The Ninth Circuit Holds That a CEO or CFO May Have Liability for a False Rule 13a-14 Certification, and SOX’s Disgorgement Provision Applies Irrespective of Whether a Restatement Is Caused by a CEO’s or CFO’s Personal Misconduct

SUMMARY

On August 31, 2016, in SEC v. Jensen, 14-55221, slip op. (9th Cir. Aug. 31, 2016), the United States Court of Appeals for the Ninth Circuit reversed the district court’s rulings interpreting Rule 13a-14 of the Securities Exchange Act and Section 304 of the Sarbanes-Oxley Act, holding that Rule 13a-14 provides the Securities and Exchange Commission with a cause of action against Chief Executive and Chief Financial Officers who provide a false certification pursuant to Rule 13a-14—not merely against those who fail to make any certification at all—and, as a matter of first impression by an appellate court, that the disgorgement remedy authorized by Section 304 applies regardless of whether an accounting restatement is caused by the personal misconduct of an issuer’s CEO or CFO. In an opinion written by the Honorable Richard R. Clifton, the panel remanded the case for a jury trial. Judge Carlos T. Bea joined the panel’s opinion and also concurred separately.

BACKGROUND

In 2011, the SEC brought an enforcement action against Peter Jensen and Thomas Tekulve, the former Chief Executive Officer and Chief Financial Officer, respectively, of the now-defunct Basin Water, Inc. (“Basin”), alleging that Defendants had participated in a scheme to defraud investors by reporting millions of dollars in revenue that was never realized. Jensen founded Basin, which manufactured water treatment units for municipalities, and Tekulve was responsible for creating the company’s accounting department and putting in place procedures and controls intended to allow the company to go public, which it did in May 2006. According to the SEC, Basin thereafter failed to comply with generally accepted accounting principles (GAAP) in recognizing revenue, and Defendants each received several hundred thousand dollars of incentive-based compensation and shares of Basin stock during the period in which they were allegedly causing Basin to fraudulently inflate its revenue. After Defendants left the company in 2008, Basin restated its financial statements for 2006 and 2007; its stock price fell significantly upon its announcement of the restatement.

The SEC appealed from the district court’s grant of partial summary judgment to Defendants on the SEC’s claim under Rule 13a-14 under the Securities Exchange Act of 1934 (Exchange Act), which requires that an issuer’s CEO and CFO certify, among other things, the issuer’s financial reports included in SEC filings fairly present in all material respects the financial condition, results of operations and cash flows as of and for the periods presented in the SEC filing. The district court held that the Rule creates a cause of action against CEOs and CFOs who do not sign or file certifications at all, but does not provide a cause of action against officers who make false certifications. The SEC also appealed the district court’s conclusion that Section 304 of the Sarbanes-Oxley Act of 2002 (SOX) requires CEOs and CFOs to disgorge bonus or other incentive- and equity-based compensation only if their companies issue an accounting restatement because of the officers’ own misconduct, but not if the restatement was caused by conduct in which the officers were not directly involved. The Ninth Circuit reversed, holding that Rule 13a-14 provides the SEC with a cause of action against executives who make a false certification, and that the disgorgement remedy of Section 304 applies regardless of whether a restatement was caused by the personal misconduct of the CEO or CFO.

THE NINTH CIRCUIT’S REASONING

A. EXCHANGE ACT RULE 13A-14

Rule 13a-14 requires that, for every report filed under Section 13(a) of the Exchange Act, each CEO and CFO of an issuer must sign a certification as to, among other things, the financial statements included in the report fairly presenting in all material respects the financial condition, results of operations and cash flow as of and for the period presented in each filing. The certification must also provide that the certifying executives “[d]esigned . . . internal control over financial reporting, or caused . . . internal control over financial reporting to be designed under [their] supervision, to provide reasonable assurance regarding . . . the preparation of financial statements for external purposes in accordance with [GAAP].”

The district court accepted Defendants’ argument that the Rule creates a cause of action against CEOs and CFOs who do not sign or file certifications but does not create a cause of action based on signed certifications that are false. The Ninth Circuit disagreed, concluding that “[t]he wording of Rule 13a-14 supports the conclusion that a mere signature is not enough for compliance,” because, “by definition, one cannot certify a fact about which one is ignorant or which one knows is false.” Accordingly, the court “conclude[d] that Rule 13a-14, like other rules promulgated under Section 13 of the Exchange Act, includes an implicit truthfulness requirement” and that it is “not enough for CEOs and CFOs to sign their names to a document certifying that SEC filings include no material misstatements or omissions without a sufficient basis to believe that the certification is accurate.”1 Observing that the issue had not been argued by the parties, the court explicitly “decline[d] to reach the question of the mental state required for a violation of Rule 13a-14.”2

B. SOX SECTION 304

SOX Section 304 provides, in relevant part, that, “[i]f 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 CEO and CFO “shall reimburse the issuer” for bonus or other incentive- and equity-based compensation received “during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement.” 15 U.S.C. § 7243(a).

In challenging the district court’s ruling that SOX Section 304 does not authorize disgorgement unless an executive personally engaged in misconduct that required the restatement of the financials, the SEC argued that the provision is “concerned not with the individual misconduct on the part of the CEO and CFO, but rather with the misconduct of the issuer.” (emphasis in original). In the first federal appellate decision to address the issue, the Ninth Circuit agreed, holding that “[t]he SEC’s interpretation . . . is consistent with the plain language of the statute,” which “provides for reimbursement to issuers 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.’” (emphasis in original). The Ninth Circuit explained: “The clause ‘as a result of misconduct’ modifies the phrase ‘the material noncompliance of the issuer,’ suggesting that it is the issuer’s misconduct that matters, and not the personal misconduct of the CEO or CFO.”

The Ninth Circuit further considered the legislative history of Section 304, which it concluded evinced “Congress’s intent to craft a broad remedy that focused on disgorging unearned profits rather than punishing individual wrongdoing.” In holding that disgorgement was warranted to “prevent corporate officers from profiting from the proceeds of misconduct, whether it is their own misconduct or the misconduct of the companies they are paid to run,” the court “decline[d] to reach the issue of the meaning of ‘misconduct’” under Section 304, again observing that the issue was neither argued by the parties nor required to resolve the appeal.3

CONCLUSION

The Ninth Circuit’s decision in Jensen provides a broad reading of Exchange Act Rule 13a-14 and SOX Section 304, and resolves an issue of first impression at the appellate level in interpreting Section 304 to apply irrespective of whether the CEO and CFO personally engaged in any misconduct. Accordingly, it could prove influential in the SEC’s decisions to bring enforcement actions against CEOs and CFOs.

The opinion leaves open both the mental state required for liability under Rule 13a-14, and the meaning of “misconduct” under SOX Section 304, although the concurring opinion addressed both questions and criticized the majority for “announc[ing] broad, but unclear rules and . . . leav[ing] for another day important questions . . . about the precise scope of the rules [the court] announce[d].” Those issues are likely to become grounds for litigation on remand in Jensen, and in future actions brought by the SEC.