By the SEC’s own account, an enforcement action the SEC initiated on July 22, 2009 represents the first occasion on which it has used the Sarbanes-Oxley Act’s "clawback" provision to recover compensation from an individual not otherwise alleged to have violated the securities laws. While this type of action apparently was contemplated by the statute, it has never been pursued before and it raises some interesting questions.


As reflected in the SEC’s July 22, 2009 press release (here), the SEC enforcement action charges Maynard L. Jenkins, the former CEO of CSK Auto, with violation of Section 304 of the Sarbanes Oxley Act, the statute’s compensation clawback provision. The action seeks to compel Jenkins to reimburse CSK Auto for the more than $4 million he received in bonuses and stock sale profits "while CSK was committing accounting fraud." A copy of the SEC’s complaint can be found here. (Hat tip to the Courthouse News Service for the complaint.)


In May 2009, the SEC brought a settled enforcement action against CSK for filing false financial statements for fiscal years 2002 though 2004. The SEC has also brought a separate civil enforcement action against four CSK officials, but Jenkins is not among the officials that the SEC is pursuing.


Section 304 does provide that if a company restates its financials, then the company’s CEO and CFO "shall reimburse" the company any bonus compensation received during the 12 months following the restated period, as well as any stock sale profits earned during those twelve months.


There is no requirement in Section 304 that the CEO or the CFO from whom the reimbursement is sought have any involvement in the events that necessitated the restatement. Indeed, the statute doesn’t require any showing of wrongdoing or fault at all.


Professor Larry Ribstein criticizes the SEC’s use of the statute this way in a post on his Ideoblog (here), for "punishing business executives even when they are not accused of making a mistake." Jenkins undoubtedly will attempt to challenge the SEC’s attempt to use the statue this way. This provision has never been challenged on this basis before, so it will be interesting to see whether it withstands the legal challenge.


The SEC’s use of the statute in this way will undoubtedly add yet another item to the long list of criticisms of Section 304. As noted here, the statute previously has been criticized, among other reasons, because it lacks a private right of action; because it can only be used against the CEO and CFO, but not other corporate officials; and because it is only available in the event of a restatement, but not for other accounting discrepancies. Now it will be criticized as well because it can, if the SEC’s position withstands judicial scrutiny, effect a forfeiture without a requirement of fault, involvement or knowledge of the circumstances requiring the restatement.


To be sure, the logic of the statute is that since the financials were restated, the compensation was never earned in the first place. But litigation has its costs, and the burden an executive hit with a suit like this must endure goes beyond just the compensation he or she might be required to return. Among other things, defending against an SEC enforcement action can be extremely costly.


An executive facing an action like this might well seek to have his or her defense expenses paid by the company’s D&O insurer. But there could be problems with that as well. There would likely be no coverage under the typical D&O policy for any returned compensation, among other reasons because of the standard exclusion for claims for any "profit or advantage" to which the executive was "not legally entitled."


Many of these exclusions are written with a broad preamble (that is, precluding coverage for any loss "based upon, arising out of, or in any way relating to"), which some carriers might attempt to rely upon to preclude coverage not just for the returned compensation but for costs incurred in defending against the claim, even before a liability finding. While this interpretation of the policy would be highly suspect, the possibility of this interpretation highlights the need to try to revise the exclusion to require an actual judicial determination of the absence of "legal entitlement" to the profit or advantage before the exclusion’s preclusive effect is triggered. This revision may help to ensure that if an executive is hit with one of these suits that there is at least insurance coverage available for the executive to mount a defense.


An interesting July 22, 2009 Bloomberg article discussing the case can be found here. The article quotes a number of commentators with a variety of perspectives on the SEC’s action.