United States: SEC v. Jenkins: No-Fault Clawbacks for Executive Compensation Take Hold

In a case of first impression, a federal district court has endorsed the SEC's interpretation of the clawback provision (Section 304) of the Sarbanes-Oxley Act (SOX) and held that the SEC can seek to clawback incentive-based compensation awarded to the CEO or CFO of a public company that restates its financial statements even when that CEO or CFO is not alleged to be involved in any misconduct associated with the restatement.

The court's opinion in SEC v. Jenkins, decided on June 9, 2010, is part of a larger trend toward no-fault clawbacks.

Section 304

SOX Section 304 requires public company CEOs and CFOs to reimburse their company for any bonus, other incentive-based compensation, or stock sale profits received during a defined period if their company is required to restate its publicly filed financial statements "due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws."¹

SEC v. Jenkins

In March and May 2009, respectively, the SEC charged four former executives of CSK Auto Corporation and then CSK itself with accounting fraud. SEC v. Fraser et al., No. 09-00442 (D. Ariz. March 5, 2009); In the Matter of CSK Auto Corp., Admin Proc. File No. 3-13485 (May 26, 2009). The SEC alleged that these executives shifted uncollectible vendor allowances (receivables) from one fiscal period to the next through the use of unsubstantiated journal entries and incorrect accounting. The complaint further alleged that in 2005, CSK filed a restatement of its previously reported financial results relating to vendor allowances and falsely attributed the misstatements to "errors in estimation" rather than intentional misstatements. The SEC did not charge CSK's former CEO, Maynard Jenkins, with involvement in the alleged fraud. In fact, the SEC's complaint against other CSK officers alleged that these officers concealed the scheme from Jenkins.

In July 2009, the SEC separately sued Jenkins, alleging violations of Section 304 in its first-ever action seeking reimbursement under the clawback provision from an individual who was not alleged to have otherwise violated the securities laws. SEC v. Jenkins, No. 09-1510 (D. Ariz). In seeking to claw back more than $4 million from Jenkins, a senior officer from the Enforcement Division stated in an SEC press release:

Jenkins moved to dismiss the SEC's complaint for failure to state a claim, asserting that the SEC could only claw back his incentive-based compensation if he was involved in the misconduct that led to the restatement. In its June 9, 2010 opinion, the district court denied Jenkins' motion to dismiss, holding that the plain language of Section 304 does not require personal misconduct. Rather, the misconduct of the company triggers liability. In other words, from the perspective of a CEO or CFO, once the SEC proves that the financial statements were materially noncompliant with reporting requirements as a result of misconduct at the company (which the SEC still must prove in the Jenkins case), Section 304 is a strict liability provision.

Acknowledged but unanswered by the court's opinion are questions relating to:

(1) Whether and to what extent must compensation subject to clawback be traceable to the company's misstatement

(2) Whether and to what extent an SEC clawback prosecution under Section 304 might violate the Due Process Clause prohibition on "excessive punitive damage awards"

(3) How a no-fault clawback prosecution might interface (or interfere) with a state statute or corporate bylaw that requires a corporation to indemnify an officer or director for liability resulting from actions taken in "good faith." and

(4) How a no-fault clawback prosecution or judgment might interface with a company's D&O insurance policy.

A First Shot, but Not the Last

The SEC's action against Jenkins was the agency's first attempt at a no-fault clawback prosecution, but the agency has since successfully clawed back executive compensation in at least one other case where the executive was not alleged to have participated in the alleged misconduct, SEC v. O'Dell, No. 10-00909 (D.D.C. June 2, 2010). O'Dell suggests that the SEC will continue to press CEOs and CFOs for no-fault clawbacks under Section 304. Like the CSK case, the SEC had previously charged the company Diebold, Inc. and several financial executives with accounting fraud. The SEC did not charge CEO O'Dell with accounting fraud, instead asserting Section 304 violations. O'Dell settled the SEC's charge that he "failed to reimburse Diebold" by agreeing to return to Diebold cash bonuses, shares of stock, and stock options that he received in the twelve months after Diebold's alleged misstatement of financial results.

In addition to the SEC, the US Congress has taken up the cause of no-fault clawbacks. If passed, the Restoring American Financial Stability Act of 2009, introduced by Senate Banking Committee Chairman Christopher Dodd, would essentially require public companies to implement a clawback policy as a condition of listing securities on a stock exchange. The clawback policy proposed in the Dodd Bill is broader than Section 304, since it would require clawbacks from executive officers, not just CEOs and CFOs, and clawback for material noncompliance with any financial reporting requirement under the securities laws regardless of whether there was misconduct.

Similar clawback policies are already required at companies participating in the Troubled Asset Relief Program (TARP). Lawmakers and regulators are embracing these policies as a means to encourage executives to implement and maintain effective financial controls and, as such, are likely here to stay.

The Significance of Jenkins

For Corporations

Given the trend toward no-fault clawbacks, public companies are exploring, and starting to adopt, executive clawback policies for the same reason that Congress and the SEC seem to favor them: to encourage executives to implement and maintain effective financial controls. Because Section 304 provides no private right of action,² corporate clawback policies will require a company to attach clawback provisions to incentive-based compensation awards, including cash bonuses, to executives who are subject to the policy. Corporations adopting clawback policies should consider implementing policies that track the language of Section 304 or the Dodd Bill to reduce the likelihood of having to renegotiate or re-execute clawback policies and agreements later based on a new legislative mandate. Such policies should address indemnification rights under state law and corporate bylaws. Corporations should also consider the impact of Jenkins and no-fault clawback policies on their D&O insurance.

For Individuals

Section 304 suggests one clear way to avoid a clawback prosecution: the executive can simply pay back any relevant incentive-based compensation before the SEC initiates an enforcement action, thereby eliminating the SEC's cause of action. The Jenkins case also suggests possible defenses to a SOX 304 claim, including for example, arguing that the SEC must prove causation, i.e., that the reimbursement it seeks is traceable to the company's misstatement of financial results, or arguing that the reimbursement sought by the SEC violates the Due Process Clause prohibition against excessive punitive damage awards. While these defenses are untested, legislators' and regulators' interest in pressing for more no-fault clawbacks suggests that they may be tested soon.

Finally, CEOs and CFOs who, pursuant to SOX, must certify that they are responsible for the design and operation of effective financial controls and the accuracy of a company's financial statements should heed the warning of the court in Jenkins that "Section 304 provides an incentive . . . to be rigorous in their creation and certification of internal controls."

Footnotes

^{1.In full, Section 304 provides:}

^{2.E.g., Neer v. Pelino, 389 F. Supp. 2d 648 (E.D. Pa. 2005).}

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