SOX 304 Claw-back

Section 304 of the Sarbanes-Oxley Act provides that:

(a) 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

• 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
• any profits realized from the sale of securities of the issuer during that 12-month period.

Did you notice the glaring ambiguity? As I explained in The Complete Guide To Sarbanes-Oxley:

A wag might call this the “Baldwin Brothers” provision—i.e., cute but dumb. Here are just some objections: It preempts the board’s power over executive compensation. It fails to define the kinds of misconduct that trigger the reimbursement obligation. It requires reimbursement even if others committed the misconduct, with no good faith defense. All of which will tend to encourage CEOs and CFOs to resist restating flawed financial statements and/or to game the timing of their compensation and stock transactions relative to any such restatements.

Did you notice how I expected the ambiguity to be resolved?

That's right. It wasn't clear from the plain text of the statute whether misconduct by persons other than the CEO or CFO could result in the claw-back being applied to CEO/CFO compensation. Yet, I expected that the SEC eventually would take the position that misconduct by others could trigger the claw-back provision.

Indeed, the SEC has now taken precisely that position in SEC v. Jenkins (complaint here). (HT: John F. Savarese) 

CSK Auto Corporation was obliged to restate its financials due to massive fraud by a number of senior officers. CEO Maynard Jenkins, however, has not been charged with any misconduct. Wachtell Lipton attorney John F. Savaresen argues that:

The SEC’s decision to depart from its prior reasonable restraint in using Section 304 is a regrettable policy choice. Clearly, the SEC believes fraud occurred at CSK, but apparently can find no basis to assert that the CEO was culpable in it. The SEC has not even pursued any of the lesser charges that would be available against a blameworthy executive in these circumstances, such as a negligence-based administrative case. In these circumstances, it is difficult to discern what conduct by similarly situated CEOs the SEC may think this case will deter or encourage. It also remains to be seen whether a federal agency may constitutionally deprive a person who is not alleged to have violated any law of compensation that was lawfully received, particularly where the statute’s intended reach is ambiguous.

In response, let me play devil's advocate for a minute. During the 1990s, restating financials became commonplace. Some firms were notorious for taking incredibly aggressive accounting positions. When they were called out for it, they simply restated their financials and claimed the SEC and/or private claim was moot.

As illustrated by other provisions of SOX, such as the CEO and CFO certification rules, Congress concluded that too many CEOs and CFOs had simply turned a blind eye to misconduct by subordinates. A claw-back rule that essentially imposes strict liability on CEOs and CFOs for subordinate misconduct arguably provides a powerful incentive for CEOs and CFOs to ensure that the company's internal controls work. 

A related argument is that much corporate financial statement shenanigans during the 1990s appears to have been motivated by efforts to maximize the value of top manager's stock options and other forms of equity and incentive compensation. Or, at least, so Congress concluded. It's precisely those forms of compensation that section 304 targets. The CEO and CFO, one might argue, should not be allowed to benefit from misconduct by subordinates, whether or not the CEO or CFO was aware of the misconduct. Any other rule would perpetuate the incentive to turn a blind eye.

Critics of my argument might argue that strict liability will result in over-deterrence. But over-deterrence of what? What valuable conduct are we concerned about overly deterring? If we assume that in this context, under-deterrence would be more costly than over-deterrence, strict liability is preferable to negligence.

How about fairness, however? I've never been a big fan of strict liability. Where someone acted in good faith, I have real problems with imposing legal liability and the shaming sanctions that accompany it. Put another way, strict liability bugs me because it ignores moral culpability. CEOs and CFOs are not insurers of stockholders, obliged to compensate them for any loss the stockholders may suffer, but that's what strict liability under 304 makes them with respect to misconduct no matter how far down the organization chart it occurs.