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Securities & Derivative Litigation

SEC Prevails on Aggressive Approach to Forfeiture of CEO and CFO Compensation Under SOX 304

By Jeffrey B. Coopersmith
January 2013
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On Nov. 13, 2012, the federal district court in Austin, Texas denied a motion to dismiss filed by the CEO and CFO of Arthrocare Corporation seeking to put an end to the SEC’s effort to claw back their incentive and equity-based compensation under Section 304 of the Sarbanes-Oxley Act. The case, SEC v. Baker, may portend a new, more aggressive phase in the SEC’s approach to Section 304, and underscores the need for internal corporate vigilance concerning misconduct associated with financial statements.

Section 304 gives the SEC discretion to file a lawsuit against CEOs and CFOs to claw back their incentive and equity-based compensation, as well as any trading profits, realized during the 12-month period following the issuance of a financial statement that is later restated “as a result of misconduct.” The statutory text does not require that the “misconduct” be on the part of the CEO or CFO. For years, the SEC used Section 304 sparingly, and rarely in cases that did not involve allegations of misconduct by the CEO or CFO. In Baker, however, the misconduct was committed by two senior vice presidents (both of whom were indicted), not by the CEO or CFO. Nevertheless, the SEC sought forfeiture of their SOX 304 compensation, a more aggressive approach that had been advocated by a senior counsel in the SEC’s enforcement division. See Rachael E. Schwartz, The Clawback Provision of Sarbanes-Oxley: An Underutilized Incentive to Keep the Corporate House Clean, 64 Bus. Law. 1, 34 (2008).

The court rejected the officers’ motion to dismiss the SEC’s SOX 304 claim. Federal district Judge Sam Sparks found that Congress had enacted Section 304 to create an incentive for CEOs and CFOs to police their organizations for misconduct, not simply to duplicate existing statutes giving the SEC remedies to disgorge ill-gotten gains. Following other courts that have considered the issue, Judge Sparks declined to read a scienter requirement into Section 304. He also rejected the officers’ constitutional challenges to Section 304, and a defense based on the “innocent owner” protection in the Civil Asset Forfeiture Reform Act (CAFRA).

This case underscores the importance of maintaining a robust compliance regime in connection with the preparation of financial statements. The case signals that the SEC is likely to go after incentive and equity-based compensation, and trading profits, in the wake of restatements brought on by employees’ misconduct, even where it is clear that the CEO and CFO committed no wrongdoing.

Full January 2013 Quarterly Securities Enforcement Briefing

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