After languishing on the books for nearly a decade, the “clawback” provision of Sarbanes Oxley (“Sox”) is experiencing a comeback, and potentially threatening executive compensation. Sox Section 304 empowers the SEC to sue a company’s CEO and CFO for repayment of incentive-based pay if the company issues an accounting restatement that resulted from “misconduct.” For years the Commission showed little interest in its clawback power, causing critics to conclude it was a “dormant enforcement tool” with a “bark decidedly worse than its bite.” See Gretchen Morgenson, Clawbacks Without Claws, N.Y. Times, Sept. 10, 2011, at BU1. But recent cases suggest the SEC intends to use its clawback power more expansively and often than ever before.

In SEC v. Baker, the Commission urged a newly expansive reading of Sox 304. 2012 U.S. Dist. LEXIS 161784, at *1-3 (W.D. Tex. Nov. 13, 2012). Arthrocare, an Austin-based manufacturer of medical devices, had been forced to issue a restatement after uncovering its executives fraudulently inflating the company’s earnings. The SEC brought a clawback suit against Arthrocare’s CEO and CFO, despite acknowledging they were personally blameless. Even so, the Commission argued it made no difference under Sox Section 304 whether the defendants personally committed misconduct, so long as misconduct occurred somewhere in the company. The defendants responded that Section 304 should require scienter (meaning the intent to deceive, manipulate, or defraud) or at least some conscious misconduct on their part.

Despite recognizing the argument was largely unprecedented, and that “it might be surprising at first glance to require CEOs and CFOs to reimburse their employers when they have not done anything illegal,” the court sided with the SEC. Id. at 14. Judge Sparks reasoned that Section 304 only requires “misconduct” by the “issuer,” not personal misconduct by the CEO or CFO. Id. at 12-13. The court found that had Congress intended to require scienter, it would have said so. Id. The court also emphasized that the statute should be read so that “officers cannot simply keep their own hands clean, but must instead be vigilant in ensuring there are adequate controls to prevent misdeeds by underlings.” Id. at 17-18.

It remains to be seen whether other courts will be similarly receptive to the SEC’s reading of Sox Section 304. But SEC v. Baker, at the very least, signals the Commission’s increasingly aggressive posture toward incentive-based compensation after a restatement. As Judge Sparks put it, “a sword does not cease to be a sword, even though it may languish in the scabbard.” Id. at 7.

Corporations have meanwhile taken similar steps by including clawback provisions in their executive-employment contracts. JP Morgan, for example, allows clawbacks if an executive “engages in conduct that causes material financial or reputational harm” or “improperly or with gross negligence fail[s] to identify, raise, or assess, in a timely manner and as reasonably expected” material risks to the corporation. The company used that provision to clawback $100 million in executive compensation after the recent “London Whale” incident, discussed here in an earlier blog post. Whether from the SEC or the corporation itself, executives face new and evolving risks to their incentive-based compensation.

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