Guest Column: Commission Alleges Violation of SOX 304

Nader H. Salehi is a partner and Elizabeth A. Marino is an associate with the law firm Bingham McCutchen LLP in New York.

Although the Securities and Exchange Commission (Commission) initially appeared hesitant to use section 304 of the Sarbanes-Oxley Act of 2002 (SOX 304) as a disgorgement tool,  now it appears to have fully embraced, if not expanded, the tool over the past year and a half.  The Commission is now seeking disgorgement, pursuant to SOX 304, from a former chief executive officer who is not accused of any misconduct, and in fact is not accused of violating any securities law except for SOX 304.  SOX 304 provides for disgorgement of certain bonuses, incentive or equity-based compensation and stock sale profits by the CEO and chief financial officer of an issuer that is required to restate its financial statements “due to the material noncompliance of the issuer, as a result of misconduct.”[1] The Commission’s initial utilizations of SOX 304 involved particularly egregious activities by those against whom it was seeking disgorgement – for example, where the alleged misconduct involved fraud by a CEO and CFO.

However, in Securities and Exchange Commission v. Maynard L. Jenkins, the Commission has broken new ground; it charged Maynard L. Jenkins, former Chairman and CEO of CSK Auto Corporation (CSK), with violating SOX 304 by not disgorging the bonuses and stock sale profits he earned during the period of CSK’s alleged misconduct.[2] The Commission did not, however, allege any misconduct, fraudulent or otherwise, by Mr. Jenkins.  In the Commission’s settled action with CSK, the Commission alleged that CSK, through several of its executives including its former chief operating officer and former CFO, engaged in a financial reporting fraud by filing false financial statements for the years 2002-2004.[3] CSK materially overstated its income for 2002-2004, which resulted in a first restatement in 2004 and a second restatement in 2007.  Mr. Jenkins was not charged with committing or facilitating CSK’s alleged financial reporting fraud.  In fact, the Commission has not charged with Mr. Jenkins with any securities laws violations besides a violation of SOX 304 (and that, for failure to disgorge his compensation).

Mr. Jenkins is the first CEO or CFO, who was not alleged to have been involved in the alleged misconduct, from whom the Commission has sought disgorgement under SOX 304.  In the absence of an underlying violation, it is unclear at what point the Commission will consider a person to have violated SOX 304.  In Jenkins, the Commission stated that “[Mr.] Jenkins has not complied, and has refused to comply, with the reimbursement requirements of [SOX 304].”[4] The Commission did not elaborate on what constituted Mr. Jenkins’ “refusal to comply” with SOX 304.

The Commission is essentially interpreting SOX 304 to have a strict liability standard.  Through Jenkins, the Commission is making clear that the CEO or CFO of an issuer that restates its financials due to “misconduct” anywhere within the company (a fact which almost always accompanies a misstatement) must voluntarily pay back to the issuer any bonuses, incentive based compensation and stock sale profits that they received during the relevant period.  If the CEO and/or CFO does not reimburse the company for such funds, they will be in violation of SOX 304 and subject to a securities law violation, even if they did not participate in or facilitate the misconduct.  It is unclear what facts the CEO and/or CFO must consider in reaching the conclusion that the requirement to repay such funds is triggered.

It is unclear if the Commission will be successful in litigating Jenkins. CSK entered into a settlement with the Commission, in which it neither admitted nor denied the allegations that it engaged in the alleged fraudulent financial reporting.  Furthermore, the issue of what constitutes the requisite misconduct is still open for interpretation.  The Commission will need to prove that CSK did engage in “misconduct,” and that such misconduct triggered the obligation to issue accounting restatements.  Neither of these elements is supported by the Commission’s settlement with CSK.  More importantly, the Commission needs to prove that their interpretation of SOX 304 is consistent with what Congress intended, and that has never been clear.

CEOs and CFOs are already subject to extraordinary regulatory and civil exposure due to the nature of their positions.  CEOs and CFOs must be able to rely on the information provided to them by their employees and agents in order to discharge the obligations of their positions.  Imposing a strict liability standard on CEOs and CFOs for misconduct that occurs within their companies resulting in accounting restatements exponentially increases such regulatory and civil exposure.

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[1] Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 15 U.S.C. § 7243 (2002).

[2] See Securities and Exchange Commission v. Maynard L. Jenkins, Case No. 2:09-cv-01510-JWS (D. Ariz., entered July 22, 2009).

[3] See In the Matter of CSK Auto Corporation, Securities Exchange Act Release No. 59973 (May 26, 2009).

[4] See Securities and Exchange Commission v. Maynard L. Jenkins, Case No. 2:09-cv-01510-JWS (D. Ariz., entered July 22, 2009).