Federal Court Authorizes Clawback of Bonuses from CEO Under SOX

In a case of first impression, SEC v. Jenkins, CV-09-1510-PHX-GMS (D. Ariz. June 9, 2010), the United States District Court for the District of Arizona refused to dismiss an action brought by the Securities and Exchange Commission (SEC) seeking reimbursement of bonuses and securities trading profits from a corporate CEO under Section 304 of the Sarbanes-Oxley Act of 2002 (SOX). The court ruled that the SEC's complaint properly stated a claim against the CEO, who had certified his company's inaccurate financial statements but otherwise had no knowledge of the accounting irregularities that led to the company's filing two separate financial restatements. In view of previous federal court decisions limiting the reach of Section 304 (for instance, by denying private plaintiffs an implied right of action under the statute), as well as other sections of SOX, it is interesting to note that the Jenkins court passed up an opportunity to narrowly construe this key provision of the SOX legislation.

Background

CSK Auto Corporation is an Arizona-based retailer engaged in sales of automotive parts and accessories under several brand names. From January 1997 through August 2007, Maynard L. Jenkins served as CSK's CEO and chairman of its board of directors. Until mid-2008, CSK's common stock was listed for trading on the New York Stock Exchange and, accordingly, CSK was obligated to file periodic reports containing financial statements with the SEC.

As a result of CSK's failure to properly account for various receivables generated under a vendor allowance program, the company's reported pretax income for fiscal years 2002 through 2004 were inflated. Jenkins, in his capacity as CEO, certified CSK's SEC reports containing the inaccurate financial statements in accordance with SOX Sections 302 and 906 and rules promulgated by the SEC thereunder. Jenkins did not participate in the scheme to boost CSK's earnings, and apparently was not even aware of its existence or impact on the company's financials. After these overstatements came to light, CSK was forced to file two separate accounting restatements, which also were certified by Jenkins.

In July 2008, CSK was acquired by O'Reilly Automotive, Inc. As a result, its stock was delisted from the NYSE and CSK's public reporting obligations with the SEC terminated. Nevertheless, in 2009, the SEC brought suit against Jenkins in U.S. District Court, seeking reimbursement (on behalf of CSK) under SOX Section 304 of the bonuses and securities trading profits received by Jenkins during the period covered by the inaccurate financial statements. During this period, Jenkins received over $2 million from CSK in the form of bonuses and other incentive-based and equity-based compensation, and realized over $2 million from the sale of CSK securities. Citing his personal innocence and the fact that CSK had ceased to be an “issuer” for purposes of SOX, Jenkins sought dismissal of the SEC's claim.

The Court's Analysis

SOX Section 304 provides that:

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 (i) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following ' filing with the Commission ' of the financial document embodying such financial reporting requirement; and (ii) any profits realized from the sale of securities of the issuer during that 12-month period.

Jenkins marks the first occasion on which a federal court has been asked to consider whether the SEC is entitled to seek reimbursement of bonuses and profits under SOX Section 304 from a corporate officer who has not been alleged to have engaged in personal wrongdoing. Applying long-settled tools of statutory interpretation, the court sided with the SEC in observing that “the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer's CEO or CFO.” After entertaining, and then rejecting, Jenkins'many arguments against applicability of the statute to him, the court ultimately denied his motion to dismiss the SEC's complaint.

Statutory Construction

The court began its inquiry by examining the text of SOX Section 304 itself in order “to discern the intent of Congress,” explaining that “'[t]he starting point for the interpretation of a statute is always its language,' and '[a]ny inquiry must cease if the statutory language is unambiguous and the statutory scheme is coherent and consistent.'” Applying this principle, the court determined that the “plain language” of SOX Section 304 ' with its reference to “material non-compliance of the issuer, as a result of misconduct” ' means that “the misconduct of the issuer is the misconduct that triggers the reimbursement obligation of the CEO and the CFO.” Further, because “a corporation acts through its officers, agents or employees and is liable for the actions of such persons acting within the scope of their agency ' the misconduct of corporate officers, agents or employees acting within the scope of their agency or employment is sufficient misconduct” for purposes of SOX Section 304 regardless of the participation or knowledge of the CEO. In support of this interpretation, the court observed that a “CEO may unfairly benefit from a misperception of the financial position of the issuer that results from those misstated financials, even if the CEO was unaware of the misconduct leading to misstated financials.” Therefore, in the court's view, “[i]t is not irrational for Congress to require that such additional compensation amounts be repaid to the issuer.”

In a persuasive footnote, the court pointed out that corporate executives (unlike Jenkins) who “are actually aware of misconduct that results in misstated financials ' may be responsible for additional civil and criminal penalties.” The existence of these penalties, the court reasoned, supports an interpretation of SOX Section 304 that avoids the redundancy with existing securities laws that would result if the section was construed as only covering situations in which CEOs and CFOs are unaware of the misconduct at issue.

The court turned next to the “larger statutory scheme of which ' [SOX Section 304] is a part.” In this context, the court observed that SOX Section 304 “provides an incentive for CEOs and CFOs to be rigorous in their creation and certification of internal controls,” as required by SOX Sections 302 and 906, “by requiring that they reimburse additional compensation received during periods of corporate non-compliance regardless of whether or not they were aware of the misconduct giving rise to the misstated financials.”

The court also rejected Jenkins' reliance on In re Digimarc Corporation Derivative Litigation, 549 F.3d 1223 (9th Cir. 2008), an earlier decision in which the Ninth Circuit potentially narrowed the reach of SOX Section 304 by ruling that there is no implied private right of action under the statute. In Jenkins' view, Digimarc stands for the proposition that SOX Section 304 “does not impose liability, but instead is merely a remedy to be applied to 'wrongdoers.'” As such, Jenkins argued, the statute could not apply to him. The Court refused to extend Digimarc in the manner suggested by Jenkins, concluding that “Digimarc does not control the Court's result here.”

Legislative History

While noting that resort to legislative history is unnecessary where (as here) “the text of the statute warrants only one interpretation,” the court nonetheless explained that the legislative history of SOX Section 304 “supports this textual reading.” Comparing the House and Senate versions of SOX, the court pointed out that only the House version, which did not become law, included language requiring knowledge on the part of the executive and subsequent “disgorgement.” In contrast, the Senate version, which was ultimately adopted, did not mention knowledge or require executive misconduct. Also, the Senate rejected an amendment to its version that would have added a “knowledge” requirement.

The court also dismissed Jenkins' argument that the use of the word “disgorge” in the Senate's report on SOX Section 304 implies that its reimbursement obligation was intended to apply only to “wrongdoers.” The court found this fact irrelevant, noting that regardless of what term the Senate report might have used, the text of Section 304 ' which is the language that ultimately controls ' uses the word “reimburse.”

Constitutional Issues

Jenkins next argued that the failure of the SEC to specify in its complaint the actual amount of reimbursement sought masked the possibility that “the SEC may be interpreting the statute too broadly,” thereby “depriving him of that part of his stock value and bonus payments that are not, in any way, traceable to any misstatement of CSK's financial positions.” If the SEC is permitted to pursue him without such specificity, Jenkins argued, the statute's purpose becomes “punitive and not remedial,” raising constitutional due process issues when applied to “innocent” parties. According to Jenkins, such constitutional issues “could and should be avoided ' by simply interpreting the statute to require the personal misconduct of the CEO as a precondition of seeking reimbursement.”

The court disposed of this argument on procedural grounds, stating that in the context of a motion to dismiss,
“[a]rguments based on the appropriate measure of reimbursement sought by the SEC are not dispositive with respect to whether the SEC has stated a claim for reimbursement against Mr. Jenkins.” Similarly, though the court acknowledged that constitutional issues may arise in particular cases of “severe and unjustified deprivation, ' the facts necessary to decide these constitutional issues cannot be decided on a motion to dismiss.”

Invoking the “absurd results canon of statutory interpretation,” Jenkins also argued that the SEC's interpretation of SOX Section 304 would produce the “absurd” result that Delaware's indemnification statute would require CSK to indemnify him for any amounts that he forfeits under SOX Section 304, at least so long as long as he acted in “'good faith' and in a manner ' 'reasonably believed to be in or not opposed to the best interests of the corporation.'” In response, the court noted that “the absurd results cannon of statutory interpretation 'has no application' where, as here, 'a statute is clear' as to what Congress 'plainly intended and provided.'” The court also pointed out that, under the U.S. Constitution's Supremacy Clause, “the existence of a state statute does not alter the meaning of the federal statute.”

Change of Circumstances

Finally, Jenkins argued that because CSK was delisted from the NYSE and deregistered with the SEC after being acquired by O'Reilly, it was no longer an “issuer” as specified in SOX Section 304 at the time the SEC brought its action against him. Under SOX, a company is an “issuer” if it is required to file periodic reports with the SEC. That obligation ceased, for all intents and purposes, when CSK was acquired by O'Reilly. Therefore, Jenkins contended, reimbursement by him was no longer required.

The court simply dismissed this position as “incorrect.” The fact that CSK had ceased to be a SOX “issuer” before the SEC brought its action against Jenkins did not alter the fact that CSK was such an issuer during the time period in which the alleged misconduct occurred. Thus, Jenkins remained subject to the reimbursement requirements under SOX Section 304 for periods in which CSK was a SOX “issuer” despite the fact that it subsequently became a wholly owned subsidiary of O'Reilly.

Conclusion

Jenkins represents the first time that a U.S. federal court has addressed the issue of whether SOX's controversial clawback provision requires reimbursement absent individual wrongdoing on the part of a CEO or CFO. It remains to be seen, of course, whether other federal courts will follow the lead of the Jenkins court in this regard. In any event, because the SEC has signaled its intention to continue bringing actions seeking reimbursement from public company CEOs and CFOs under SOX Section 304, Jenkins places those officers on notice that the certification process cannot be taken lightly, and that there will be consequences to their failure, or inability, to uncover misconduct at their companies regardless of their individual culpability or innocence.

Robert S. Reder, a member of this newsletter's Board of Editors, is a New York-based partner in the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP. The author gratefully acknowledges the assistance of Julie Constantinides, an associate in the firm's Global Corporate Group, and of Andrew Tsang, a member of the firm's 2010 summer program, in the preparation of this article.

In a case of first impression, SEC v. Jenkins, CV-09-1510-PHX-GMS (D. Ariz. June 9, 2010), the United States District Court for the District of Arizona refused to dismiss an action brought by the Securities and Exchange Commission (SEC) seeking reimbursement of bonuses and securities trading profits from a corporate CEO under Section 304 of the Sarbanes-Oxley Act of 2002 (SOX). The court ruled that the SEC's complaint properly stated a claim against the CEO, who had certified his company's inaccurate financial statements but otherwise had no knowledge of the accounting irregularities that led to the company's filing two separate financial restatements. In view of previous federal court decisions limiting the reach of Section 304 (for instance, by denying private plaintiffs an implied right of action under the statute), as well as other sections of SOX, it is interesting to note that the Jenkins court passed up an opportunity to narrowly construe this key provision of the SOX legislation.

Background

CSK Auto Corporation is an Arizona-based retailer engaged in sales of automotive parts and accessories under several brand names. From January 1997 through August 2007, Maynard L. Jenkins served as CSK's CEO and chairman of its board of directors. Until mid-2008, CSK's common stock was listed for trading on the New York Stock Exchange and, accordingly, CSK was obligated to file periodic reports containing financial statements with the SEC.

As a result of CSK's failure to properly account for various receivables generated under a vendor allowance program, the company's reported pretax income for fiscal years 2002 through 2004 were inflated. Jenkins, in his capacity as CEO, certified CSK's SEC reports containing the inaccurate financial statements in accordance with SOX Sections 302 and 906 and rules promulgated by the SEC thereunder. Jenkins did not participate in the scheme to boost CSK's earnings, and apparently was not even aware of its existence or impact on the company's financials. After these overstatements came to light, CSK was forced to file two separate accounting restatements, which also were certified by Jenkins.

In July 2008, CSK was acquired by O'Reilly Automotive, Inc. As a result, its stock was delisted from the NYSE and CSK's public reporting obligations with the SEC terminated. Nevertheless, in 2009, the SEC brought suit against Jenkins in U.S. District Court, seeking reimbursement (on behalf of CSK) under SOX Section 304 of the bonuses and securities trading profits received by Jenkins during the period covered by the inaccurate financial statements. During this period, Jenkins received over $2 million from CSK in the form of bonuses and other incentive-based and equity-based compensation, and realized over $2 million from the sale of CSK securities. Citing his personal innocence and the fact that CSK had ceased to be an “issuer” for purposes of SOX, Jenkins sought dismissal of the SEC's claim.

The Court's Analysis

SOX Section 304 provides that:

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 (i) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following ' filing with the Commission ' of the financial document embodying such financial reporting requirement; and (ii) any profits realized from the sale of securities of the issuer during that 12-month period.

Jenkins marks the first occasion on which a federal court has been asked to consider whether the SEC is entitled to seek reimbursement of bonuses and profits under SOX Section 304 from a corporate officer who has not been alleged to have engaged in personal wrongdoing. Applying long-settled tools of statutory interpretation, the court sided with the SEC in observing that “the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer's CEO or CFO.” After entertaining, and then rejecting, Jenkins'many arguments against applicability of the statute to him, the court ultimately denied his motion to dismiss the SEC's complaint.

Statutory Construction

The court began its inquiry by examining the text of SOX Section 304 itself in order “to discern the intent of Congress,” explaining that “'[t]he starting point for the interpretation of a statute is always its language,' and '[a]ny inquiry must cease if the statutory language is unambiguous and the statutory scheme is coherent and consistent.'” Applying this principle, the court determined that the “plain language” of SOX Section 304 ' with its reference to “material non-compliance of the issuer, as a result of misconduct” ' means that “the misconduct of the issuer is the misconduct that triggers the reimbursement obligation of the CEO and the CFO.” Further, because “a corporation acts through its officers, agents or employees and is liable for the actions of such persons acting within the scope of their agency ' the misconduct of corporate officers, agents or employees acting within the scope of their agency or employment is sufficient misconduct” for purposes of SOX Section 304 regardless of the participation or knowledge of the CEO. In support of this interpretation, the court observed that a “CEO may unfairly benefit from a misperception of the financial position of the issuer that results from those misstated financials, even if the CEO was unaware of the misconduct leading to misstated financials.” Therefore, in the court's view, “[i]t is not irrational for Congress to require that such additional compensation amounts be repaid to the issuer.”

In a persuasive footnote, the court pointed out that corporate executives (unlike Jenkins) who “are actually aware of misconduct that results in misstated financials ' may be responsible for additional civil and criminal penalties.” The existence of these penalties, the court reasoned, supports an interpretation of SOX Section 304 that avoids the redundancy with existing securities laws that would result if the section was construed as only covering situations in which CEOs and CFOs are unaware of the misconduct at issue.

The court turned next to the “larger statutory scheme of which ' [SOX Section 304] is a part.” In this context, the court observed that SOX Section 304 “provides an incentive for CEOs and CFOs to be rigorous in their creation and certification of internal controls,” as required by SOX Sections 302 and 906, “by requiring that they reimburse additional compensation received during periods of corporate non-compliance regardless of whether or not they were aware of the misconduct giving rise to the misstated financials.”

The court also rejected Jenkins' reliance on In re Digimarc Corporation Derivative Litigation, 549 F.3d 1223 (9th Cir. 2008), an earlier decision in which the Ninth Circuit potentially narrowed the reach of SOX Section 304 by ruling that there is no implied private right of action under the statute. In Jenkins' view, Digimarc stands for the proposition that SOX Section 304 “does not impose liability, but instead is merely a remedy to be applied to 'wrongdoers.'” As such, Jenkins argued, the statute could not apply to him. The Court refused to extend Digimarc in the manner suggested by Jenkins, concluding that “Digimarc does not control the Court's result here.”

Legislative History

While noting that resort to legislative history is unnecessary where (as here) “the text of the statute warrants only one interpretation,” the court nonetheless explained that the legislative history of SOX Section 304 “supports this textual reading.” Comparing the House and Senate versions of SOX, the court pointed out that only the House version, which did not become law, included language requiring knowledge on the part of the executive and subsequent “disgorgement.” In contrast, the Senate version, which was ultimately adopted, did not mention knowledge or require executive misconduct. Also, the Senate rejected an amendment to its version that would have added a “knowledge” requirement.

The court also dismissed Jenkins' argument that the use of the word “disgorge” in the Senate's report on SOX Section 304 implies that its reimbursement obligation was intended to apply only to “wrongdoers.” The court found this fact irrelevant, noting that regardless of what term the Senate report might have used, the text of Section 304 ' which is the language that ultimately controls ' uses the word “reimburse.”

Constitutional Issues

Jenkins next argued that the failure of the SEC to specify in its complaint the actual amount of reimbursement sought masked the possibility that “the SEC may be interpreting the statute too broadly,” thereby “depriving him of that part of his stock value and bonus payments that are not, in any way, traceable to any misstatement of CSK's financial positions.” If the SEC is permitted to pursue him without such specificity, Jenkins argued, the statute's purpose becomes “punitive and not remedial,” raising constitutional due process issues when applied to “innocent” parties. According to Jenkins, such constitutional issues “could and should be avoided ' by simply interpreting the statute to require the personal misconduct of the CEO as a precondition of seeking reimbursement.”

The court disposed of this argument on procedural grounds, stating that in the context of a motion to dismiss,
“[a]rguments based on the appropriate measure of reimbursement sought by the SEC are not dispositive with respect to whether the SEC has stated a claim for reimbursement against Mr. Jenkins.” Similarly, though the court acknowledged that constitutional issues may arise in particular cases of “severe and unjustified deprivation, ' the facts necessary to decide these constitutional issues cannot be decided on a motion to dismiss.”

Invoking the “absurd results canon of statutory interpretation,” Jenkins also argued that the SEC's interpretation of SOX Section 304 would produce the “absurd” result that Delaware's indemnification statute would require CSK to indemnify him for any amounts that he forfeits under SOX Section 304, at least so long as long as he acted in “'good faith' and in a manner ' 'reasonably believed to be in or not opposed to the best interests of the corporation.'” In response, the court noted that “the absurd results cannon of statutory interpretation 'has no application' where, as here, 'a statute is clear' as to what Congress 'plainly intended and provided.'” The court also pointed out that, under the U.S. Constitution's Supremacy Clause, “the existence of a state statute does not alter the meaning of the federal statute.”

Change of Circumstances

Finally, Jenkins argued that because CSK was delisted from the NYSE and deregistered with the SEC after being acquired by O'Reilly, it was no longer an “issuer” as specified in SOX Section 304 at the time the SEC brought its action against him. Under SOX, a company is an “issuer” if it is required to file periodic reports with the SEC. That obligation ceased, for all intents and purposes, when CSK was acquired by O'Reilly. Therefore, Jenkins contended, reimbursement by him was no longer required.

The court simply dismissed this position as “incorrect.” The fact that CSK had ceased to be a SOX “issuer” before the SEC brought its action against Jenkins did not alter the fact that CSK was such an issuer during the time period in which the alleged misconduct occurred. Thus, Jenkins remained subject to the reimbursement requirements under SOX Section 304 for periods in which CSK was a SOX “issuer” despite the fact that it subsequently became a wholly owned subsidiary of O'Reilly.

Conclusion

Jenkins represents the first time that a U.S. federal court has addressed the issue of whether SOX's controversial clawback provision requires reimbursement absent individual wrongdoing on the part of a CEO or CFO. It remains to be seen, of course, whether other federal courts will follow the lead of the Jenkins court in this regard. In any event, because the SEC has signaled its intention to continue bringing actions seeking reimbursement from public company CEOs and CFOs under SOX Section 304, Jenkins places those officers on notice that the certification process cannot be taken lightly, and that there will be consequences to their failure, or inability, to uncover misconduct at their companies regardless of their individual culpability or innocence.

Robert S. Reder, a member of this newsletter's Board of Editors, is a New York-based partner in the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP. The author gratefully acknowledges the assistance of Julie Constantinides, an associate in the firm's Global Corporate Group, and of Andrew Tsang, a member of the firm's 2010 summer program, in the preparation of this article.