New Ninth Circuit Case on SOX Clawback Leaves Unresolved Issues

Stay up-to-date with the latest developments in securities law through access to both news and all statutes and regulations. Find relevant corporate filings through a searchable EDGAR database. And...

Matthew J. O'Hara

By Matthew J. O'Hara

Matthew J. O'Hara, partner and business trial lawyer at Hinshaw & Culbertson LLP, Chicago, practices in commercial litigation and professional liability defense. In his practice, he represents corporate directors and officers and professionals in securities enforcement matters.

Section 304 of the Sarbanes-Oxley Act of 2002 requires public company chief executive officers and chief financial officers who certify financial statements to reimburse their companies for incentive compensation received during periods when the company later determined to restate prior financials because of misconduct. The Ninth Circuit recently became the first appeals court to decide whether this “clawback” statute applies when the misconduct was not that of the CEO or CFO but of lower level employees, holding in SEC v. Jensen, No. 14-55221 (9th Cir. Aug. 31, 2016), that it does.

Despite its seemingly broad sweep, Sarbanes-Oxley Section 304 has been the subject of relatively few judicial opinions, especially by reviewing courts that set precedent, since it was enacted in 2002. Many other important issues regarding SOX 304 remain undecided by the courts. One such issue, noted in a concurrence in Jensen, is what type of conduct constitutes “misconduct” within the meaning of the statute. There are a number of other issues relating to this important enforcement tool left open even after Jensen.

I. The Sarbanes-Oxley Clawback Statute

Section 304(a) of Sarbanes-Oxley provides as follows:

  • 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.

15 U.S.C. §7243(a). Cases from the district courts show that ambiguities continue to lurk in nearly every phrase in this statute.

II. The Ninth Circuit Decision in Jensen

In Jensen, the district court ruled in favor of the CEO and CFO of a public company, Basin Water, Inc., after a trial on the SEC's claims to force a clawback by Basin from its executives. The trial court “held that SOX 304 requires CEOs and CFOs to disgorge incentive- and equity-based compensation if their companies issue an accounting restatement because of the the officers' own misconduct, but not if the restatement was issuer misconduct in which the officers were not involved.” Jensen, slip op. at 4. The Ninth Circuit disagreed, reversing and remanding – becoming the first court of appeals to decide a question previously addressed only by several district courts. “[W]e hold that SOX 304 allows the SEC to seek disgorgement from CEOs and CFOs even if the triggering restatement did not result from misconduct on the part of those officers.” Jensen, slip. op. at 28. The court expressly followed district court opinions that reached the same conclusion. See SEC v. Baker, Case No. A-12-CA-285-SS, 2012 WL 5499497, at *5-7 (W.D. Tex. Nov. 13, 2012); SEC v. Geswein, No. 5:10CV1235, 2011 WL 4541303, at *3 (N.D. Ohio Sept. 29, 2011); SEC v. Jenkins, 718 F. Supp.2d 1070, 1072 (D. Ariz. 2010); SEC v. Life Partners Holdings, Inc., 71 F. Supp.3d 615, 625 (W.D. Tex. 2014); see also SEC v. Microtune, Inc., 783 F. Supp.2d 867, 886-87 (N.D. Tex. 2011). The Ninth Circuit concluded that the remedy of “reimbursement” in the statute is an equitable remedy of disgorgement and is not legal in nature. Jensen, slip. op. at 28.

The Ninth Circuit thus placed its approval on a draconian reading of the reach of the statute by holding that it may be employed to claw back large amounts paid to top executives who engaged in no wrongdoing.

Judge Carlos Bea concurred, but wrote to address several other issues, including “what qualifies as ‘misconduct’ as necessary to trigger disgorgement under SOX 304….” Jensen, slip. op. at 41-42. Judge Bea then explained that in his view, “‘misconduct’ requires an intentional violation of a law or standard (such as GAAP) on the part of the issuer, which can be shown by evidence that any employee (not only the CEO or CFO), acting within the course and scope of that employee's agency, intentionally violated a law or standard.” Jensen, slip op. at 42. Thus, what the Ninth Circuit gave with one hand, the concurrence might partly take back, in that not all restatements of financial statements involve scienter.

III. Some Unresolved Issues After Jensen

It is important to bear in mind that the Ninth Circuit has had only the first word among reviewing courts on the question of whether any misconduct must be that of the CEO or CFO. But even accepting its conclusion on this point, the concurring opinion in Jensen only scratches the surface of how to interpret open issues involving a now fourteen-year-old statute that seemingly gives the SEC very broad enforcement powers. Here are some of those issues:

A. What is “Misconduct”?

As an initial matter, the SEC may well continue to contend for a less stringent standard than that urged by the concurrence in Jensen. The term “misconduct” arguably embraces conduct performed with states of mind states less culpable than scienter. For purposes of securities fraud, the term scienter has been defined as intent to deceive, manipulate, or defraud, while the term “misconduct” has been more broadly defined as “dereliction of duty” or “unlawful or improper behavior.” SeeErnst & Ernst v. Hochfelder , 425 U.S. 185, 193 (1976) (defining scienter); Sabella v. Scantek Med., Inc., Case No. 08 CIV 453(CM)(HBP), 2009 WL 3233703 (S.D.N.Y. Sept. 25, 2009) (defining misconduct); Black's Law Dictionary (defining both terms). These definitions of “misconduct” suggest that misconduct does not require intent. Other courts of appeal may follow this tack.

If the concurring opinion is accepted on this point, a whole host of agency-related questions arise about whether the conduct of an employee who acts with scienter can be attributed to the issuer. According to Jensen, “it is the issuer's misconduct that matters….” Jensen, slip op. at 26. Issuers are corporations who can only act through their human agents. In that vein, in Jenkins, the district court held that “the plain language of the statute indicates that the misconduct of corporate officers, agents or employees acting within the scope of their agency or employment is sufficient misconduct to meet this element of the statute.” 718 F. Supp.2d at 1074-75 (emphasis added).

Some district court cases have addressed the “misconduct” requirement. In SEC v. Mercury Interactive, LLC, Case No. C 07-2822 JF (RS), 2009 WL 2984769 (N.D. Cal. Sept. 15, 2009) (“ Mercury Interactive II”), the court indicated that the misconduct that triggers application of Section 304 is the company's “filing of the inaccurate annual and quarterly financial reports,” not the underlying transactions that were misstated in the financial statements. In that case, the SEC brought a clawback claim against Mercury Interactive's CEO and CFO after it restated its financial statements for 2002-2004 due to a stock option backdating scheme. The SEC had alleged that the CEO and CFO participated in, and benefited from, the issuance of the backdated options that were inaccurately recorded in the company's financial statements. SEC v. Mercury Interactive, LLC, Case No. C 07-2822 JF (RS), 2008 WL 4544443, *2 (N.D. Cal. Sept. 30, 2008) (“ Mercury Interactive I”).

Mercury Interactive's officers moved to dismiss the Section 304 claim, arguing that Sarbanes-Oxley did not apply because the last in-the-money options were issued before its enactment on July 30, 2002 and federal statutes are presumed not to apply retroactively. Mercury Interactive II, 2009 WL 2984769, at *5-6. But the court found that the relevant misconduct was not “granting in-the-money stock options,” but rather the “the failure to [accurately] record and report the compensation expense associated with the granting of such options.” 2009 WL 2984769, at *6. Because the issuance of the incorrect financial statements occurred after Sarbanes-Oxley's enactment, the SEC's claim did not require the act to be applied retroactively, and the misconduct requirement was met.

Consistent with the concurrence in Jensen, “misconduct” under Section 304 should not include GAAP violations and financial misstatements for which the issuer (as a result of the conduct of its agents acting within the scope of their agency) bears no sense of culpability. It is black letter law in the context of securities fraud that “[a]llegations of a violation of [GAAP] or SEC regulations, without corresponding fraudulent intent [on the part of the issuer], are not sufficient to state a securities fraud claim.” Chill v. General Elec. Co., 101 F.3d 263, 268 (2d Cir. 1996).

Whether an issuer engaged in intentional misconduct within the meaning of the Jensen concurrence raises the thorny question of when an agent's conduct can be imputed to the corporation. Under Delaware law, an employer or principal is liable for the fraud of an agent even though the fraud was committed without the knowledge, consent or participation of the principal “if the act was done in the course of the agent's employment and within the apparent scope of the agent's authority.” Vichi v. Koninklijke Philips Elecs., N.V., 85 A.3d 725, 798-99 (Del. Ch. 2014). An employee acts with “apparent authority” if the employer leads a third party to reasonably believe the employee has authority to act on behalf of the employer as a result of the employer's manifestations. Id. at 799.

An exception to the general rule that an agent's knowledge and conduct can be imputed to his principal arises when the agent's own interests become adverse to the principal's interests. See, e.g., Penn Mut. Life Ins. Co. v. Norma Espinosa 2007-1 Ins. Trust, Case No. C.A. 09-300-JJF, 2010 WL 3023402, *3 (D. Del. July 30, 2010); see also Restatement (Third) of Agency §5.04 (2006) (“notice of a fact that an agent knows or has reason to know is not imputed to the principal if the agent acts adversely to the principal in a transaction or matter”). Moreover, “A principal should not be held to assume the risk that an agent may act wrongfully in dealing with a third party who colludes with the agent in action that is adverse to the principal.” Id.

“When corporate fiduciaries have a self-interest in concealing information—such as the falsity of the financial statements that they had helped prepare—their knowledge cannot be imputed to the corporation,” at least in litigation by the corporation against the faithless fiduciary. In re HealthSouth Corp. Shareholders Litig., 845 A.2d 1096, 1108 n.22 (Del. Ch. 2003), aff'd,847 A.2d 1121 (Del. 2004). In most states, the adverse-interest exception requires that the agent act solely in his own interest and entirely against the principal's interest. The court in Penn Mutual noted that the weight of authority indicates that the exception does not apply if “the principal itself can be thought to have benefited from the agent's fraudulent schemes, even if those benefits turned out to be short-lived.” Penn. Mut., 2010 WL 3023402, at *4. Further, courts have declined to apply the adverse-interest exception if “the agent's actions benefit or are motivated to benefit, at least in part, the principal.” Id.

This issue of imputation of a person's conduct to an issuer of securities becomes more complicated when we consider that many issuers present consolidated financial statements on behalf of multiple subsidiaries. Fraudulent intent on the part of a subsidiary's officers is insufficient to hold the parent liable for securities fraud. The “parent-subsidiary relationship is not on its own sufficient to impute the scienter of the subsidiary to the parent. Instead, plaintiffs must demonstrate that the parent or affiliate possessed some degree of control over, or awareness about, the fraud.” Valentini v. Citigroup, Inc., 837 F. Supp. 2d 304, 317 (S.D. N.Y. 2011); see also Higginbotham v. Baxter Int'l, Inc., 495 F.3d 753, 757 (7th Cir. 2007) (where parent restated financial statements due to fraud by employees of a foreign subsidiary, court dismissed securities fraud suit against parent because plaintiffs failed to allege facts showing that parent's management knew of the subsidiary's fraud); Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702, 711 (7th Cir. 2008) (reading Higginbotham as holding that where fraud is committed at the issuer's subsidiary, plaintiffs must show that the issuer's management knew about the fraud to establish scienter for purposes of securities-fraud claim).

In sum, the question of what is “misconduct” under SOX 304 remains a question on which reviewing courts have yet to speak. The concurrence in Jensen on this point is not necessarily consistent with the views of several trial courts or of the SEC. Apart from the disputed question of whether a mental state is required for misconduct, and what that mental state is, thorny factual issues may pose barriers to the SEC in imputing misconduct of company agents to CEOs and CFOs who themselves engaged in no wrongdoing.

B. What it Mean to be Required to Prepare an Accounting Restatement?

One of the elements of a Section 304 enforcement claim is that the issuer was “required to prepare” an accounting restatement. While this fact may be incontrovertible in many circumstances, this is not always the case. One reported case has addressed this requirement. In that case, the issuer had not actually restated its financial statements for the period in which the SEC was seeking reimbursement from the issuer's CEO. SEC v. Shanahan, 624 F. Supp.2d 1072, 1077-78 (E.D. Mo. 2008). The SEC contended that because those financial statements contained material errors, restatement was required and Section 304 applied. Id. at 1078. The court held that “the ordinary, contemporary, common meaning of Section 304 is that, before penalties may be imposed, an issuer must be compelled or ordered to prepare a financial restatement, and must actually file the restatement.” Id. Accordingly, the court dismissed the SEC's Section 304 claim. Id. No court of appeals has addressed this component of the statute.

Construing the phrase “required to prepare” may be important when financial statements may be in error but for some reason the auditors did not require restatement, or where auditors' views are ambiguous about the need to restate but an issuer, in the exercise of prudence, decides in any event to restate.

C. Who Is an Issuer?

At first blush, the question of who is an issuer seems very straightforward. But two district court cases reveal that a company's status as an issuer under SOX 304 is not always straightforward. These cases considered the issue of whether the SEC can pursue reimbursement on behalf of companies that were but are no longer publicly held.

An “issuer” under Sarbanes-Oxley is a company that (in the present tense) has registered securities or that is required to file reports with the SEC or has filed a registration statement that has not yet become effective. 15 U.S.C. §7201(a)(7). Similarly, an issuer under the Securities Exchange Act of 1934 is the company that issued the security, and not a parent or subsidiary. 15 U.S.C. §78c(a)(8); Gollust v. Mendell, 501 U.S. 115, 123 (1991).

In Jenkins, the issuer, CSK Auto Corporation, restated its financial statements in 2004 and in 2007. 718 F. Supp.2d at 1072-73. In July 2008, CSK became a wholly-owned subsidiary of another company and deregistered its stock. Id. The SEC did not file its enforcement action until 2009, and the CEO argued that he could not be compelled under Section 304 to reimburse CSK because it was no longer an issuer. Id. at 1079. The district court rejected this argument, explaining as follows:

  • Because Section 304 refers to a specific time and action – filing restatements as a result of financial-reporting misconduct – the statutory term “issuer” refers to the entity that issued stock at that time. Once this liability triggering event has been established by reference to the “issuer” at the relevant time, then the SEC may bring an enforcement action under Section 304. Merely because CSK does not now have any registered securities does not mean that CSK was not an issuer as it relates to legal rights and responsibilities accruing to CSK during the time period that it was subject to such regulation.

Id. The court went on to note that the acquirer would succeed to CSK's right to receive the money. Id.

The same scenario and the same argument were addressed by another district court later the same year. SEC v. Mercury Interactive, LLC, Case No. 5:07-CV-02822-JF/PVT, 2010 WL 3790811, *5 (N.D. Cal. Sept. 27, 2010) (“ Mercury Interactive III”). In that case, the issuer at the time of the restatement, Mercury Interactive, was acquired by a public company, Hewlett Packard Company, and became a non-trading subsidiary of Hewlett Packard. Id. The court agreed with the reasoning in Jenkins.Id. The court also added, “to the extent that [the CEO] argues that permitting a §304 claim might result in a ‘windfall’ to Hewlett Packard, the Court concludes that in the event liability arises under §304 Hewlett Packard is a more appropriate recipient than a wrongdoer adjudged liable under the statute.” Id.

SOX 304 does not provide that reimbursement may be made to anyone other than to an issuer – such as the successor to an issuer. While reading Section 304(a) to apply only where the company remains an issuer at the time of filing suit may seem like an overly technical reading of the statute, the Supreme Court has said in the context of another “strict liability” statute under the Exchange Act that “we have been reluctant to exceed a literal, ‘mechanical’ application of the statutory text in determining who may be subject to liability, even though in some cases a broader view of statutory liability could work to eliminate an ‘evil that Congress sought to correct through §16(b).’” Gollust, 501 U.S. at 122 (quoting Reliance Elec. Co. v. Emerson Elec. Co., 404 U.S. 418, 425 (1975)).

The SEC and the district courts confronting the question of whether a formerly public company is an issuer for purposes of SOX 304 thus far clearly take the view that being a public company at a time when misstated financials were issued is sufficient to trigger reimbursement. Nevertheless, where companies go private or acquired, serious arguments and policy concerns remain about whether the SEC can and should be able to seek such a remedy.

D. Is a Causal Link Between the Misconduct and the Incentive Compensation Required?

Typically, courts assess disgorgement or penalties in response to the conduct of the person who is the subject of the enforcement action. SOX 304, however, may be read to suggest that reimbursement by the CEO and CFO is mandatory (absent exemption by the SEC) whenever a restatement was required as a result of misconduct. The Ninth Circuit in Jensen did not explicitly address the causation requirement.

Several district court opinions stand for the proposition that neither wrongdoing by the executive nor a causal connection between the misconduct and the executive's incentive compensation are required. According to these courts, the SEC can claw back the full amount of an executive's incentive compensation, regardless of fault and regardless of whether the compensation was increased due to the misconduct. Baker, 2012 WL 5499497, at *5-7; Microtune, 783 F. Supp.2d at 886-87; Jenkins, 718 F. Supp.2d at 1072.

The Ninth Circuit's holding in Jensen that reimbursement under SOX 304(a) is an equitable remedy of disgorgement may operate to restrain the SEC in the amounts that it can seek. This is because disgorgement must reasonably approximate profits causally connected to the violation. SEC v. First City Fin. Corp., 890 F.2d 1215, 1231 (D.C. Cir. 1989). “Equity requires only that a defendant give up [his] unjust enrichment.” Rowe v. Maremont Corp., 850 F.2d 1226, 1241 (7th Cir. 1988) (emphasis in original).

The broadest conclusions reached by the federal trial courts in Baker, Microtune, and Jenkins as to causal connection are undermined if SOX 304(a) is a disgorgement remedy. Even Jensen may not sweep as far as the SEC might like, in that the SEC may well still have to prove as part of a disgorgement analysis that incentive compensation would not have been awarded but for any misconduct within the company that filed misstated financial statements. It may not be enough that there was simply a restatement and the top executives received incentive compensation during the restated periods.

E. What is the Clawback Period?

SOX 304 is drafted in ways that often present a myriad of factual and legal issues to counsel in an investigation or enforcement action under the statute. One such issue is how to construe the phrase “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” to determine the clawback period. See 15 U.S.C. §7243(a)(1). This problem rises to the fore particularly when there were multiple periods were restated.

In the Mercury Interactive litigation, the district court issued several opinions dealing with what triggers the 12-month clawback period under Section 304. Mercury Interactive issued backdated stock options in April 2002, before Sarbanes-Oxley was enacted. In August 2002 and March 2003, Mercury filed a quarterly statement and an annual statement that understated compensation expenses because the stock options were recorded at the stock price prevailing on the false back-date instead of the actual grant date. The defendants argued that Sarbanes-Oxley did not apply because the misconduct at issue was the back-dating of the stock options which occurred before Sarbanes-Oxley's enactment. The court disagreed, finding that the misconduct subject to Sarbanes-Oxley was the filing of financial statements that understated Mercury's compensation expenses due to the backdated options. Mercury Interactive II, 2009 WL 2984769, at *6.

The Mercury Interactive defendants further argued that the August 2002 quarterly report (for the second quarter) was the “first public issuance or filing” embodying the financial reporting requirement, and that the clawback applied only to compensation received in the 12 months following its filing. The SEC argued to the contrary that the officers were “responsible for repayment of all bonuses and stock sales” in the year following each annual and quarterly financial statement. The court agreed with the defendants that a new clawback period was not triggered by subsequent filings of the same misstated financial information – because those filings were not the “first” public issuance of that information. Id. The court dismissed the Section 304 claim, ordering the SEC to plead additional details about the “first public issuance or filing” that triggered the clawback period. Id. at *6-7.

After the SEC amended the complaint, it sought to claw back compensation during the 12-month period following the issuance of each misstated quarterly and annual report. Mercury Interactive III, 2010 WL 3790811, *4. The officers renewed their motions to dismiss, arguing that the accounting restatement was necessitated by the general requirement to record compensation expenses consistent with GAAP, and the “first public issuance or filing” embodying this requirement was the 2Q 2002 quarterly statement. The court agreed with the company officers on this issue. The SEC then argued that “because separate reporting requirements compel the filing of both quarterly and annual reports, see Securities Exchange Act Rules 13a–1 (annual reports) and 13a–13 (quarterly reports),” the first annual report to misstate material information will trigger a separate 12-month period – even if it is filed after the first quarterly report that misstates material information. The court agreed with the SEC on this score. Id. at *5.

In 2011, the district court certified for interlocutory appeal its order finding that under Section 304 “any reporting requirement under the securities laws” included the issuer's obligations to file annual and quarterly statements, and was not instead limited to the requirement to file GAAP-compliant financial statements. SEC v.Mercury Interactive, LLC, Case No. 5:07-CV-02822-JF, 2011 WL 1335733 (N.D. Cal. Apr. 7, 2011) (“ Mercury Interactive IV”). The Ninth Circuit denied the defendants' petition for leave to appeal.

In another case after the Mercury Interactive line of cases, in an appeal from a jury trial of an enforcement action against a CFO, a district court had found that a one-year clawback period began with the filing of each successive annual financial statement. SEC v. Jasper, 678 F.3d 1116, 1130 (9th Cir. 2012). On appeal, the defendant did not apparently challenge this finding, and therefore the Ninth Circuit did not address the question. Id. The court did not discuss the Mercury Interactive cases.

These cases show that there is room for debate under SOX 304 as to whether the SEC can seek clawbacks for more than one accounting period when multiple periods are restated, and as to the date that should be used to determine the first public issuance or filing of misstated financials. How these questions are answered can have a dramatic impact in particular cases in calculating incentive compensation subject to reimbursement.

IV. Conclusion

The Ninth Circuit's opinion in Jensen was a milestone in the development of SOX 304 jurisprudence. Whether other courts of appeal will agree with its conclusion that misconduct by CEOs and CFOs is not required to trigger a right to seek reimbursement from them in an enforcement action remains to be seen. The question of whether scienter is required by an issuer to trigger such a right, as addressed by the concurrence in Jensen, is at some tension with previous district court opinions and perhaps with the approach to be taken by the SEC's Enforcement Division. These two issues aside, reviewing courts have yet to decide many other issues relating to the construction of a statute that has been on the books since the days of the Enron scandal and that the SEC believes grants it very broad powers. If the SEC moves to aggressively pursue enforcement actions under SOX 304 against top executives who engaged in no misconduct themselves, these issues will be in play in future cases.

Copyright © 2016 The Bureau of National Affairs, Inc. All Rights Reserved.

Request Securities & Capital Markets on Bloomberg Law