Court Rules That SEC May Use Sarbanes-Oxley to Clawback Executive Compensation Even Where Executive Engaged in No Misconduct
June 18, 2010
In a significant victory for the Securities and Exchange Commission ("SEC"), the U.S. District Court for the District of Arizona recently ruled in favor of the SEC in holding that the Commission could use the "clawback" provision of the Sarbanes-Oxley Act ("SOX") to compel the return of incentive-based compensation by CEOs and CFOs – even in the absence of any allegation that those executives had engaged in personal misconduct. SEC v. Jenkins, No. CV 09-1510-PHX-GMS (D. Ariz. June 9, 2010). The court in Jenkins declined to dismiss the SEC’s complaint, which sought the return of over $4 million in bonuses and stock sale profits from Maynard L. Jenkins, the former CEO of CSK Auto Corporation, which he had received during a period when CSK’s financial statements were materially misstated. Notably, the SEC brought this case against Mr. Jenkins, even though there were no allegations that he was involved in any wrongdoing or had any awareness of the company’s misstatements.
Section 304 of SOX requires a CEO or CFO to reimburse the issuer for any incentive-based pay or stock sale profits in the event of a financial restatement that is required "as a result of misconduct." 15 U.S.C. § 7243(a). In Jenkins, the SEC alleged that CSK had reported inaccurate financial statements from 2002 through 2004, when Mr. Jenkins was CEO. While the SEC has brought accounting fraud charges against other former CSK executives, the SEC conspicuously has not alleged that Mr. Jenkins himself committed any "misconduct." Nonetheless, the SEC argued – and the court agreed – that Section 304 requires "only the misconduct of the issuer" and not necessarily specific misconduct by the CEO or CFO whose compensation is being clawed back. As the court ruled: "A CEO need not be personally aware of financial misconduct to have received additional compensation during the period of that misconduct, and to have unfairly benefitted therefrom. . . . It is not irrational for Congress to require that such additional compensation amounts be repaid to the issuer."
The court did leave open the possibility that, if some portion of Mr. Jenkins’s incentive-based compensation were not fairly traceable to the misstatement of CSK’s financials, then the clawback of those amounts might be so punitive as to raise constitutional issues of due process. The court declined to address that issue, however, in the absence of further factual development that, on a motion to dismiss, was not available.
Moreover, even under the Jenkins court’s interpretation of Section 304, the SEC would still have to show "misconduct" by someone. In a situation where multiple former CSK executives have been indicted on criminal charges and one has already pleaded guilty, that may not be much of an obstacle. In other cases, however, the SEC might be put to its burden of proving that a company’s financial misstatements were, in fact, the result of "misconduct" – which presumably implies some culpable state of mind (although it is unclear whether that requires fraudulent intent or may be satisfied by some lesser showing of recklessness or even negligence).
The Jenkins case represents the first time a court has endorsed the SEC’s efforts to use Section 304 of SOX to clawback compensation from an innocent executive. This decision will no doubt embolden the SEC to make greater use of this tactic as part of its increasingly aggressive enforcement policy. But it remains to be seen whether the Commission – which also has the discretion to exempt executives from the application of Section 304, see 15 U.S.C. § 7243(b) – will still be open to weighing mitigating factors and measuring the amount to be reimbursed proportionately, or whether the courts will have to be called on to intervene under the Due Process Clause to prevent punitive over-reaching.