Claw-Backs under SOX 304

In 2002, Congress passed the Sarbanes-Oxley Act (SOX) in an effort to increase the accuracy of financial reporting and to restore investor confidence in the truthfulness and dependability of public disclosures made by issuers. Section 304 is one of the key enforcement provisions included in SOX and allows the SEC to claw-back executive compensation when an issuer files documents that materially misstate its financials. Specifically, SOX 304 provides that if, as a result of misconduct, it is necessary for an issuer to file an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, the chief executive officer and the chief financial officer shall reimburse the issuer for any bonus or other incentive or equity based compensation received within the 12-month period after a misstated financial statement had been filed, as well as any profits realized from the sales of securities of the issuer during that 12-month period.

From 2002 until 2009, claw-back actions brought by the SEC under SOX 304 only involved CEOs and CFOs who were charged with violating securities laws and alleged to have been primary actors in the misconduct that led to the filing of misstated financials. In 2009, however, the SEC began broadening its interpretation of the scope of SOX 304 and started seeking to claw-back compensation from CEOs and CFOs who were not accused of participating in the underlying misconduct. The SEC asserted that even though innocent of any wrongdoing, these executives were liable under SOX 304 because of their position with the issuer when the fraudulent accounting occurred.

CSK Auto Corporation

In early 2009, the SEC initiated its first enforcement action in which it sought a clawback from an executive who, by the SEC's own admission, had not participated in the underlying misconduct. The case involved CSK Auto Corporation (CSK) and its CEO, Maynard Jenkins. In 2004, CSK twice restated its financial statements for fiscal years 2002 through 2004. These restatements were prompted by CSK's treatment of a practice known as vendor allowances. Under this practice, in exchange for CSK marketing vendors' products, vendors would pay CSK allowances at fixed amounts or as a percentage of the goods CSK purchased from the vendor. These allowances were used to lower the cost of the products sold at CSK's stores and generally lowered CSK's cost of goods sold, thereby increasing pre-tax income. Under GAAP, uncollected vendor allowances are written off as an unpaid receivable, but CSK applied later paid vendor allowances to prior years and failed to correctly account for vendor allowances paid back to vendors. This practice, which CSK referred to as "filling the bucket," resulted in CSK overstating its pre-tax income in fiscal 2002 by $11 million, or 47 percent, in fiscal year 2003 by $34 million, resulting in the reporting of pre-tax income instead of loss, and in fiscal 2004 by $21 million, or 65 percent.

In response to these financial misstatements, CSK terminated its CFO, COO and controller, as well as the director of its vendor allowance program. In addition, the SEC initiated charges against all four of these individuals, alleging in its March 5, 2009, complaint that the defendants had "orchestrated a multi-million dollar accounting scheme to inflate the company's financial results and overstate its net income in 2002 through 2004." Although Jenkins was neither terminated by CSK nor personally charged by the SEC with respect to any of CSK's misconduct, the SEC filed a complaint asserting that he had violated the claw-back provision of SOX 304 because he had failed to reimburse CSK for the incentive based compensation and profits he received from selling CSK stock in the 12 months after the filing of the misstated financials.

Beazer Homes USA, Inc.

A similar case involving Beazer Homes USA, Inc. (Beazer) was brought in August 2011, when the SEC filed a complaint against Beazer's former CFO, James O'Leary, for failure to reimburse Beazer for incentive compensation and stock sale profits he received after it was discovered that the company had committed accounting fraud. Beazer had, on multiple occasions, misstated its net income in its quarterly and annual earnings reports from 2002 through 2006. Specifically, Beazer's senior vice president and chief accounting officer, Michael T. Rand, supervised a reserve accounting scheme under which reserves for certain future homebuilding expenses were improperly established, inflated and/or maintained in order to artificially increase the income and earnings reported for fiscal year 2006. Additionally, Rand instituted a scheme through which Beazer recognized millions of dollars in revenues and operating income that would not have been recognized under GAAP.

These practices resulted in Beazer having to restate its financial statements for various years including 2006. In connection with this accounting fraud, the SEC charged Rand with conducting a multi-year fraudulent earnings management scheme but did not personally charge O'Leary with the underlying misconduct. Nevertheless, because O'Leary was CFO of Beazer when the financial fraud had taken place, the SEC, utilizing SOX 304, sought reimbursement of all incentive and equity-based compensation and stock sale profits that O'Leary realized during the year following the filing of the misstated financials.

The Court Weighs In

In 2010, while the enforcement actions against Jenkins and O'Leary were active, Jenkins filed a motion to dismiss the SEC's claim with the United States District Court for the District of Arizona. Jenkins argued that the SEC could only use SOX 304 to claw back executive compensation if a CEO or CFO was involved in the underlying misconduct that forced a company to restate its financials. In denying Jenkins's motion to dismiss, the Court held that SOX 304 "require[s] only the misconduct of the issuer, but do[es] not necessarily require the specific misconduct of the issuer's CEO or CFO... [T]he plain language of the statute indicates that 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."

Discord at the SEC?

Following the denial of his motion to dismiss, Jenkins and the SEC staff entered into settlement discussions. In March 2011, the SEC advised the Court that, subject to the approval of the SEC Commissioners, a settlement had been reached between Jenkins and the SEC staff for approximately $4.1 million. This represented the full amount of bonus compensation and stock sale profits that Jenkins had received during the relevant period. The SEC Commissioners, however, rejected this settlement. Many commentators believe that this rejection was due to internal conflict within the SEC over whether SOX 304 should be used as a no-fault enforcement mechanism against CEOs and CFOs and, if so, to what degree their compensation should be clawed-back. On Nov. 15, 2011, the SEC announced that the SEC Commissioners had approved a settlement with Jenkins in which he agreed to return only $2.8 million in bonus compensation and stock sale profits he received in the 12 months following CSK's filing of misstated financials.

In contrast, O'Leary's settlement agreement was approved by the SEC Commissioners on Aug. 30, 2011, with O'Leary agreeing to return approximately $1.4 million to Beazer. This settlement represented the entire amount that the SEC could have required O'Leary to reimburse Beazer under SOX 304. The relative timing of and inconsistent approaches taken in these two cases suggest that there may be continuing disagreement within the SEC over the appropriate scope of reimbursements sought under SOX 304 in no-fault cases.

Increasing Concerns Under Dodd-Frank

The use of SOX 304 as a no-fault enforcement mechanism against CEOs and CFOs has received significant attention both within and outside of the SEC. While the enforceability of such an action may have initially been in doubt, the decision of the District Court in Arizona to deny Jenkins' motion to dismiss and the successful settlements ultimately reached with Jenkins and O'Leary have established a firm basis for no-fault claw-backs under SOX 304. This increase in the scope of the SEC's enforcement power under SOX 304 and soon-to-be enacted Dodd-Frank Act provisions indicate that the trend towards no-fault claw-backs is likely to continue.

Under Section 954 of the Dodd-Frank Act, issuers must adopt policies that require any current or former executive to reimburse the company for incentive-based compensation (including stock options awarded as compensation) received during a three-year period preceding the date that restated financials were required to be filed as a result of the issuer's material noncompliance with any financial reporting requirement under the securities laws. The executive is required to return any excess of the incentive compensation actually received over what would have been received under the accounting restatement.

There are four key features that distinguish Section 954 of Dodd-Frank from SOX 304:

  1. Liability under Section 954 of Dodd-Frank applies to any current or former executive officer of the issuer, not just the CEO or CFO;
  2. Section 954 of Dodd-Frank allows an issuer to be reimbursed for the three-year period preceding the financial restatement, whereas SOX 304 only applies to the 12-month period after the filing of misstated financials;
  3. Section 954 of Dodd-Frank does not require that misconduct occur in order to impose liability; and
  4. Section 954 of Dodd-Frank only requires repayment of incentive based compensation and not profits realized from the sale of the issuer stock as is the case with SOX 304.

Section 954 of Dodd-Frank, explicitly, and SOX 304, through SEC and judicial interpretation, both allow for no-fault claw-backs of executive compensation. While they differ in the types of compensation that can be recovered and the time period for which an issuer will be entitled to reimbursement, together they represent a significant increase in the potential exposure for executives of issuers that restate their financial statements. In light of the SEC's growing tendency to seek executive claw-backs under SOX 304 and given the expansion of this power under Section 954 of Dodd-Frank, executives should be increasingly dedicated to developing, maintaining and monitoring effective internal controls in order to avoid restatement of financials and the resulting severe monetary penalties.

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