Court rules clawback provision of SOX applies only when restatement actually filed

On December 12, 2008, U.S. District Judge Jean Hamilton (E.D. Mo.) ruled that the “clawback” provision of Section 304 of the Sarbanes-Oxley Act of 2002 only applies where an accounting restatement actually is filed.  The court found that it is not enough that an accounting restatement should have been filed because of a company’s material non-compliance with SEC financial reporting requirements.

Michael F. Shanahan, Sr.

The ruling came in the court’s order on a motion for summary judgment filed in SEC v. Shanahan.  As previously discussed here, Michael F. Shanahan, Sr., the former CEO of Engineered Support Systems, Inc., pleaded guilty in July 2008 to one charge related to backdating company options. He reportedly admitted to signing falsely dated stock option award letters.

Section 304 of SOX states:

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.

Shanahan sought summary judgment on the SEC’s claim against him demanding he repay bonuses or other incentive-based or equity-based compensation under Section 304.  He argued that the SEC could not prove a necessary element of Section 304, namely that Engineered Support was “required to prepare an accounting restatement,” and that Section 304 only applies where an accounting restatement actually was filed.

The SEC claimed that because Engineered Support’s 2002 financial statement contained material errors, restatement was required under general accounting principles, and thus Section 304 applied.

Judge Hamilton ruled, however, that:

The Eighth Circuit has never ruled on whether Section 304 requires the actual filing of restated accounting reports. In interpreting the statute, this Court must be guided by the rule that, “[c]ourts properly assume, absent sufficient indication to the contrary, that Congress intends the words in its enactments to carry their ‘ordinary, contemporary, common meaning.'” Pioneer Inv. Servs. Co. v. Brunswick Assoc. Ltd. Partnership, 507 U.S. 380, 388 (1993) (quoting Perrin v. United States, 444 U.S. 37, 42 (1979)). It is the opinion of this Court 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. See S. Rep. 107-205, p.53 (legislative history indicates Congress contemplated the statute’s applicability only in terms of “accounting restatements that result from material non-compliance,” rather than cases where there should have been an accounting restatement because of material non-compliance). See also 3B Sec. & Fed. Corp. Law § 13:58 (2d. ed) (finding the elements of a Section 304 action include that “the issuer must restate its financial statements”). The Court therefore will grant Defendant Shanahan’s Motion for Partial Summary Judgment, and dismiss the Commission’s claim under Section 304 of the Sarbanes-Oxley Act of 2002.

Read the court’s opinion in SEC v. Shanahan

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