The SOX 'Clawback' Provision

Big bonus payouts at troubled financial institutions in the midst of the recent financial crisis have pushed executive compensation issues into the public spotlight. The stimulus bills passed in late 2008 and early 2009 each contained a package of executive compensation restrictions for institutions taking government TARP funds. The SEC, motivated by the belief that pay practices contributed to the crisis, has proposed rules requiring all public companies to disclose how their compensation arrangements align with their risk management objectives. A plethora of bills currently pending in Congress ' following up on policy initiatives advanced by the Obama administration in June ' would impose new independence requirements on compensation committees and their advisors, and require all public companies to offer their shareholders a non-binding vote on their executive compensation programs.

Section 304

In the wake of this renewed interest in executive compensation issues, a recent SEC enforcement action involving Section 304 of the Sarbanes Oxley Act ' also known as the compensation “clawback” provision ' has generated a flurry of attention. Briefly, Section 304 requires the CEO and CFO of a publicly traded company to repay the company for any incentive compensation they've received and any proceeds from any company stock they've sold during a period in which the company is required to restate its financials due to “misconduct.” In SEC v. Jenkins, an enforcement action currently pending in federal district court in Arizona (complaint available at http://sec.gov/litigation/complaints/2009/comp21149.pdf), the SEC is claiming that the former CEO of CSK Auto Corporation, Maynard Jenkins, is required to reimburse the company for over $4 million in incentive compensation and stock sale proceeds which he received from 2002 to 2004, years for which the company's financials were later required to be restated (twice).

A Radical Departure

For the first five years of SOX's existence, the SEC never pursued an enforcement action under Section 304. In the handful of occasions in which Section 304 has been used since then, it has been used exclusively in cases in which the CEO or CFO was directly engaged in some sort of fraudulent activity requiring the restatement, for the most part stock option backdating cases. What makes this case interesting is that the CEO, Mr. Jenkins, by the SEC's own admission is not alleged to have violated any securities laws, aside from his alleged failure to comply with Section 304.

The fact that the SEC has even filed this case is pretty remarkable. It represents a radical departure from the way the SEC has interpreted Section 304 in the past. Were the SEC to be successful ' were the case not to be settled, and to proceed to trial (as now seems likely), and were the court to decide in favor of the SEC, that would represent a true sea change in the scope of Section 304 liability and have enormous repercussions for CEOs and CFOs of publicly traded companies whose financials are required to be restated.

Background: CSK Auto Corporation

During the relevant time period here, CSK was a major retailer of auto parts headquartered in the southwest U.S. Its CEO was Maynard Jenkins, who joined the company in 1997 and retired in 2007. By all accounts, the company was pretty successful during the first half of his tenure, but during the second half it ran into some problems. It was required to restate its financial statements not once, but twice during this period, each time for a three-consecutive-year period from 2002 through 2004. The restatements arose primarily from the company's failure to write-off millions of dollars in uncollectible “vendor allowances,” which were a sort of credit which CSK received from its auto part vendors which the vendors were supposed to reimburse CSK for in the future, but in some cases were unable to.

The company's first attempt to restate its income to account for these uncollectible allowances apparently failed to capture all of the uncollectible allowances, resulting in the second restatement. Prior to the second restatement, the CFO, the COO, the controller and one other senior executive were all terminated by the company and have since been charged with various violations of the federal securities laws. Importantly, Mr. Jenkins the CEO was not charged with any violations himself.

However Mr. Jenkins did not escape the SEC's reach entirely. In July 2009, a few months after the other executives were charged, the SEC filed a separate action against Mr. Jenkins alleging his failure to comply with Section 304.

The Ambiguous 'Misconduct' Requirement of Section 304

The relevant portion of Section 304 reads as follows (emphasis added):

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 for '

The italicized language requires that in order for liability under Section 304 to attach, the restatement of a company's financials must be “as a result of misconduct.” The language here is ambiguous to say the least. There is no indication in the statute what the term misconduct means, or indeed who must actually engage in the misconduct ' whether it must be the CEO or CFO, or whether anyone else's misconduct will suffice. Nevertheless, the SEC had always, until now, interpreted Section 304 to require actual misconduct in some form by the CEO or CFO. The SEC press release issued when the case was filed emphasized the fact that the SEC had not otherwise charged Mr. Jenkins with any securities laws violations, and that this was the first case under Section 304 of its kind. Clearly the SEC views this as a test case of the breadth of its powers under Section 304.

What makes the case particularly interesting is that the SEC's complaint doesn't even allege that Jenkins had knowledge of the violations by the other executives, or was reckless or negligent in failing to uncover them. The SEC's legal theory regarding why Jenkins should be liable under Section 304 is apparently that he was “captain of the ship” and that in essence Section 304 imposes a kind of strict liability on CEOs and CFOs of companies whose financials are restated, regardless of whether the CEOs and CFOs personally engaged in, or indeed had any knowledge of, the misconduct in question.

Another interpretive question that appears as though it will likely be answered during this case is the true scope of the Section 304 remedy ' whether it requires repayment of all incentive compensation and stock sale proceeds during the restatement period, or only that portion of the incentive compensation and stock sale proceeds that are attributable to the misstated financials. The statutory language supports the broader interpretation, but some commentators (as well as Mr. Jenkins himself, in his answer to the SEC complaint) have argued that the narrower reading is more equitable.

Implications and Related Developments

Although the Jenkins case is still in its relatively early stages now, it currently does appear as though it will advance to trial, so a decision on the merits is a definite possibility. If the SEC is successful, it would represent a dramatic expansion of the liability exposure of CEOs and CFOs whose company's financials are required to be restated. Unfortunately there won't be much that CEOs and CFOs will be able to do about it, other than making sure that their financials are as accurate as possible the first time. One piece of good news for CEOs and CFOs here is that Section 304 can only be enforced by the SEC and does not provide a private right of action.

Recent actions by the SEC also indicate that the Jenkins enforcement action is anything but an isolated event. On Nov. 16, 2009, Beazer Homes released a Form 8-K report disclosing that the SEC was preparing to bring a civil suit under Section 304 against its CEO to reclaim millions of dollars in incentive compensation earned by him during periods in which the company's financials were required to be restated. Like the SEC's claim in Jenkins, the SEC has apparently not alleged any wrongdoing or lack of due care on the part of the company's CEO.

Conclusion

These cases and the more aggressive posture exhibited by the SEC falls in line with some developments we are currently seeing in other areas of executive compensation law. The executive compensation restrictions for banks and other financial institutions which accepted government TARP funds include a clawback provision that is actually broader than the Section 304 restriction in many respects. All public companies are currently required to disclose in their CD&As whether they have adopted clawback policies, and recent SEC changes to these rules will require additional disclosure regarding the extent to which the issuer's clawback policy (or absence thereof) materially impacts its risk profile. According to at least one survey, over half of Fortune 100 companies have voluntarily adopted a clawback policy in one form or another (see “SEC Orders Ex-CEO to Return Pay,” The Wall Street Journal, July 23, 2009).

Thus it's safe to say that, regardless of how things turn out for Mr. Jenkins, executive compensation clawbacks are going to be an issue that companies will need to wrestle with for the foreseeable future.

G. William Tysse is an attorney at McGuireWoods LLP in the firm's Tax and Employee Benefits department, focusing on executive compensation issues. He can be reached at 202- 857-1730 or at [email protected].

Big bonus payouts at troubled financial institutions in the midst of the recent financial crisis have pushed executive compensation issues into the public spotlight. The stimulus bills passed in late 2008 and early 2009 each contained a package of executive compensation restrictions for institutions taking government TARP funds. The SEC, motivated by the belief that pay practices contributed to the crisis, has proposed rules requiring all public companies to disclose how their compensation arrangements align with their risk management objectives. A plethora of bills currently pending in Congress ' following up on policy initiatives advanced by the Obama administration in June ' would impose new independence requirements on compensation committees and their advisors, and require all public companies to offer their shareholders a non-binding vote on their executive compensation programs.

Section 304

In the wake of this renewed interest in executive compensation issues, a recent SEC enforcement action involving Section 304 of the Sarbanes Oxley Act ' also known as the compensation “clawback” provision ' has generated a flurry of attention. Briefly, Section 304 requires the CEO and CFO of a publicly traded company to repay the company for any incentive compensation they've received and any proceeds from any company stock they've sold during a period in which the company is required to restate its financials due to “misconduct.” In SEC v. Jenkins, an enforcement action currently pending in federal district court in Arizona (complaint available at http://sec.gov/litigation/complaints/2009/comp21149.pdf), the SEC is claiming that the former CEO of CSK Auto Corporation, Maynard Jenkins, is required to reimburse the company for over $4 million in incentive compensation and stock sale proceeds which he received from 2002 to 2004, years for which the company's financials were later required to be restated (twice).

A Radical Departure

For the first five years of SOX's existence, the SEC never pursued an enforcement action under Section 304. In the handful of occasions in which Section 304 has been used since then, it has been used exclusively in cases in which the CEO or CFO was directly engaged in some sort of fraudulent activity requiring the restatement, for the most part stock option backdating cases. What makes this case interesting is that the CEO, Mr. Jenkins, by the SEC's own admission is not alleged to have violated any securities laws, aside from his alleged failure to comply with Section 304.

The fact that the SEC has even filed this case is pretty remarkable. It represents a radical departure from the way the SEC has interpreted Section 304 in the past. Were the SEC to be successful ' were the case not to be settled, and to proceed to trial (as now seems likely), and were the court to decide in favor of the SEC, that would represent a true sea change in the scope of Section 304 liability and have enormous repercussions for CEOs and CFOs of publicly traded companies whose financials are required to be restated.

Background: CSK Auto Corporation

During the relevant time period here, CSK was a major retailer of auto parts headquartered in the southwest U.S. Its CEO was Maynard Jenkins, who joined the company in 1997 and retired in 2007. By all accounts, the company was pretty successful during the first half of his tenure, but during the second half it ran into some problems. It was required to restate its financial statements not once, but twice during this period, each time for a three-consecutive-year period from 2002 through 2004. The restatements arose primarily from the company's failure to write-off millions of dollars in uncollectible “vendor allowances,” which were a sort of credit which CSK received from its auto part vendors which the vendors were supposed to reimburse CSK for in the future, but in some cases were unable to.

The company's first attempt to restate its income to account for these uncollectible allowances apparently failed to capture all of the uncollectible allowances, resulting in the second restatement. Prior to the second restatement, the CFO, the COO, the controller and one other senior executive were all terminated by the company and have since been charged with various violations of the federal securities laws. Importantly, Mr. Jenkins the CEO was not charged with any violations himself.

However Mr. Jenkins did not escape the SEC's reach entirely. In July 2009, a few months after the other executives were charged, the SEC filed a separate action against Mr. Jenkins alleging his failure to comply with Section 304.

The Ambiguous 'Misconduct' Requirement of Section 304

The relevant portion of Section 304 reads as follows (emphasis added):

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 for '

The italicized language requires that in order for liability under Section 304 to attach, the restatement of a company's financials must be “as a result of misconduct.” The language here is ambiguous to say the least. There is no indication in the statute what the term misconduct means, or indeed who must actually engage in the misconduct ' whether it must be the CEO or CFO, or whether anyone else's misconduct will suffice. Nevertheless, the SEC had always, until now, interpreted Section 304 to require actual misconduct in some form by the CEO or CFO. The SEC press release issued when the case was filed emphasized the fact that the SEC had not otherwise charged Mr. Jenkins with any securities laws violations, and that this was the first case under Section 304 of its kind. Clearly the SEC views this as a test case of the breadth of its powers under Section 304.

What makes the case particularly interesting is that the SEC's complaint doesn't even allege that Jenkins had knowledge of the violations by the other executives, or was reckless or negligent in failing to uncover them. The SEC's legal theory regarding why Jenkins should be liable under Section 304 is apparently that he was “captain of the ship” and that in essence Section 304 imposes a kind of strict liability on CEOs and CFOs of companies whose financials are restated, regardless of whether the CEOs and CFOs personally engaged in, or indeed had any knowledge of, the misconduct in question.

Another interpretive question that appears as though it will likely be answered during this case is the true scope of the Section 304 remedy ' whether it requires repayment of all incentive compensation and stock sale proceeds during the restatement period, or only that portion of the incentive compensation and stock sale proceeds that are attributable to the misstated financials. The statutory language supports the broader interpretation, but some commentators (as well as Mr. Jenkins himself, in his answer to the SEC complaint) have argued that the narrower reading is more equitable.

Implications and Related Developments

Although the Jenkins case is still in its relatively early stages now, it currently does appear as though it will advance to trial, so a decision on the merits is a definite possibility. If the SEC is successful, it would represent a dramatic expansion of the liability exposure of CEOs and CFOs whose company's financials are required to be restated. Unfortunately there won't be much that CEOs and CFOs will be able to do about it, other than making sure that their financials are as accurate as possible the first time. One piece of good news for CEOs and CFOs here is that Section 304 can only be enforced by the SEC and does not provide a private right of action.

Recent actions by the SEC also indicate that the Jenkins enforcement action is anything but an isolated event. On Nov. 16, 2009, Beazer Homes released a Form 8-K report disclosing that the SEC was preparing to bring a civil suit under Section 304 against its CEO to reclaim millions of dollars in incentive compensation earned by him during periods in which the company's financials were required to be restated. Like the SEC's claim in Jenkins, the SEC has apparently not alleged any wrongdoing or lack of due care on the part of the company's CEO.

Conclusion

These cases and the more aggressive posture exhibited by the SEC falls in line with some developments we are currently seeing in other areas of executive compensation law. The executive compensation restrictions for banks and other financial institutions which accepted government TARP funds include a clawback provision that is actually broader than the Section 304 restriction in many respects. All public companies are currently required to disclose in their CD&As whether they have adopted clawback policies, and recent SEC changes to these rules will require additional disclosure regarding the extent to which the issuer's clawback policy (or absence thereof) materially impacts its risk profile. According to at least one survey, over half of Fortune 100 companies have voluntarily adopted a clawback policy in one form or another (see “SEC Orders Ex-CEO to Return Pay,” The Wall Street Journal, July 23, 2009).

Thus it's safe to say that, regardless of how things turn out for Mr. Jenkins, executive compensation clawbacks are going to be an issue that companies will need to wrestle with for the foreseeable future.

G. William Tysse is an attorney at McGuireWoods LLP in the firm's Tax and Employee Benefits department, focusing on executive compensation issues. He can be reached at 202- 857-1730 or at [email protected].