Securities and Exchange Commission Is Showing Its Claws With an Increased Focus on Recouping Executive Compensation

• Publication year: 2023

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Scott F. Mascianica and Javan Porter ^*

In this article, the authors provide an overview of the compensation clawback provision within Section 304 of the Sarbanes-Oxley Act of 2002, a brief history of the Securities and Exchange Commission's use of the provision, and key applicability considerations.

The government's focus on clawbacks is at a fever pitch. At the Practicing Law Institute's recent "SEC Speaks" conference, ¹ senior officials within the Division of Enforcement of the Securities and Exchange Commission ("SEC") emphasized the agency's increasing use of the executive compensation clawback provision under the Sarbanes-Oxley Act of 2002 ("SOX").

This comes on the heels of the SEC—once again—reopening comment ² on a proposed rule for securities exchanges to require listed companies to adopt clawback policies and Deputy Attorney General Lisa Monaco's recent comments ³ around compensation clawbacks.

In response, this article provides an overview of the compensation clawback provision within SOX (Section 304), a brief history of the SEC's use of the provision, and key applicability considerations.

Overview of SOX Section 304

Under SOX Section 304:

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

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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 occurs first) 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. ⁴

A review of the legislative history for the provision emphasizes that this remedy was created to address concerns about management retaining "profits they receive as a result of misstatement of their company's financials. . . ." ⁵ As one court noted, an analysis of the legislative history reveals that the purpose of the statute was not to punish individual wrongdoing, but rather to create an equitable remedy that prevented executives from benefitting from company misconduct. A broader analysis of the Senate legislative history reveals the more expansive purpose behind the provision:

Recent events have raised concern about management benefitting from unsound financial statements, many of which ultimately result in corporate restatements. The President has recommended that "CEOs or other officers should not be allowed to profit from erroneous financial statements," and that "CEO bonuses and other incentive-based forms of compensation [sh]ould be disgorged in cases of accounting restatement and misconduct." ⁶

Title III includes provisions designed to prevent chief executive officers ("CEOs") or chief financial officers ("CFOs") from making large profits by selling company stock, or receiving company bonuses, while management is misleading the public and regulators about the poor health of the company. The bill requires that in the case of accounting restatements that result from material noncompliance with SEC financial reporting requirements, CEOs and CFOs must disgorge bonuses and other incentive-based compensation and profits on stock sales, if the non-compliance results from misconduct. ⁷

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As one court held, "the amount or reimbursement is not limited to income attributable to the wrongdoing of others." ⁸ This meshes with the rule's purpose that corporate officers "cannot simply keep their own hands clean, but must instead be vigilant in ensuring there are adequate controls to prevent misdeeds by underlings." ⁹

SEC Use of SOX Section 304

Although the provision was implemented in 2002 in response to major corporate and accounting scandals, the SEC was initially reluctant to use the provision. ¹⁰ As one court noted, "[f]or reasons best known to the SEC, the Commission has been historically reluctant to utilize § 304 in the ten years since [SOX] was enacted." ¹¹ The SEC first utilized the provision in 2007—and did so with a bang—when it disgorged ¹² nearly $470 million from the former CEO and chair of a public health company in connection with a stock backdating matter.

After that the SEC utilized the provision with greater frequency under Chairs Mary Shapiro and Mary Jo White, filing scores of settled and litigated actions involving Section 304 clawback claims. Moreover, the agency started to bring more "standalone" claims under Section 304, meaning the CFO and/or CEO in question were not alleged to have engaged in any wrongdoing. ¹³ However, under prior SEC Chair Jay Clayton, the SEC utilized the provision far less, bringing only a dozen SOX Section 304 claims and pursuing only one standalone claim during his three-plus years at the helm.

Not surprisingly, the tide has shifted under SEC Chair Gary Gensler. Under his leadership, the SEC has increasingly pursued SOX Section 304 actions, including several high-profile standalone clawback actions totaling millions of dollars. ¹⁴ In a recent press release tied to one action, SEC Division of Enforcement Director Gurbir Grewal noted that the SEC is "committed to using SOX § 304 as Congress intended: to incentive a culture of compliance at public companies by ensuring that senior executives are not rewarded when their firms violate core reporting requirements. Executives should be on notice that we view SOX § 304 as broad authority in seeking all forms of compensation that should be reimbursed to the company." ¹⁵

With this in mind, this article will try to answer three of the most pressing questions about SOX Section 304:

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1. What, exactly, constitutes "misconduct" under the statute?
2. How are bonuses and trading profits calculated?
3. How have courts interpreted the "restatement" element of this provision, and what does this mean for "Big R"/"little r" restatements?

What Constitutes "Misconduct"?

The SEC has historically argued—and courts have typically held—that SOX Section 304 does not require CEOs or CFOs to have personally engaged in the misconduct at issue to be required to disgorge profits under the statute. ¹⁶ As one district court held, "A CEO [or CFO] need not be personally aware of financial misconduct to have received additional compensation during the period of that misconduct and to have unfairly benefited from it." ¹⁷ Instead, as the U.S. Court of Appeals for the Ninth Circuit has held, "it is the issuer's misconduct that matters, and not the personal misconduct of the CEO or CFO." ¹⁸

Concerning the issuer's misconduct, courts have found that it must be "sufficiently serious to result in material noncompliance with a financial reporting requirement under the securities laws." ¹⁹ But how serious? What mental state is necessary to reach "misconduct"? This has led several commentators to claim that the contours of "misconduct" remain a mystery. Although there is some truth to the...