District Court Affirms SEC's SOX Section 304 Right to Recoup Bonus Compensation from Executives of Companies Restating Financials
In a November 13, 2012 opinion (here), Western District of Texas Judge Sam Sparks has upheld the right of the SEC under Section 304 of Sarbanes Oxley to seek to clawback bonus compensation paid to the CEO and CFO of Arthrocare, after the company restated its prior financial statements., even though the CEO and CFO had no involvement in or even awareness of the misconduct that caused the company to misreport its financial results. Judge Spark’s opinion provides a detailed theoretical underpinning for the SEC’s authority under Section 304 and represents a broad affirmation of the SEC’s rights to seek to recoup bonus compensation as provided in the statute. .
Michael Baker and Michael Glick were, respectively the CEO and CFO of Arthrocare during the period 2006 through the first quarter of 2008. The company later restated the financial statement it had filed with the SEC during this period, owing to the alleged fraud of two of the company’s senior vice presidents, John Raffle and David Applegate. The SEC brought separate enforcement actions against Raffle and Applegate, which resulted in agreed judgments against them. The SEC then filed an action against Baker and Glick, seeking to recover on behalf of Applegate the bonus compensation the company had paid them in connection with the financial reporting periods that the company restated.
The defendants moved to dismiss the SEC’s action, arguing in essence that the SEC did not have the right under the statute to pursue claims against them when they had not involvement in or even awareness of the misconduct that led to the restatements.
Judge Sparks rejected these arguments, citing with approval from District of Arizona G. Murray Snow’s opinion in the case involving Maynard Jenkins, the CEO Of CSK Auto (about which refer here). Judge Sparks noted that though “it might be surprising at first glance” for the corporate officials to have to reimburse their companies when they have done nothing illegal, there are “good policy reasons” for Section 304’s broad scope. He specifically noted that “by requiring reimbursement, even in the absence of any wrongdoing, Congress was logically extending and expanding the regulatory scheme for publicly traded companies in reaction to the various accounting scandals which triggered Sarbanes Oxley.” The construction of the statute urges by Baker and Glick “would render Section 304 redundant of existing fraud laws.”
Judge Sparks also rejected the arguments of Baker and Glick that Section 304 is unconstitutional. Specifically he rejected their arguments that the clawback statute violates the due process clause, is void for vagueness or violates the excessive fines clause.
In reaching these conclusions upholding the SEC”s rights to seek to clawback bonus compensation in reliance on Section 304, Judge Sparks got to the heart of Section 304’s sanctions and its purposes:
Baker and Applegate, who were senior vice presidents, apparently used their positions of authority to perpetuate serious misconduct, over a significant time period of time. Baker and Glick should have been monitoring the various internal controls to guard against such misconduct; they signed the SEC filings in question and represented they in fact were guarding against noncompliance. As such, they shouldered the risk of Section 304 reimbursement when noncompliance nevertheless occurred.
Sparks went on to note that Section 304’s requirements are “crystal clear”; the Act “tells executives precisely what they must do to avoid reimbursement liability.” They must, Sparks noted, “ensure the issuer files accurate financial statements.” They are to do so by establishing and maintaining internal controls. Judge Sparks went further to find that there is a “reasonable relationship” between the conduct and the penalty; “where, as here …corporate officers are asleep on their watch,” they are liable for a penalty that is limited to the amounts of their bonus compensation.
As noted above, there have been prior rulings upholding the SEC”s right to pursue clawback actions under Section 304 even in the absence of allegations that the corporate executives from whom compensation clawback is sought were involved in or even aware of the misconduct that led to the restatement. However, Spark’s opinion provides a broad theoretical justification for the SEC’s use of the provision and may represent something of an encouragement to the agency to use its authority under the statute; indeed, in his conclusion, Sparks said:
Apologists for the extraordinarily high compensation given to corporate officers have long-justified such pay as asserting CEOs take “great risks,” and so deserve great rewards. For years, this has been a vacuous saw, because corporate law, and private measures such as wide-spread indemnification of officers by their employers, and the provisions of Directors & Officers insurance, have ensured any “risks” taken by these fearless captains of industry almost never impact their personal finances. In enacting Section 304 of Sarbanes Oxley, Congress determined to put a modes measure of real risk back into the equation. This was a policy decision, and while its fairness or wisdom can be debated, its legal effect cannot. Section 304 creates a powerful incentive for CEOs and CFOs to take their corporate responsibilities very seriously indeed.
The question of the SEC’s clawback authority has even broader implications in the wake of the enactment of the Dodd-Frank Act, which makes a much broader range of corporate officials potentially subject to clawback liability. As discussed here and here, under Section 954 of the Dodd-Frank Act, the national securities exchanges are required to promulgate rules requiring reporting companies to adopt and disclose procedures providing for the recovery of any amount of incentive based compensation paid to any current or former executive that exceeds the amount which would have been paid under an accounting restatement in the three years prior to the date on which the company was required to prepare the restatement. The Dodd-Frank provision is quite a bit broader than Sox Section 304, as it extends to all executives and it reaches back three years and to all incentive based compensation.
I have long felt that Section 304 represents part of a dangerous legal trend that tends to want to try to impose liability without culpability (as I discussed at length here). However, I also agree with Judge Sparks that while we may debate the merits or demerits of the SEC’s authority under Section 304, the provision is the law and it does give the SEC broad authority to recoup bonus compensation. I still think attention needs to be given to the unfortunate trend toward imposing liability without culpability, and by way of example of a looming problem, I question whether the SEC’s clawback authority should have been (as it was in the Dodd-Frank act) extended to reach corporate officials beyond those who have responsibility for certifying financial results. At a minimum, I would argue that the theoretical justification that Sparks gives for the SEC’s authority Section 304 does not work as well when the clawback authority is extended beyond the officers responsible for financial statement certification.
I have previously discussed the potential D&O insurance implications of Section 304 clawback actions here.
Alison Frankel's November 16, 2012 post on her On the Case blog about Judge Sparks's opinion can be found here. I know that sometimes it may feel that I just follow Frankel around and write about what she has written about. I fee compelled to point out that I had written my post about Judge Spark's opinion before I learned that she had also written about this case. Besides, her blog is so comprehensive, if I coudln't write about things she has written about, I would be left without anything to write about. I will say to all of my readers, if you are not reading Frankel's blog every day, you are making a serious mistake.