Are the SEC's Executive Clawback Suits Unconstitutional?

Susan Beck

The American Lawyer

04-11-2012

Are we seeing the start of a wave of executive compensation clawback lawsuits by the Securities and Exchange Commission?

As Kevin LaCroix pointed out in his D&O Diary blog, last week the SEC filed two lawsuits to recoup compensation from former top executives of two companies. These actions are the latest examples of the SEC's increased use of Section 304 of Sarbanes-Oxley, which has been interpreted to allow the SEC to recover incentive compensation paid to top executives at companies that restate their earnings as a result of wrongdoing, even if the executives aren't the ones accused of the misdeeds.

The first case was filed April 2 against the former CEO and CFO of ArthroCare, an Austin, Tex.-based company that makes medical devices. (The complaint is here.) In this case, the SEC wants to claw back an unspecified amount of compensation from former CEO Michael Baker and former CFO Michael Gluk, even though the two aren't accused of wrongdoing. Instead, two former Arthro sales executives have been charged by the SEC with inflating revenue by channel stuffing.

The second case, filed on Friday, targets former leaders of the failed Franklin Bank of Houston: former CEO Anthony Nocella and former CFO Russell McCann. In contrast to the ArthroCare case, these two men are accused of wrongdoing in that they allegedly misrepresented the bank's underperforming loans. (That complaint is here.)

Bother cases were filed by the SEC's Forth Worth office.

Section 304 of the Sarbanes-Oxley Act states that if a company has restated its financials because of misconduct, then the CEO or CFO must reimburse incentive compensation to the company. In 2009 a federal court ruled for the first time that this provision can be used against executives who aren't charged with misconduct. That case was brought against Maynard Jenkins, the former CEO of CSK Auto Corporation. Last January the SEC used Section 304's strict liability provisions to claw back $450,000 in compensation from the former CEO of Symmetry Medical Inc., and $185,000 from its chief financial officer, who were not themselves charged with wrongdoing. (You can read our article about that case here.)

The lawyers for the former ArthroCare executives blasted the SEC's action as unconstitutional. Jay Pomerantz of Fenwick & West, who represents former CEO Baker, asserted that the SEC is relying on "a flawed interpretation of the Sarbanes-Oxley Act." He added: "Such overreaching against an admittedly innocent person violates constitutional principles of fairness and due process." Jason Lewis of Locke Lord, who represents former CFO Gluck also maintained that the SEC's action "raises numerous constitutional and equitable concerns." He stated: " With its overreaching and broad interpretation of the Sarbanes-Oxley Act, the SEC is telling public companies and their officers that even being diligent and innocent of wrongdoing does not protect you from the SEC’s grasp.  This certainly could not have been the intent behind the law and Mr. Gluk intends to vigorously defend himself against this unjust action.”

In the Franklin Bank case, Nocella is represented by James Munisteri of Gardere Wynne Sewell. Munisteri told the Wall Street Journal that the SEC's complaint doesn't tell the whole story. "Conspicuously absent from the SEC's mischaracterization of events are many important facts that the SEC will not be able to ignore during a court proceeding," he said. Barrett Reasoner of Gibbs & Bruns, who represents McCann, pointed out that a class action against Nocella and and McCann stemming from the bank's failure was dismissed, and that ruling was upheld by the U.S. Court of Appeals for the Fifth Circuit. "Just as the class action claims were dimsissed, the SEC's claims similarly will not pass muster," Reasoner told the Litigation Daily.

A spokesperson for the SEC told us: "The SEC has staked out its legal position in cases like Jenkins. Our position is very clear."

This article originally appeared in The AmLaw Litigation Daily.