Opinion

Alison Frankel

Texas judge: SEC can claw back CEO and CFO bonuses, options under SOX

By Alison Frankel
November 14, 2012

Huddled masses of the 99 percent, U.S. District Judge Sam Sparks of Austin, Texas, speaks for you. Here’s what Sparks had to say on Tuesday, at the end of a precedent-setting ruling that, under a provision of Sarbanes-Oxley known as Section 304, the Securities and Exchange Commission can force the CEOs and CFOs of companies that violated securities laws to surrender their bonuses and stock options: “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 judge wrote. “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. In enacting Section 304 of Sarbanes-Oxley, Congress determined to put a modest measure of real risk back into the equation.”

Those are strong words about the personal accountability of CEOs and CFOs, and Sparks backs them up by rejecting all of the challenges, including constitutional arguments, that the former top officials of a company called Arthrocare raised in the SEC’s so-called clawback suit under Section 304. The SEC is demanding that the Arthrocare officials, former CEO Michael Baker and former CFO Michael Gluk, return to the company the unspecified bonuses, stock options and stock-sale profits they received in 2006 and 2007 — even though Baker and Gluk were not involved in the accounting misconduct that forced Arthrocare to restate its financials in those years. The ruling marks the second time a federal judge has okayed an SEC clawback case against executives not involved in corporate wrongdoing, but, according to Sparks, it is the first time a court has considered arguments that the SOX clawback provision is unconstitutional.

I’ve previously written about the reluctance of federal prosecutors to bring criminal cases under Sarbanes-Oxley against CEOs and CFOs who certify financial reports that turn out to be materially false. Section 304 is a sort of civil analog to the criminal false certification law, imposing a financial penalty on corporate officials who certify inaccurate SEC filings. By demanding that they return bonuses and other incentive compensation to the company, the provision “creates an incentive for (officials) to be diligent in carrying out those (certification) duties,” the judge wrote, noting that Congress deliberately drafted the law to apply to officials who weren’t involved directly in cooking the books. “The absence of any requirement of personal misconduct is in furtherance of that purpose: It ensures corporate officers cannot simply keep their own hands clean, but must instead be vigilant in ensuring there are adequate controls to prevent misdeeds by underlings.”

The SEC had been, in Sparks’s words, “historically reluctant” to assert Section 304 clawback claims but has recently become more aggressive. Most of the cases, according to the judge, are still against execs implicated directly in corporate wrongdoing, but in the SEC’s newfound boldness, Sparks said, there have been a few clawback suits against the likes of Baker and Gluk, who are not accused of any kind of wrongdoing.

The two men, represented by Fenwick & West (for Baker) and Locke Lord (for Gluk) raised some interesting defenses in their motions to dismiss. In addition to asserting that the SOX provision requires proof of scienter — an argument already raised and rejected in a previous Section 304 clawback case in Arizona — Baker and Gluk said the clawback provision violates the Constitution’s Due Process and Excessive Fines clauses and is also an impermissible forfeiture under the Civil Asset Forfeiture Act.

In a tart, terse discussion, Sparks disagreed. He said Section 304 is a penalty for CEOs and CFOs who fail in their duty. Sarbanes-Oxley puts them on notice, he said, and the clawback provisions are not excessive. “(If) corporate officers are asleep on their watch, it is reasonable for Congress to impose a penalty,” he wrote. “The degree of penalty is reasonable too: it is limited to bonuses, incentive-based pay, and stock-sales profits.” The law on forfeitures, he added, simply does not apply to SOX clawbacks, which are not defined in the statute as civil forfeitures.

“Baker and Gluk should have been monitoring the various internal controls to guard against (accounting) misconduct,” Sparks said. “They signed the SEC filings in question, and represented they in fact were actively guarding against noncompliance. As such, they shouldered the risk of Section 304 reimbursement when noncompliance nevertheless occurred.”

Baker’s counsel, Jay Pomerantz of Fenwick, sent me an email comment on Sparks’s ruling. “An innocent executive should not be forced to forfeit his compensation because of the actions of others,” it said. “We believe that Section 304 requires a showing of misconduct by any executive whose compensation is to be forfeited. The SEC’s effort to penalize admittedly innocent executives violates constitutional principles of fairness and due process.” Gluk’s lawyer didn’t respond to an email request for comment.

The ruling on Tuesday was just on the defendants’ motion to dismiss, which means the SEC hasn’t won yet. Nevertheless, Sparks’s decision should strike fear in corporate CEOs and CFOs overseeing companies that stepped over the line: The risk is real, at least according to one Texas judge.

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