Federal authorities have recently launched new salvos against executives deemed to have received excessive compensation, and this time the weapon of choice is the “claw back.” Earlier this summer the U.S. Treasury Department appointed Kenneth Feinberg as the “pay czar” to review and determine the compensation of executives at seven companies still holding TARP funds. Feinberg has until the middle of October to make compensation decisions for his wards and can claw back compensation already paid. Commenting on his ability to recover compensation not only from companies currently under the TARP umbrella, but also from companies that have exited TARP, Feinberg said: “Anything is possible under the law.”

Employing Kenneth Feinberg’s mantra as their sword, the SEC recently filed two actions to recover compensation from executives using various disgorgement tools, including Section 304 of the Sarbanes-Oxley Act of 2002. In SEC vs. Conaway, Civil Action No. 05- CV0-40263 (E.D. Mich. July 30, 2009), the SEC is seeking to recoup a forgiven loan and associated tax gross-up, as well as interest and civil penalties, from Charles Conaway, the former CEO of Kmart who was found guilty of securities law violations after a June jury trial. Kmart’s board of directors previously authorized Kmart’s creditors to pursue Conaway for the loan and gross-up, so the SEC’s suit displays a proactive posture meant to bring to bear the gravitas of an SEC enforcement action and supplant the so-far fruitless efforts of the board and bankruptcy court to claw back the funds from Conaway.

The SEC’s case against Maynard Jenkins, the retired CEO of CSK Auto Corp., the former parent of a group of auto parts retailers, takes the “anything is possible” theory to a level never before attempted by the SEC – seeking disgorgement of bonuses and profits from the sale of CSK stock from an executive who was never alleged to have violated the securities laws. In SEC vs. Jenkins, Civil Action No. 09-CV-01510-JWS (D. Ariz. July 23, 2009), the SEC seeks to recoup approximately $4 million from CSK’s former CEO, despite the fact that he was one of the few members of the executive suite not subject to both civil and criminal charges as a result of accounting fraud in CSK’s annual reports.

Conaway and the SEC’s Requested Remedies

If 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 of the securities laws,” Section 304 requires the CFO and CEO to reimburse the issuer for bonuses, incentive- or equity-based compensation, and profits from the sale of stock received during the year following issuance of the original financial statements. In Conaway, however, the SEC demonstrates that Section 304 is not the only weapon it will use to attempt to claw back previously paid compensation.

Conaway and Kmart’s former CFO, John McDonald, were charged with making material misrepresentations and omissions about Kmart’s financial condition prior to Kmart’s 2002 bankruptcy filing. A massive inventory purchase in the summer of 2001 pushed Kmart’s liquidity to the brink. Kmart’s management delayed payments to Kmart’s suppliers to no avail, leaving Kmart with a deficit of approximately $300 million between its available cash and money owed to suppliers, all well before the beginning of the lucrative holiday shopping season.

Conaway and McDonald, in both analyst calls and instructions to employees, blamed the delay in payments on a new inventory and accounting system. Kmart’s third-quarter Form 10-Q failed to adequately describe the reasons behind material increases in both accounts payable and inventory, and during a conference call with analysts, Conaway downplayed the number of Kmart suppliers that were refusing to ship product to Kmart stores and claimed Kmart was caught up in its overdue payments to suppliers. Unable to pay off its massive debt after the holiday season, Kmart filed for bankruptcy in early 2002.

The SEC charged Conaway and McDonald with violating, as well as aiding and abetting violations of, the reporting and antifraud provisions of the Exchange Act. McDonald settled shortly before trial, agreeing to injunctions against violating securities laws, temporary bars on serving as an officer, director or accountant, and civil penalties. Conaway was found guilty on all counts in a jury trial that concluded in June 2009.

The SEC requested that the court enforce similar injunctions and permanent bars on Conaway. The SEC’s impassioned memorandum goes further though, arguing the case for clawing back millions in compensation and imposing additional millions in penalties and interest relating to Conaway’s fraud. Specifically, the SEC seeks to recoup a forgiven $5 million dollar loan from Kmart to Conaway, along with a tax gross-up of approximately $3.9 million. The SEC alleged that, at the time the loan was forgiven and the gross-up paid, Kmart’s board did not know about Conaway’s misrepresentations in his communications with investors and analysts, and therefore did not fire Conaway for cause. Prejudgment interest and a civil penalty equal to the amount of the loan and gross-up bring the SEC’s requested disgorgement total to $22.56 million.

Although Kmart restated its financials for 2001 in June 2002, the SEC did not attempt to claw back Conaway’s loan under Section 304, perhaps because the restatement was filed prior to enactment of Sarbanes-Oxley, or perhaps because the forgiven loan and grossup are not the type of incentive compensation Section 304 is meant to recoup. Instead, the SEC argued that had Conaway revealed his fraud to Kmart’s board, he would have been terminated for cause, his loan would not have been forgiven and he would not have received the gross-up.

Following an internal investigation in 2002, Kmart’s board came to a similar conclusion and authorized a committee of creditors to proceed against Conaway to recoup the forgiven loan and gross-up. While Kmart’s board did not have the ability to seek injunctions, bars or civil penalties against Conaway through the bankruptcy estate, the board authorized the creditors to pursue Conaway for the money, and presumably interest, he would not have received had he been fired for cause. By stepping in with its own disgorgement claims, the SEC is unleashing its enforcement division to seek conclusion of a matter that Kmart’s board and the bankruptcy court have been unable to resolve for more than six years and demonstrating a revived vigor for aggressively pursuing compensation paid to those who violate the securities laws.

The Jenkins Complaint

The SEC’s new attitude towards claw backs and creative use of the tools at its disposal is no more evident than in Jenkins. While Jenkins was chairman and CEO, CSK had to restate its financials for fiscal years 2002 through 2004 twice, and Jenkins signed each of the annual reports containing the original financial statements.

The reason for the restated financials was CSK’s accounting treatment of a practice known as vendor allowances, in which CSK’s vendors would pay CSK allowances at fixed amounts or as a percentage of the goods CSK purchased from the vendor in exchange for CSK marketing the vendor’s products. These allowances were used to lower the cost of the products sold in CSK’s stores, and generally lowered CSK’s cost of goods sold, thereby increasing pre-tax income. Under GAAP, uncollected vendor allowances are written off as an unpaid receivable, but CSK applied later-paid vendor allowances to prior years and failed to correctly account for vendor allowances paid back to vendors. CSK’s accounting practices resulted in overstatements of pre-tax income of $11 million, $34 million and $21 million in fiscal years 2002 through 2004, respectively.

CSK restated its financials for the first three quarters of 2004 and all of 2001 through 2003 in its 2004 Form 10-K when the company realized that it could not collect all of the 2003 vendor allowance receivables. A subsequent internal audit and special investigation revealed that CSK had not caught all of the accounting irregularities and CSK restated its financials for 2002 through 2004 a second time. Additionally, CSK’s CFO, COO, controller and the director of the vendor allowance program were all terminated. The SEC instituted a settled enforcement action against CSK, as well as civil charges against the terminated employees, and each of the terminated employees has either pled guilty or is the subject of parallel criminal actions by the Department of Justice. Jenkins was not terminated or subject to any SEC or criminal action, but agreed to retire and help CSK find a new CEO. The SEC alleges that during the 12 months following the restatements, Jenkins received approximately $2 million in bonus payments and realized approximately $2 million in profit on sales of CSK stock. In a complaint filed in late July 2009, the SEC seeks to claw back this $4 million in bonuses and profits under Section 304.

Jenkins, Conaway and the Future of Claw Back Enforcement

Jenkins is the first case under Section 304 that seeks to claw back compensation from an executive who is not alleged to have violated the securities laws. When compared with Conaway, the two cases demonstrate different approaches to clawing back compensation and may suggest an evolution in the SEC’s enforcement that boards and executives should be aware of.

The SEC’s comparative views of Jenkins’ conduct versus Conaway’s actions are clear from the court documents. The SEC makes it apparent that Conaway was the architect of the fraud, stating that he chose “deception over candor” and that his “prolonged sequence of lies” was disproportionately felt by the citizens of Michigan, Kmart’s home state. In contrast, other than being named as a defendant, Jenkins is rarely mentioned in the SEC’s complaint. CSK, and not Jenkins, is portrayed as the villain, and the accounting fraud is the “result of its misconduct.” The SEC’s differential proportioning of blame is also evident in the remedies requested from the respective courts. The SEC requests only to recoup bonuses and profits realized on the sale of CSK stock from Jenkins. Conversely, the SEC seeks pre-judgment interest at the standard IRS rate and the harshest (third-tier) civil penalties against Conaway, arguing that the statutory maximum is insufficient punishment, and Conaway’s pecuniary gain should be used as the measure of civil penalties.

Even though the SEC employs a relatively light touch on Jenkins when compared to the arsenal aimed at Conaway, the fact that the SEC brought suit under Section 304 against Jenkins raises a number of concerning issues. In light of the fact that Jenkins was not alleged to have participated in the accounting fraud, it appears that the SEC is applying a strict liability standard to Section 304. If Jenkins portends the future, a CFO or CEO of a company that files restated financials because of “material noncompliance” and “misconduct” by anyone at the company can expect to defend themselves against an SEC suit to recoup incentive-based compensation and profits from selling company stock. We may be witnessing the SEC adopting a zero tolerance policy against executives running a company that must restate its financials, despite no misconduct on the part of those executives.

Further, Jenkins sends mixed messages in this era of increased scrutiny over executive compensation. A common outcry is that executives should not be richly compensated when their companies do not perform. If Section 304 is now a strict liability statute, however, there is a disincentive for executives to accept bonuses or other performance-based compensation for particularly good results, because under Section 304 that incentivebased compensation is clearly subject to claw backs. An executive may opt to take a large base salary rather than an equivalent combination of base salary, stock options, bonus and incentive payments because the large base salary is arguably immune from Section 304, but the incentives for good performance can be lost, even if the executive is not culpable in any accounting irregularity.

While briefing and hearings in both Conaway and Jenkins lie ahead and may clarify whether Section 304 can be applied against an innocent executive, or whether the SEC can step into an action between creditors and the executive that defrauded them, it is clear that with the SEC’s current enforcement stance, anything is possible.