Section 304 claw backs: can negligence qualify as 'misconduct?'.

• Author: Cimino, Thomas P., Jr.
• Position: Legal Issue

By enacting the Sarbanes-Oxley Act of 2002, Congress sought to rein in rampant fraud following the well-publicized accounting scandals involving corporate giants Enron Corp., Global Crossing Ltd., WorldCom Inc. and Adelphi Communications Corp., among others.

Section 304(a), relates to accounting restatements a company issues as a result of "misconduct." This section requires the CEO and chief financial officer (CFO) to reimburse any bonus, incentive-based and equity-based compensation received--payments known as "clawback" claims. Section 304(b) of Sarbanes-Oxley grants the U.S. Securities and Exchange Commission (SEC) discretion to "exempt any person" from the application of Section 304(a) "as it deems necessary and appropriate."

The SEC's increased action of late relating to clawback claims has generated some concern--as well as some confusion--about what, exactly, qualifies as misconduct under Section 304(a) of Sarbanes-Oxley. Accordingly, corporations and their CEOs and CFOs should not only remain aware of activity with respect to clawback claims, but also devote appropriate internal and external resources for maintaining effective corporate internal controls to strengthen the defense against any potential claw-back claim by the SEC.

Evolving Enforcement and 'Innocent Executives'

The SEC largely ignored Section 304 between 2002 and 2009. When it did allege a clawback claim, it did so because a defendant personally engaged in alleged fraud or similar misconduct that led to the filing of a restatement. Then, in 2009, the SEC sought to expand its use of Section 304 when it sued Maynard Jenkins, former CEO of CSK Auto Corp. In filing this suit, the SEC did not allege that Jenkins violated securities laws or personally participated in any misconduct.

This and similar cases have come to be known as "innocent executives" cases. Through these cases the SEC has taken the position that--despite a host of constitutional and other legal challenges--personal misconduct by CEOs and CFOs is not a condition necessary to warrant a Section 304 clawback because the CEO or CFO was "driving the bus" while the misconduct occurred.

Even in the face of the SEC's expanded use of Section 304 against innocent executives, it is important to note that the SEC has never brought a Section 304 claim against an executive where the alleged triggering misconduct was anything less than intentional and pervasive accounting fraud. This, however, does not mean that the SEC...