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Under SOX Section 304, SEC could seek compensation from company’s CEO and CFO even though they were not charged with any wrongdoing

November 15th, 2012  |  Cynthia L. Hackerott

In a case arising out of a securities scandal involving publicly traded medical device company Arthrocare, the SEC could, acting under Section 304 of the Sarbanes–Oxley Act (SOX), seek statutory reimbursement —on behalf of Arthrocare—of cash bonuses, incentives, and equity-based compensation earned by Arthrocare’s CEO and CFO, a federal district court in Texas has ruled (SEC v Baker, WDTex, November 13, 2012). The SEC could seek this Section 304 compensation (the cash bonuses, incentives, and equity-based compensation) even though the Commission did not allege that the CEO and CFO engaged in any conscious wrongdoing; it was enough that they were CEO and CFO at the time of the alleged fraud, and thus signed the SEC filings at issue. The court noted that the SEC’s complaint in this case evinces a more aggressive interpretation of the reach of Section 304 than the Commission has, for the most part, previously utilized.

Section 304. Section 304 of SOX (15 USC Section 7243), entitled “Forfeiture of certain bonuses and profits,” provides:

(a) Additional compensation prior to noncompliance with Commission financial reporting requirements

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—(1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

(b) Commission exemption authority

The Commission may exempt any person from the application of subsection (a) of this section, as it deems necessary and appropriate.

Although Section 304 does not create any private right of action, it nevertheless establishes that the SEC may sue the CEO and CFO of a company when the company has been required to restate its earnings due to noncompliance with securities laws, the court explained. The SEC “has been historically reluctant to utilize [Sec.] 304 in the ten years since Sarbanes–Oxley was enacted,” the court observed, adding that federal agencies have discretion in when and how to carry out regulatory enforcement actions.

In recent years, however, the SEC has filed a number of actions seeking to compel CEOs and CFOs to reimburse their employers in the wake of SEC restatements. Still, most of these prior actions have involved allegations of improprieties by the CEO or CFO in question. In those cases, Section 304 was asserted as an ancillary claim, standing alongside more traditional securities causes of action, such as violations of Section 10(b) of the Securities and Exchange Act. Here, the SEC has taken the apparently unusual action of seeking standalone Section 304 reimbursement where the Commission does not allege that CEO or CFO participated in the wrongful conduct.

SEC complaint. The Section 304 compensation the SEC seeks reimbursement of was earned during the years following Arthocare’s filing of quarterly (Form 10-Q) and annual (Form 10-k) financial statements which were subsequently restated due to alleged fraud by two senior vice presidents of Arthrocare. The statements in question were filed in 2006, 2007, and the quarter ending March 31, 2008. The CEO and CFO were not alleged in the SEC’s complaint to have committed any conscious wrongdoing; rather, the SEC argued the defendants are required to reimburse Arthrocare simply because they were the CEO and CFO at the time (and thus signed the filings which subsequently required restatements).

The Commission pled the requisite elements of a Section 304 action, the court found. It was undisputed that Arthrocare had to file restatements for the periods in question. Those restatements were allegedly necessitated by the misconduct of the two senior vice presidents, which were plausibly attributable under agency principles to Arthrocare, the court stated. There was also no dispute that the CEO and CFO received Section 304 compensation (the cash bonuses, incentives, and equity-based compensation) within the time period covered by the complaint (within a year of the various Forms 10-k and 10-q which were subsequently restated).

Nevertheless, the CEO and CFO moved to dismiss the SEC’s complaint pursuant to FRCP Rule 12(b)(6) for failure to state a claim for which relief can be granted, arguing that either: (1) Section 304 cannot be construed as broadly as the SEC claims; in other words, to impose liability on CEOs and CFOs without any element of scienter, or (2) Section 304 is unconstitutional. They also raised a statutory defense based on the Civil Asset Forfeiture Reform Act (CAFRA).

Liability. Rejecting the defendants’ argument that the SEC could not impose liability on CEOs and CFOs without any element of scienter, the court stated that the text of the statute plainly contains no such additional requirements, and absent any ambiguity, the words of the statute itself are dispositive. Rather, SOX unambiguously requires CEOs and CFOs to reimburse the issuer for any qualifying compensation they receive within one year of a filing which the issuer is subsequently forced to restate due to misconduct by the issuer or its agents.

The only decision of which the court had been apprised that addressed the arguments made by the defendants here was SEC v Jenkins (DAriz 2010), where the SEC brought a Section 304 action in the absence of any misconduct by the defendant corporate officer. Jenkins persuasively rejected a similar attempt by the defendant officer in that case to read into the statute a requirement of misconduct by the officer, according to the court.

Moreover, there were good policy reasons to support the SEC’s broad interpretation of Section 304, the court wrote. The SEC’s pursuit of Section 304 relief is not solely intended to reimburse a company; it also furthers important public purposes as an enforcement mechanism that ensures the integrity of the financial market by preventing CEOs and CFOs from benefitting from profits they receive as a result of misstatements of their company’s financials. The legislative history of SOX also suggested that Congress specifically wanted to expand instances in which CEOs and CFOs are required to return certain profits beyond income attributable to a particular violation, the court concluded.

Limiting the scope of Section 304, as the defendants urged, would render it a meaningless act on the part of Congress, because the SEC’s power to seek equitable disgorgement of profits gained through wrongdoing pre-dates SOX by many years, the court pointed out. Thus, the court held that under Section 304, “reimbursement is required without any showing of wrongdoing by the CEO or CFO, and the amount or reimbursement is not limited to income attributable to the wrongdoing of others.” The court further found that this interpretation was consistent with both other SOX provisions and with securities laws generally. By requiring reimbursement, even in the absence of any wrongdoing, Congress was logically extending and expanding the regulatory scheme for publicly traded securities in reaction to the various accounting scandals which triggered the enactment of SOX; in contrast, the construction proposed by the defendants would render Section 304 redundant of existing civil and criminal securities fraud laws, reasoned the court.

The CEO and CFO also argued that Section 304 should be construed as some type of statutory disgorgement provision, equivalent to the long-standing common-law doctrine of equitable disgorgement. Significantly, the court pointed out, disgorgement on equitable grounds is generally limited to cases in which the officers themselves have engaged in wrongdoing. But the court agreed with the SEC in finding that: (1) Section 304 is a cause of action, not just a remedy, and (2) “reimbursement” has a different meaning—one not necessarily connected to misconduct—than “disgorgement.”

Constitutionality. Section 304 is constitutional on its face, the court ruled. The CFO and CEO were not members of any protected class, or otherwise shown fundamental rights are at stake, requiring a heightened level of scrutiny. Thus, rational basis review applied, and there was a rational basis for Section 304 in that it created a personal incentive for CEOs and CFOs to take their reporting and certification duties seriously. The court then rejected the first two of the defendants’ arguments that Section 304 is unconstitutional, finding that: (1) the text of Section 304 is not vague, and (2) the Excessive Fines Clause of the Eight Amendment was in applicable because Section 304 falls outside the Clause’s scope and only requires reimbursement to the issuer with no money forfeited to the government.

Further, the court rejected the defendants’ third argument that Section 304 is unconstitutional because it violates the Due Process Clause. Assuming arguendo that Section 304 reimbursement is a penalty, there is a reasonable relationship between the triggering conduct and the penalty, the court determined. By signing SEC filings, corporate officers are making solemn guarantees that they have carefully reviewed the filings for accuracy, and that such accuracy is underwritten by adequate controls. It is reasonable for Congress to impose a penalty when, as in this case, “corporate officers are asleep on their watch,” the court found. In addition, the degree of penalty is reasonable in that it is limited to bonuses, incentive-based pay, and stock-sales profits, with officers’ base salaries being outside the scope of Section 304. Congress also provided a safety valve by giving the SEC power to exempt corporate officers when appropriate.

Moreover, the SEC must file a lawsuit in federal court in order to force corporate officers to reimburse their employers under Section 304. “In such proceedings,” the court noted, “the officers have the full panoply of due process protections afforded civil defendants such as, to take a random example, the opportunity to test the adequacy of the SEC’s pleadings via long and complex Rule 12(b)(6) motions.”

CAFRA. The CAFRA, at 18 USC Section 983(d)(1), provides that: “an innocent owner’s interest in property shall not be forfeited under any civil forfeiture statute.” However, the court ruled that CAFRA is inapplicable to an action under Section 304. The U.S. Supreme Court has explained (in United States v Ursery (1996)) that civil forfeiture actions are in rem proceedings, whereas Section 304 plainly creates an in personam cause of action. That CAFRA is in fact limited to in rem actions is confirmed by its definition of innocent owner as being one who “did all that reasonably could be expected under the circumstances to terminate such use of the property.” (18 USC Section 983(d)(2)(A) (emphasis added by the court). This language is only logical in the context of in rem forfeiture proceedings, the court explained, noting that such forfeitures are justified because the owner permitted the property in question to be used for an illegal purpose. A Section 304 action, in contrast has nothing to do with property being put to an illegal purpose, but is instead directed at failure to comply with securities filing requirements.

To buttress its point, the court pointed out that Section 304 was passed about two years after CAFRA. If the defendants were correct in their assertion that CAFRA applies to Section 304 proceedings, then Section 304 would be meaningless because: (1) recovery of compensation from CEOs and CFOs who are not “innocent owners” is already provided for by various other provisions of SOX and the Securities and Exchange Act, and (2) such recovery, prior to Section 304’s enactment, was limited to wrongdoers, to whom CAFRA’s protection would be unavailable.

“Apologists for the extraordinarily high compensation given to corporate officers have long justified such pay by asserting CEOs take ‘great risks,’ and so deserve great rewards,” the court wrote in its conclusion. “For years, this has been a vacuous saw, because corporate law, and private measures such as wide-spread indemnification of officers by their employers, and the provision of Directors & Officers insurance, have ensured any ‘risks’ taken by these fearless captains of industry almost never impact their personal finances.” By enacting Section 304 of SOX, “Congress determined to put a modest measure of real risk back into the equation. This was a policy decision, and while its fairness or wisdom can be debated, its legal effect cannot. Section 304 creates a powerful incentive for CEOs and CFOs to take their corporate responsibilities very seriously indeed.”

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