Section 304 of the Sarbanes-Oxley Act “establishes that the SEC may sue the CEO and CFO of a company” for reimbursement of bonus and incentive compensation “when the company has been required to restate its earnings due to noncompliance with securities laws.”6 Pirelli Armstrong Tire Corp. Retiree Med. Benefits Trust ex rel. Fed. Nat’l Mortg. Ass’n v. Raines, 534 F.3d 779, 793 (D.C. Cir. 2008) (Kavanaugh, J.).
On November 13, 2012, the Western District of Texas held that the SEC may state a claim under Section 304 without alleging that the executives “committed any conscious wrongdoing.” SEC v. Baker, 2012 WL 5499497, at *1 (W.D. Tex. Nov. 13, 2012) (Sparks, J.). The court also rejected constitutionality challenges to Section 304. The court reasoned that “[i]n enacting § 304 of Sarbanes-Oxley, Congress determined to put a modest measure of real risk back into the [compensation] equation” for corporate officers. Id. at *11. “Section 304 creates a powerful incentive for CEOs and CFOs to take their corporate responsibilities very seriously indeed.” Id.
On July 21, 2008, ArthroCare Corporation restated its financial statements for 2006, 2007, and the quarter ending March 31, 2008 as a result of “alleged fraud by two senior vice presidents of Arthrocare, John Raffle and David Applegate.” Id. at *1. The SEC subsequently brought suit under Section 304 of the Sarbanes-Oxley Act seeking “statutory reimbursement—on behalf of Arthro[C]are—of cash bonuses, incentives, and equitybased compensation” earned by ArthroCare’s CEO, Michael A. Baker, and its CFO, Michael T. Gluk, during the periods affected by the restatements. Id.
The SEC did not allege that Baker and Gluk had “committed any conscious wrongdoing.” Id. Instead, the SEC asserted that the defendants were “required to reimburse Arthro[C]are simply because they were the CEO and CFO at the time (and thus signed the filings which subsequently required restatements).” Id. Baker and Gluk moved to dismiss the SEC’s claims on the grounds that “§ 304 either cannot be construed … to impose liability on CEOs and CFOs without any element of scienter, or, alternatively, because § 304 is unconstitutional.” Id. The defendants “also raise[d] a statutory defense in the form of the Civil Asset Forfeiture Reform Act.” Id.
The Court Finds Section 304 Does Not Require Scienter or Misconduct
The defendants contended that Section 304 should be construed “(1) to require misconduct by the corporate officer himself, (2) to define ‘misconduct’ as an independent violation of securities law, [or] (3) as only providing a remedy for the SEC when an officer engages in misconduct which is itself a violation of another securities law.” Id. at *4. The court rejected these claims, finding that “[t]he text of the statute plainly contains no such additional requirements.” Id. at *5. “Rather,” the court held that “the statute unambiguously requires CEOs and CFOs to reimburse the issuer for any qualifying compensation they receive within one year of a filing which the issuer is subsequently forced to restate due to misconduct by the issuer or its agents.” Id.
The court noted that “[t]he handful of cases which have had occasion to describe the import of § 304 are likewise devoid of any mention of a scienter requirement.” Id. For example, in SEC v. Jenkins, 718 F. Supp. 2d 1070, 1072 (D. Ariz. 2010) (Snow, J.), the court “persuasively rejected similar attempts by the officer defendant to read into the statute a requirement of misconduct by the officer.” Baker, 2012 WL 5499497, at *4.
The Jenkins court held that “the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer’s CEO or CFO.” Jenkins, 718 F. Supp. 2d at 1074. The court explained that “it was Congress’s purpose to recapture the additional compensation paid to a CEO during any period in which the corporate issuer was not in compliance with financial reporting requirements.” Id. at 1075. “A CEO need not be personally aware of financial misconduct to have received additional compensation during the period of that misconduct, and to have unfairly benefitted therefrom.” Id. The Jenkins court found that “[i]t is not irrational for Congress to require that such additional compensation amounts be repaid to the issuer.” Id.
The Baker court explained that while “it might be surprising at first glance to require CEOs and CFOs to reimburse their employers when they have not done anything illegal, there are good policy reasons why Congress may have provided for the broad scope of § 304 suggested by the SEC.” Baker, 2012 WL 5499497, at *5. “Imagine if someone told you that they would take away half of everything you earned this year if you did not catch the misconduct of one of your employees.” Id. (quoting Alison List, Note, The Lax Enforcement of Section 304 of Sarbanes—Oxley: Why is the SEC Ignoring its Greatest Asset in the Fight Against Corporate Misconduct?, 70 OHIO ST. L.J. 195, 216 (2009)). “You would most likely be highly motivated to catch the misconduct.” Id. (internal quotations omitted). This is why Sarbanes-Oxley “includes provisions designed to prevent CEOs or 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.” Id. at *6 (quoting S. REP. NO. 107-205, 2002 WL 1443523, at *23 (2002) (emphasis added by the court).
Here, the defendants had “received generous compensation, while two managers, Raffle and Applegate, were misleading the public about Arthro[C]are’s financial condition.” Id. The court noted that “[i]f legislative history is any indication, Congress had facts similar to this case squarely in mind in enacting” Sarbanes-Oxley. Id.
The Baker court also reasoned that “limit[ing] the scope of § 304 as Baker and Gluk suggest would render it a meaningless act on the part of Congress, because the SEC’s power to seek equitable disgorgement of profits gained through wrongdoing pre-dates Sarbanes- Oxley by many years.” Id. “In addition, various other securities laws penalize active wrongdoing, either on the basis of intentional, knowing, or negligent acts or omissions.” Id. “By requiring reimbursement, even in the absence of any wrongdoing, Congress was logically extending and expanding the regulatory scheme for publicly traded securities in reaction to the various accounting scandals which triggered Sarbanes-Oxley.” Id.
The Court Holds Section 304 Is Not an Equitable Disgorgement Provision
The defendants argued that “§ 304 should be construed as some type of statutory disgorgement provision, equivalent to the long-standing commonlaw doctrine of equitable disgorgement” and should therefore be “generally limited to cases in which the officers themselves have engaged in wrongdoing.” Id. at *7. In support of this claim, the defendants pointed to case law from the Ninth Circuit holding that “the reimbursement provision of [Section] 304 is considered an equitable disgorgement remedy and not a legal penalty.” SEC v. Jasper, 678 F.3d 1116, 1130 (9th Cir. 2012) (Bea, J.) (relying on In re Digimarc Corp. Derivative Litig., 549 F.3d 1223, 1232-33 (9th Cir. 2008) (Bybee, J.)).
Rejecting the defendants’ contention, the Baker court held that “§ 304 is not equivalent to equitable disgorgement.” Baker, 2012 WL 5499497, at *8. The court explained that the defendants’ argument “cannot be harmonized with the language of § 304, which is devoid of any necessary link between the acts of the CEO or CFO, and the compensation which is subject to reimbursement.” Id. at *7. As to the Ninth Circuit cases on which the defendants relied, the Baker court explained that neither case “address[ed] whether … § 304 reimbursement [is limited] to profits attributable to wrongdoing.” Id. The court also noted that it was not bound by the Ninth Circuit’s rulings in any event. Id. Finally, the Baker court observed that at least one other court to consider the issue has held that “§ 304 reimbursement is a penalty, not a disgorgement.” Id. at *8 (citing SEC v. Microtune, 783 F. Supp. 2d 867, 886-87 (N.D. Tex. 2011) (Boyle, J.)).
The Court Rejects the Defendants’ Constitutionality Challenges to Section 304
Turning to the defendants’ constitutionality challenges, the Baker court found Section 304 “constitutional on its face.” Id. The court explained that “only rational basis review applies” to Section 304 because the defendants are not “members of any protected class,” nor had they “otherwise shown fundamental rights are at stake, requiring a heightened level of scrutiny.” Id. The court determined that “there is a rational basis for § 304: it creates a personal incentive for CEOs and CFOs to take their reporting and certification duties seriously.” Id.
The defendants argued that “it is unclear whose misconduct will trigger reimbursement” under Section 304. Id. The court disagreed, explaining that “the ‘misconduct’ in question is misconduct by the issuer … [and] its agents.” Id. “As a practical matter,” the court found that “the ‘who’ will also no doubt be limited to those agents of the issuer who are in sufficiently high-ranking positions as to be able to cause ‘material noncompliance … with any financial reporting requirement under the securities laws.’” Id. (quoting 15 U.S.C. § 7243(a) (2012)).
The defendants further claimed that “§ 304 is vague because it does not clearly state when or why liability will be imposed.” Id. at *9. The court found that “§ 304’s requirements upon CEOs and CFOs are crystal clear, when read in conjunction with the rest of Sarbanes-Oxley.” Id. “Section 302 of the Act tells executives precisely what they must do to avoid reimbursement liability under § 304: they must ensure the issuer files accurate financial statements.” Id. “And it tells them how they are to go about doing so, such as by: ‘establishing and maintaining internal controls.’” Id. (quoting 15 U.S.C. § 7241(a)(4)(A) (2012)).
With respect to the defendants’ assertion that § 304 violates the Excessive Fines Clause of the Eighth Amendment, the court found this clause “inapplicable” because “§ 304 only requires reimbursement to the issuer: no money is forfeited to the government.” Id. The court further determined that Section 304 “falls outside of the scope of the Excessive Fines Clause” because it is “at least partly remedial in nature.” Id.
The court also rejected the defendants’ claim that “§ 304 violates the Due Process Clause by not requiring any reasonable relationship between the triggering conduct and the penalty imposed on an otherwise innocent person.” Id. “[B]y signing SEC filings, corporate officers are making solemn guarantees that they have carefully reviewed the filings for accuracy, and that such accuracy is underwritten by adequate controls.” Id. “When, as here, those controls prove inadequate, and corporate officers are asleep on their watch, it is reasonable for Congress to impose a penalty.” Id. “The degree of penalty is reasonable too: it is limited to bonuses, incentive-based pay, and stocksales profits.” Id. “Furthermore, Congress provided a safety valve, namely the SEC’s power to exempt corporate officers when appropriate.” Id.
In addition, the court found no basis for the defendants’ argument that “§ 304 fails to provide fair notice.” Id. at *10. The court explained that “Sarbanes- Oxley as a whole provides ample notice of what conduct is required.” Id.
The Court Finds That CAFRA Does Not Apply to § 304
Lastly, the defendants argued that “the Civil Asset Forfeiture Reform Act (CAFRA) independently bars a § 304 action against ‘innocent’ officers such as themselves.” Id. at *4. CAFRA provides that “an innocent owner’s interest in property shall not be forfeited under any civil forfeiture statute.” 18 U.S.C. § 983(d)(1) (2012).
The court determined that “CAFRA is inapplicable to an action under § 304.” Baker, 2012 WL 5499497, at *10. “First and foremost, the Supreme Court has explained that civil forfeiture actions are in rem proceedings, … whereas § 304 plainly creates an in personam cause of action.” Id. (citing United States v. Ursery, 518 U.S. 267, 275 (1996) (Rehnquist, C.J.)). “[A] § 304 action has nothing to do with property being put to an illegal purpose; rather, it is directed at failure to comply with securities filing requirements.” Id. Moreover, if CAFRA “applie[d] to § 304 proceedings, then it would follow [that] Congress chose to enact a meaningless statute in § 304, because recovery of compensation from CEOs and CFOs who are not ‘innocent owners’ is already provided for by various other provisions of the Sarbanes-Oxley Act and the Securities and Exchange Act.” Id. at *11. “Of course, Congress is … presumed to not engage in meaningless acts.” Id. The court therefore held that “Congress must have assumed and intended CAFRA would have no application to § 304.” Id.