Insights

SEC Faces Challenge to Its Attempt to "Claw back" Millions from Senior Executive Not Charged with Wrongdoing

On September 15, 2009, Maynard Jenkins, former CEO of CSK Auto Corp. ("CSK"), moved to dismiss a Securities and Exchange Commission ("SEC") complaint filed against him in federal court in the District of Arizona. The SEC's case against Jenkins is ground breaking in that the SEC is attempting to use section 304(a) of the Sarbanes-Oxley Act ("SOX") to "claw back" millions of dollars in compensation and stock profit from Jenkins, even though it has never charged Jenkins with personally violating the securities laws.

Jenkins' motion argues that the SEC's interpretation of SOX 304(a) is unfounded and unconstitutional. His motion sums up the case against him as follows:

The SEC does not contend that Mr. Jenkins participated in or condoned any fraud at CSK. Nor does it assert that he was negligent. Instead, the SEC claims that Mr. Jenkins should forfeit millions of dollars because other employees that worked at CSK, unbeknownst to him, committed misconduct and hid it from him. The SEC's nonsensical view is that Mr. Jenkins must pay (literally and figuratively) for that misconduct by others because he was the "captain of the ship," despite the fact that under its own view of the evidence, his crew was mutinous – deceiving him, and secretly circumventing the ship's controls.

Whether Jenkins prevails on his motion is likely to be of immense significance to directors and officers of public companies.

Background

In May of this year, the SEC settled an administrative action against CSK, alleging that the company violated the securities laws by failing to properly account for vendor rebates. In the Matter of CSK Auto Corporation, Securities Act Rel. No. 9032 (May 26, 2009). The SEC initiated an investigation of the company after the company restated its financial statements for fiscal years 2002, 2003, and 2004. The company consented to the entry of a cease-and-desist order.

In addition to the charges against the company, the SEC filed a civil action, SEC v. Fraser, et al., Case No. 2:09-CV-00443-LOA (D. Ariz.); Lit. Rel. No. 20933 (Mar. 6, 2009), and the Department of Justice filed a criminal action, against CSK's former CFO, COO, Controller, and Director of Receivables. Both actions allege numerous intentional violations of the securities laws. The SEC, however, never alleged Jenkins knew or even should have known about the alleged fraud. In fact, both the SEC and DOJ alleged that the individual defendants took affirmative steps to conceal from Jenkins the fraud they were allegedly perpetrating. Nor did the SEC directly allege the fraud allowed Jenkins to obtain any incentive based compensation or increased profit on his stock sales. Nevertheless, the SEC, in a departure from its previous enforcement under SOX 304, determined to seek over $2 million in incentive based compensation and $2 million in stock profits Jenkins earned in the twelve-month periods following each of the restated fiscal years.

Jenkins' Motion to Dismiss

Jenkins' motion to dismiss focuses primarily on two arguments. First, Jenkins argues that it would be unconstitutionally punitive to apply SOX 304 against an innocent executive. Jenkins' second argument is that principles of statutory construction, as well as other courts' interpretations of SOX 304, require the court to reject the SEC's proposed expansion of SOX 304.

Constitutionality of the SEC's Interpretation

Jenkins' first argument revolves around the constitutional idea that the Government may not punish those who have not engaged in wrongdoing. Jenkins argues that since the SEC has not alleged any of his compensation or stock profit was facilitated by wrongful actions (which could thus give rise to a claim for unjust enrichment), the SEC's use of SOX 304 to recoup his compensation and stock profit inflicts a punitive remedy on an innocent person.

Jenkins points to several Supreme Court cases that he argues suggest a punitive remedy must be tied to particular wrongdoing, and if it is not, a violation of Due Process has occurred. Jenkins argues that because the SEC has not alleged he engaged in any wrongdoing, or indeed, even negligence, any attempt to use SOX 304 to punish him for other executives' wrongs is an unconstitutional violation of Due Process.

Additionally, Jenkins argues that the SEC's interpretation of SOX 304 violates the constitutional prohibition on excessive punishment. Jenkins points to several Supreme Court cases in which the Supreme Court struck down penalties it found excessive in relation to the conduct alleged and then argues that any punishment in the absence of wrongdoing is excessive.

Finally, Jenkins points to the bedrock Supreme Court principle that if a statute is capable of two interpretations, one being clearly constitutional and the other posing grave constitutional concerns, the former interpretation must be adopted. Jenkins argues that because the SEC's interpretations present, at the very least, serious constitutional concerns, the court must reject the SEC's construction.

Statutory Interpretation

Jenkins also argues that under principles of statutory construction, SOX 304 requires misconduct on the part of the defendant. Jenkins first points to the "rule of lenity," which states that ambiguities in punitive statutes must be resolved in the defendant's favor. Jenkins argues that because many aspects of SOX 304, including the misconduct requirement, are widely considered to be ambiguous, the court must construe the statute in Jenkins' favor.

Jenkins next argues that SOX 304 is in fact a remedy, and not a stand-alone basis for liability. Jenkins points out the SEC has previously interpreted the statute in the same manner, and it is only now that it is revising its interpretation to fit his case.

Jenkins further argues that common law principles dictate that an officer of a corporation is not liable for the actions of the corporations' employees, even if the officer is their supervisor. If Congress wants to abrogate common law principles, it must do so clearly and directly. Jenkins argues that imposing strict liability on a CEO for the actions of his employees would be a radical departure from common law principles.

Jenkins also argues that other courts that have considered the issue agree SOX 304 requires misconduct on the part of the defendant. Jenkins points to several courts that have characterized SOX 304 as aimed at wrongdoer's "ill-gotten gains" and "wrongdoing officer's profits." Jenkins argues that these courts clearly contemplate a requirement of misconduct on the part of the defendant.

Finally, Jenkins argues that the legislative history of SOX 304 indicates Congress intended a requirement of misconduct on the part of the defendant. Jenkins points to several House and Senate reports that refer to SOX 304 as requiring "disgorgement." Because disgorgement requires a connection between the amounts to be disgorged and some wrongdoing, Congress could not have intended SOX 304 to apply to wholly innocent parties.

Conclusion

Disgorgement, a traditionally equitable remedy used by the SEC to deprive wrongdoers of "ill-gotten" gains, has never been sought in similar circumstances. Typically, the SEC has pursued third parties who benefit from a fraud as relief defendants and argued that the third party was holding proceeds pursuant to equitable "constructive trust" theories. Under that theory, however, the SEC must generally show that the relief defendant has no legitimate claim to the funds being sought by the SEC.

The SEC's new interpretation of SOX 304 presents a radical departure from its previous enforcement and presents a serious concern for CEOs and CFOs who cannot possibly monitor every action of every employee. There is no doubt that executives around the country will be turning their attention to the District of Arizona as this motion to dismiss plays out.

For more information, please contact:

David L. Carden
New York
+1.212.326.3839
dlcarden@jonesday.com

Peter J. Romatowski
Washington
+1.202.879.7625
pjromatowski@jonesday.com

Patricia J. Villareal
Dallas
+1.214.969.2973
pjvillareal@jonesday.com

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