A Texas federal judge denied defendants ArthoCare CEO Michael A. Baker and CFO Michael T. Gluk’s motion to dismiss the SEC’s claim against them under Sarbanes-Oxley (“SOX”) Section 304’s clawback provision. Section 304 requires CEOs and CFOs to reimburse their company for any bonus or similar compensations, or any profits realized from the sale of company stock, for the 12-month period following a financial report, if the company is required to prepare an accounting restatement due to material noncompliance committed as a result of misconduct.
Baker and Gluk, who were not alleged to have participated in the misconduct that led to ArthoCare’s restatement, challenged Section 304 as unconstitutional, arguing that the SEC could not require them to repay bonus compensation and profits from stock sales for merely holding CEO and CFO positions during the time of the alleged misconduct. In particular, they argued that Section 304 is vague and is unconstitutional because it does not require a reasonable relationship between the triggering conduct and the penalty as is required by the Due Process Clause.
Judge Sam Sparks of the Western District of Texas rejected the Officer-Defendants’ constitutional arguments. Judge Sparks first held that Section 304 was not vague because it clearly referred to misconduct on behalf of the issuer of the allegedly false financial statement. Judge Sparks noted that Defendants “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 actively guarding against noncompliance. As such, they shouldered the risk of Section 304 reimbursement when noncompliance nevertheless occurred.”
Judge Sparks further held that Section 304 did not violate the Due Process Clause because a reasonable relationship between the triggering conduct and the penalty existed. By signing the SEC filings, the corporate officers made guarantees that they carefully reviewed the filing for accuracy, and that such accuracy was verified by adequate controls. “Where, as here, those controls prove inadequate, and corporate officers are asleep on their watch, it is reasonable for Congress to impose a penalty. The degree of penalty is reasonable too: it is limited to bonuses, incentive-based pay, and stock-sales profits.”
Judge Sparks finally ruled that Section 304 should not be interpreted to require that CEOs or CFOs engaged in the misconduct themselves or acted with scienter. Not only because the plain language of Section 304 does not include such requirements, but also because by not including those requirements, Section 304 is consistent with the spirit of SOX to “ensure corporate officers cannot simply keep their own hands clean, but must instead be vigilant in ensuring that there are adequate controls to prevent misdeeds by underlings.”
This is the most recent of very few reported cases to hold that a CEO and CFO must disgorge their prior compensation under SOX Section 304 regardless of whether they had any involvement in or knowledge of the underlying “misconduct” that resulted in the financial restatement. See SEC v. Jenkins, 718 F. Supp. 2d 1070, 1074-79 (D. Ariz. 2010). In essence, the Texas court found that SOX Section 304 is a strict liability statute. At the very least, the ruling will place even more pressure on CEOs and CFOs to closely scrutinize the financial statements and require additional assurances from those persons preparing the financial statements in the future. The ruling could also impact cases under Section 954 of the Dodd-Frank Act, which can also be the basis of a private right of action.
Section 954 of Dodd-Frank Act adds new Section 10D to the Exchange Act requiring all companies listed with national securities exchanges and associations to enact “clawback” policies. Such policies must recover any incentive-based compensation (including stock options) from current or former executive officers for the prior three years in the event of a financial restatement due to material noncompliance with any financial reporting requirement under the securities laws. The amount of the recovery is the difference between the amount of incentive-based compensation received and the amount that should have been received under the restated financial results.
Section 954 is different from SOX Section 304 in four significant respects. First, the new provision is enforceable, not just by the SEC, but by plaintiffs’ attorneys in derivative cases if companies fail to seek such relief. Such plaintiffs may initiate litigation regarding restatements that did not occur, yet which allegedly would have, but for some claimed conflict of interest by management. Second, while Section 304 only allows disgorgement from the company’s CEO and CFO, the Dodd-Frank Act covers the company’s current and former “executive officers,” which could mean all Section 16 officers. Third, the Dodd-Frank Act lowers the trigger for clawbacks to instances of “material noncompliance with applicable accounting principles,” whereas Section 304 of SOX requires a restatement resulting from “misconduct.” Fourth, the Dodd-Frank Act expands the look-back period in SOX Section 304 from one year to three years. Section 954 also raises thorny state law issues if a current or former executive chooses to fight the clawback. This is because the legislation appears to conflict with a board’s business judgment authority to forego such actions where the costs of litigation may outweigh the recovery. The Dodd-Frank Act does not contain a deadline for the SEC to issue rules to the national securities exchanges pursuant to Section 954 or a deadline for the national exchanges to pass such rules.