The Case For Aggressive Enforcement Of The Sarbanes-Oxley “Claw Back” Provison

(Editor’s Note: This post comes to us from Daniel J. Hurson of the Hurson Law Firm LLP, and relates to a recent client memorandum by Mr. Hurson, which can be found here.)

In a recent forum post, John F. Savarese and Wayne M. Carlin of Wachtell Lipton are critical of the SEC’s recent filing of a case against former CEO Maynard Jenkins of CSK Auto Corp., seeking payback of over $4 million in bonuses and stock sale proceeds. The SEC alleges that his company engaged in a massive accounting fraud, requiring a restatement, and thus Jenkins must payback these funds under Section 304 of SOX, the so-called “claw back” provision. Section 304, rarely used in the past by the SEC and never before against a CEO who was not personally accused of fraud, requires repayment to his company of certain bonuses and stock sale profits from a CEO or CFO whose company must make a restatement based on “misconduct.” The SEC pointedly did not accuse Mr. Jenkins of personal participation or knowledge of the fraud.

The Wachtell authors question the SEC’s taking action under Sec. 304 against a CFO not personally accused of fraud, calling it a “regrettable policy choice” and an “unfortunate contribution to the overheated atmosphere surrounding executive compensation.” Other commentators have also questioned the lawsuit, suggesting that it will have unfortunate consequences if successful. They too feel the statute is too ambiguous regarding whose “misconduct” is required to hit the CEO or CFO with claw back actions. The SEC, however, appears very much committed to the case and eager to test its new enforcement agressivness in an area with considerable potential deterrent impact.

In my recent client advisory, published thru the Mondaq news service, I argue the contrary. I believe there should be strict and aggressive enforcement by the SEC under the clear language of Sec. 304 to seek claw back from CEO’s and CFO’s who certify financial statements which ultimately have to be restated. There should be consequences to top managers who give these sweeping certifications to investors only later to have to issue restatements, often disclosing material weaknesses in internal controls or worse, which have the effect of making the certifications worthless. Since several courts have held there is no private remedy under Section 304, the SEC alone bears the responsibility to enforce this provision of SOX and give teeth to the certification requirements.

As I point out in the article, the legislative history, while sparse, supports a broad interpretation of Section 304 in which personal misconduct by the CEO or CFO, as opposed to management in general, is not required. Neither the Bush administration nor either branch of Congress, I submit, intended the statute to require proof that the individual managers from whom claw back is sought have to be proven guilty of personal misconduct. Rather, the fact that they preside over the filing of, and personally certify, financial statements which subsequently have to be restated, often leading to market value declines and substantial costs to the company, is enough to hold them responsible under Section 304 to repay compensation and profits which might not have been awarded or obtained had the truth come out or the weaknesses been corrected.

I further argue that going forward, the SEC should establish clear criteria for future cases, including a better definition of what kind of “misconduct” and materiality meets the threshold for claw back actions. The SEC should also, if it succeeds in the Jenkins suit, seriously consider revisiting the many restatements filed over the past several years, particularly among companies caught up in the present financial crisis, to see if other CEO’s and CFO’s have unduly profited from misstated financials, and initiate similar Section 304 claw back actions against them. In my view, shareholders who relied on the rosy certifications deserve no less.

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