SEC Position on SOX 304 Clawbacks Adopted by Ninth Circuit

Under Section 304 of the Sarbanes Oxley Act the Commission can seek to clawback certain discretionary CEO and CFO compensation and trading profits if there is a restatement of the issuer’s financial statements based on wrongful conduct. The SEC has repeatedly argued that the CEO and CFO need not have been involved in the wrongful conduct which lead to the restatement of the firm’s financial statements to be subject to a SOX clawback. The SEC’s position has been repeatedly sustained in the district courts. SEC v. Jensen, No. 14-55221 (9th Cir. Decided August 31 2016) is the first circuit court decision adopting the Commission’s position.

The SEC brought suit against Peter Jensen and Thomas Tekulve, respectively, the former CEO and CFO of Basin Water, Inc. After both executives left the company in 2008, the firm restated its financial statements for 2006 and 2007 based on accounting improprieties. The SEC filed suit, alleging a financial fraud involving the two former executives. The complaint alleged in part violations of Exchange Act Rule 13a-14 regarding certification and sought a clawback under SOX Section 304.

The district court granted partial summary judgment in favor of defendants on the Rule 13a-14 claims, holding that the Rule did not provide a cause of action. Following a bench trial the court found in favor of the defendants. The district court also concluded that the two executives were not subject to SOX 304 clawbacks since neither was a fault. The ninth circuit reversed on the Rule 13a-14 claims as well as those under Section 304.

First, Rule 13a-14 requires that for every report filed under Section 13(a) each principal executive and financial officer of the issuer execute a certification as to the accuracy of the financial statements within the report. Defendants argued that the rule creates a claim against CEOs and CFOs who fail to execute the certification, not for those who do sign but where the certificates are false.

The court disagreed. Signers of documents are responsible for the statements in the documents. The signing of the document is not a simple formality. To the contrary it signifies that the signer has read the document and attests to its accuracy. The plain language of the rule, which uses the word “certify,” supports this conclusion. Indeed, other circuits have read rules promulgated under Section 13 to require truthfulness. It is thus not enough for the CEO and CFO to sign the document. Rather, they must certify that it includes no material misstatements or omissions.

Second, the court rejected the finding of the district court that the executives were not liable under Section 304 because neither was involved in the wrongful conduct. In this regard the SEC argued that “SOX 304 is concerned not with individual misconduct on the part of the CEO and the CFO, but rather with the misconduct of the issuer.” (emphasis original).

The SEC’s interpretation of SOX 304 is consistent with the plain language of the Section. It provides in part 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 . . .” certain incentive based or equity based compensation.

The SEC’s position is also consistent with the history of the Section, the court found. The legislative reports echoed then President George W. Bush’s “recommendations that CEOs or other officers should not be allowed to profit from erroneous financial statements, and that CEO bonuses and other incentive-based forms of compensation should be disgorged in cases of accounting restatement and misconduct.” (internal citations omitted). Thus, while no other circuit court has addressed the question, most district courts that have examined the issue have adopted the SEC’s position. The court thus held that “SOX 304 allows the SEC to seek disgorgement from CEOs and CFOs even if the triggering restatement did not result from the misconduct on the part of those officers.”

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