of or participate in the fraud. Even the meaning of the term “misconduct” isn’t defined.

“Section 304 is riddled with ambiguity,” Salehi says. “This case will resolve much of it.”

In a prepared statement, the SEC said Jenkins must return the proceeds since he was “captain of the ship and profited during the time that CSK was misleading investors about the company’s financial health.” It notes that CSK filed two restatements related to overstated vendor allowances while Jenkins was CEO. Earlier this year, the SEC charged four former CSK executives with securities fraud. In May, the agency brought a settled enforcement action against CSK for filing false financial statements for fiscal years 2002 through 2004.

“We look forward to demonstrating to the court that the law does not permit such overreaching against an admittedly innocent person.”

—John Spiegel,

Lawyer,

Munger Tolles & Olson

A Commission spokesman said the agency is “determined to use all of the remedies available to us to protect investors and deter future wrongdoing.”

Jenkins’ attorney, John Spiegel of the law firm Munger Tolles & Olson, fired off his own statement that the SEC “does not and cannot allege that Mr. Jenkins has done anything wrong or had any knowledge of the accounting issues described in its complaint.”

“We look forward to demonstrating to the court that the law does not permit such overreaching against an admittedly innocent person,” Spiegel said.

Some observers view the action as a sign of a more aggressive SEC under Chairman Mary Schapiro, who’s been trying to restore the agency’s battered reputation since taking the helm in January.

Ribstein

“I don’t think we’d see the SEC pushing this provision in normal times, but I’m not sure these are normal times,” says University of Illinois Law Professor Larry Ribstein. “We had the stock market meltdown and the SEC has been struggling to regain credibility.”

Salehi calls the Jenkins action “an extremely aggressive position for the SEC given the current political climate,” and he says, “It’s not unusual for a case to take years to get to this point.”

Theory Behind Enforcement

A critical question corporate lawyers have right now is whether the Jenkins action is merely the opening shot in wider SEC enforcement of Section 304. If it is, they say, that should set off alarm bells in the corner office.

Ryan

“This … is the first time the SEC has used the statute without alleging any misconduct by the defendant,” says Russell Ryan, a partner in the law firm King & Spalding and a former SEC attorney. “Unless and until a court rejects the SEC’s interpretation, public company CEOs and CFOs should be very concerned.”

The case could also raise novel questions about indemnification under director-and-officer insurance policies. “The SEC is taking the view that the captain responsible for everything on the ship,” says Kevin LaCroix, a director at OakBridge Insurance Services who blogs on D&O issues. “It doesn’t matter whether he’s culpable.”

LaCroix

Depending on how a company’s D&O policy is written, LaCroix says, an executive facing a similar action might have difficulty getting an insurer to cover a claim for defense expenses or an obligation to repay; standard provisions in many policies exclude claims for any “profit or advantage” to which the executive was “not legally entitled,” and a Section 304 action might qualify.

TEXT OF SECTION 304

Forfeiture of Certain Bonuses and Profits

Additional Compensation Prior to Noncompliance With Commission Financial Reporting Requirements.

If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for:

1.any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and

2.any profits realized from the sale of securities of the issuer during that 12-month period.

b.Commission Exemption Authority. The Commission may exempt any person from the application of subsection (a), as it deems necessary and appropriate.

Source

Sarbanes-Oxley Section 304 (2002).

David Furbush, a securities litigation partner at the law firm Pillsbury Winthrop, says some insurers might be will willing to add language explicitly covering SOX 304 liability, at least in cases where the fraud exclusion doesn’t apply.

Furbush

Under Delaware law, for example, if a legal action is deemed to be “by or in the right of the corporation” (typically a derivative suit), a CEO can’t be indemnified for a judgment against him—although he could still be reimbursed for defense expenses, if the court determines the executive is entitled to indemnity. But, Furbush adds, the lawsuit might be covered under a section of Delaware corporation law that permits indemnification for judgments in actions “other than an action by or in the right of the corporation” if the CEO acted in good faith.

Still, he adds, the SEC would probably argue that Section 304 indemnification is void against federal policy (even if it’s allowed under state law), since indemnifying a CEO for amounts he must pay back to the company defeats the whole purpose of Section 304.

“If the SEC prevails, a lot of CEOs and CFOs could be at risk for having significant financial liabilities,” he says.

LaCroix also notes that a company’s D&O policy may have been eroded by prior enforcement actions. “This is a reminder to executives to make sure their D&O coverage is structured so that if they’re faced with a similar lawsuit, there’s coverage available to mount a defense,” he says.