July 23, 2009

Clawbacks: SEC Finally Provides Clues re: “Misconduct” under Section 304

Yesterday, the SEC announced an action to clawback bonuses and stock profits from a former CEO under Section 304 of Sarbanes-Oxley. The SEC asked the U.S. District Court for the District of Arizona to order the former CEO of CSK Auto Corporation, Maynard Jenkins, to reimburse the company for more than $4 million that he received in bonuses and stock sale profits while the company was committing accounting fraud. This is the third Enforcement action that the SEC has brought regarding CSK’s alleged accounting shenanigans, which resulted in two restatements – one of them charges four of the company’s executives with wrongdoing (but not the former CEO).

Although this is not the first Section 304 action from the SEC, it’s the first one where the “clawee” isn’t alleged to have violated the securities laws. The SEC has brought very few 304 actions since the provision was enacted seven years ago, mainly because of the uncertainty over what constitutes the “misconduct” required by the provision. Here is how Section 304 opens:

If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer…

As noted in the “D&O Diary” Blog, “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.” And remember there is no private right-of-action under 304 – only the SEC can enforce it.

Okay, so what type of “misconduct” did the SEC find here? For openers, the SEC’s press release refers to the CEO as the “captain of the ship.” Did the SEC decide that the captain is responsible for the ship and that alone is enough to find “misconduct”? I don’t think so.

Based on a cursory reading of the SEC’s complaint, I believe the SEC found that the captain engaged in some “misconduct” – but that misconduct didn’t amount to a violation of the securities laws. I get to this conclusion by noting that a number of the allegations (i.e. #43-47) in the SEC’s complaint explain the “conduct” and “misconduct” by the company that led to this action and then #48 states: “By engaging in the conduct described above, Jenkins violated, and unless ordered to comply will continue to violate, Section 304(a) of the Act, 15 U.S.C. ยง 7243(a).”

There’s not a lot of meat in the SEC’s allegations to explain what role the former CEO actually had in the accounting fraud, leaving the SEC open to criticism (such as this Ideoblog commentary). But maybe that’s the SEC’s point – that merely being captain of the ship while rampant fraud occurs on your watch is “misconduct” enough. We’ll be posting memos analyzing this case in’s “Clawback Policies” Practice Area.

At a minimum, the SEC’s action seems like a wake-up call to CEOs and CFOs of companies that have had restatements due to some accounting misconduct: you are not safe – the SEC may come after you. And hopefully, this action will spur companies to attempt to enforce their own clawback policies (Equilar reports more than 64% of the Fortune 100 now have them; compared to just 17% in ’06). I’m not aware of any company that ever has (although it’s possible it has happened behind closed doors). I imagine companies sometimes deal with situations where it’s not clear if their own clawback policy – or Section 304 – applies. Or if it does apply, whether it’s prudent to seek recapture from the executive (weighing cost/time of litigation; indemnification issues, etc.).

Rather than decide to just move on and not do anything, it’s time to put teeth into those clawbacks as I wrote about in my article “Ten Steps to a Clawback Provision with “Teeth.”

The SEC’s B-Day Party: Rum Baba with Tropical Fruits & Berry Coulis

As I blogged recently, the SEC Historical Society held a pricey dinner to celebrate the 75th anniversary of the birth of the Commission (too expensive for a home gamer like me). Given the heat that the agency is feeling, the timing was not good – as portrayed in this Politico article. From what I hear, Chair Schapiro’s speech perhaps reflected the mood among the Staff these days as it was quite short. Here is a more playful review of the event.

How Do You Look Up a SEC Rule?

A member recently emailed about how fast the Government Printing Office responded when he emailed them that one of the SEC’s rules was unreadable online (eCFR is what the SEC’s site links to for the SEC’s rules). It seems that the GPO gets right on these things as the correction was quickly made. It led me to wonder how folks typically look up a SEC rule these days – and hence this anonymous poll:

Online Surveys & Market Research

– Broc Romanek