The SEC has made it clear that it intends to use Section 304 of the Sarbanes-Oxley Act to "clawback" compensation from CEOs and CFOs of companies that restate their financial statements, even if the individuals are not alleged to have engaged in any wrongdoing. A recent district court opinion confirms that the statute gives the SEC the authority to proceed on that basis. These actions raise complex D&O insurance coverage concerns that arguably suggest certain necessary policy adjustments.
Section 304 provides that if a company restates its financials, the company’s CEO and CFO, who certified the financial statements under Sox Section 302, "shall reimburse" the company for 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 CFO from whom 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.
The SEC’s first use of this statutory provision to clawback compensation from a corporate official against whom no wrongdoing is alleged was the enforcement action filed in July 2009 against Maynard Jenkins, the former CEO of CSK Auto. I first wrote about this enforcement action in a prior post, here.
CSK Auto had restated its financial statements for the fiscal years 2002 to 2004. The SEC filed separate enforcement actions against the company and four company officials for securities law violations in connection with the restatements. However, Jenkins is not among the company officials alleged to have violated the securities laws.
The SEC’s action, filed in reliance on Section 304, seeks to compel Jenkins to reimburse CSK Auto for more than $4 million he received in bonuses and stock sale profits "while CSK was committing accounting fraud." Jackson not only is not alleged to have had any role in or awareness of the alleged scheme, but the SEC has actually alleged in its separate enforcement action against the other CSK officials that the others concealed their scheme from Jenkins.
Jenkins moved to dismiss the SEC’s clawback action on numerous grounds, arguing that he cannot properly be forced to disgorge compensation in the absence of any personal wrongdoing.
In a June 9, 2009 order (here), District of Arizona Judge G. Murray Snow held that the SEC’s complaint against Jenkins alleges facts sufficient to state a claim under Section 304, stating further that "the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer’s CEO or CFO."
Judge Snow elaborated by saying that "the misconduct of the issuer is the misconduct that triggers the reimbursement obligation of the CEO and the CFO." Before reimbursement can be required "the issuer’s misconduct must be sufficiently serious to result on material noncompliance with a financial reporting requirement."
The SEC has already made it clear that it intends to use Section 304 to try to clawback compensation from other CEOs and CFOs who are not alleged to have done anything wrong. For example, just a few days ago, the SEC settled a Section 304 filed against Walden O’Dell, the former CEO of Diebold, even though, as noted in the SEC’s June 2, 2010 litigation release, the SEC’s complaint does not allege that O’Dell engaged in the alleged fraud at Diebold.
Judge Snow’s opinion in the Jenkins case confirms that the SEC may properly pursue Section 304 clawbacks even against corporate officials who are not alleged to have engaged in personal wrongdoing (although he did leave open the question whether the statute could be used in ways that would be unconstitutionally punitive).
Though statutorily authorized, the statute’s use to effect a forfeiture without culpability or fault raises troubling questions, including even basic questions of fairness. On the other hand, it might also fairly be asked whether the CEO or CFO ought to be able to retain benefits accumulated at a time when the investing public was being misled, by financial statements that the CEO and CFO certified, about the company’s financial condition.
Beyond these issues, these kinds of actions may also raise complex D&O insurance coverage questions.
A Section 304 claim potentially would raise at least two possible coverage concerns – first, whether the claim involves an allegation of a "wrongful act" as required to trigger coverage; and second, whether coverage for the claim is precluded by the "profit or advantage" exclusion.
D&O insurance typically is only triggered by a claim made against an insured person for an actual or alleged wrongful act. Under a Section 304 claim in which no personal wrongdoing is alleged, the question would arise whether a wrongful act has been sufficiently alleged to trigger coverage under the policy.
I think it could fairly be argues that a Section 304 claim does involve a wrongful act even if no personal wrongdoing is alleged against the individual defendant. As Judge Snow’s opinion in the Jackson case emphasized, a prerequisite to a Section 304 claim is misconduct by the issuer (which is an "insured" under the typical public company D&O insurance policy’s "entity coverage" provision).
Given the statutory prerequisite of issuer wrongdoing, a Section 304 claim necessarily involves a claim for a wrongful act, even if the wrongful act alleged is not that of the targeted individual. The typical D&O policy emphatically does not say that the claim must be made against an insured person for that insured person’s own wrongful act – to the contrary, the typical policy requires only that the claim be made for "an actual or alleged wrongful act," without specifying whose act it must be.
Nevertheless, I can still imagine a carrier bent upon denying coverage urging that this policy provision requires a wrongful act by the insured person against whom the claim has been made, which may indicate the need for certain policy revisions, as detailed below.
Even if the wrongful act concern can be overcome, there is still the policy exclusion to be dealt with. The typical D&O policy excludes coverage for any loss based on a claim for any "profit or advantage" to which the insured is not legally entitled. A carrier might attempt to rely on this provision not only to deny coverage for the amount of any reimbursed compensation, but also to try to deny coverage for the costs of defending the claim.
One way to try to circumvent this concern about Section 304 defense costs is to amend the exclusionary provision to required a judicial determination in the underlying claim that the insured was not legally entitled to the "profit or advantage," which would at least allow defense costs to be advanced up until there has been such a judicial determination. The limitation of this approach is that once there has been a judicial determination, the carrier might seek to be reimbursed for the advanced defense costs.
The point here is that the question of D&O insurance coverage for the costs of defending a Section 304 clawback claim could be problematic. One approach to try to address these concerns would be to amend the policy to provide that the "profit or advantage" exclusion will not be applied to the costs of defending a Section 304 act, and to further amend the policy to provide that the carrier will not take the position that a Section 304 action does not allege a wrongful act.
At least one insurer has taken an alternative approach to address the Section 304 defense cost issue in its revised policy form. Under this approach, the costs of defending a Section 304 claim are expressly included in the policy’s definition of Loss.
It is not my intention here to debate the merits of these alternative approaches (which indeed may not be mutually exclusive) or of any other alternative approaches that might exist. My purpose here is simply to point out that this issue has reached the point where the question of Section 304 defense expenses ought to be addressed in the D&O policy form.
Just as a few years ago, the D&O insurance industry quickly adapted express policy language designed to address concerns arising from SOX whistleblower claims, it may now be time for the industry to adapt express policy provisions addressing Section 304 defense costs. Policyholders should not have to wait until the claim has been filed to find out what the carrier’s position will be on Section 304 defense expenses.
2010 World Cup: Some Early Notes:
1. Vuvuzela: Did the site selection committee know about those damned vuvuzela horns when they chose South Africa as the 2010 World Cup venue? What an awful, idiotic noise. (There are reports that the event organizing committee is considering a ban.)
2. Remember, The Beautiful Game is Fast, Too: England was up on the U.S. by a goal before I even had a chance to turn the T.V. on.
3. U.S. Goal Inspires Headline Writers Everywhere: Here’s my entry – "English Green’s Gift Gaffe Gives Yanks a Goal."
4. Most Underappreciated: Tim Howard ought to be one of the most celebrated athletes in the U.S. He certainly is one of the most talented.
5. Go Figure: The official nickname of the Australian team is the "Socceroos." Discuss.
6. Self-Destruction (and Team Takeout, Too): Substitute Algerian striker Abdelkader Ghezzal entered his team’s game against Slovenia in the 58th minute (which was a scoreless tie at the time). Approximately five seconds later he was given a yellow card for an aggressive tackle. Then in 74th minute, he earned his second yellow (and an automatic red card, requiring his ejection from the game) for a flagrant hand ball . Within minutes, his shorthanded team conceded Slovenia’s winning goal.
7. Divided By a Common Language: The "pitch" is the playing field. A "side" is a team. A "strike" is a shot. To "win a cap" is to be selected to play for your country’s team. "Nil" means zero. "Draw" means tie. And "nil-nil draw" (usually preceded by the word "dreaded") means a scoreless tie. The phrase "argy bargy" is not susceptible to translation.