When Congress passed the Sarbanes-Oxley Act of 2002 (SOX), it included a clawback tool. Flowing out of the accounting scandals that led to SOX’s creation, Section 304 provides that if a public company has to restate its financials as a result of misconduct, the company’s CEO and CFO must reimburse the company for any incentive-based compensation or trading profits they made during the 12-month period in question.

Many public companies have incorporated similar clawback provisions into their bylaws–which may be one reason Section 304 gets little use. Still, in an October 2010 speech, SEC Commissioner Luis Aguilar called the SEC’s historical failure to invoke the provision a “clear example where the Commission ignored a Congressional mandate set forth in Sarbanes-Oxley.” Aguilar went on to outline the importance of Section 304 as an incentive for CEOs and CFOs “to be diligent in establishing an honest culture of reporting and in choosing the right people to work for them.”

Although four years passed between SOX’s enactment and the SEC’s first application of Section 304, since then it has risen higher in the agency’s toolbox. The new Dodd-Frank Act, meanwhile, has bolstered the section to encompass all executives and cover a three-year period. It also puts the onus on companies to adopt their own clawback provisions.

The increased focus has led to an exploration of some of Section 304′s ambiguities, including whether it provides for a private right of action. The 9th Circuit has squarely said it does not, and the D.C. Circuit has come to a similar conclusion in dicta. Most recently, the 2nd Circuit took on a corollary issue in a Sept. 30, 2010 ruling that addressed for the first time whether, in a private agreement, parties can indemnify a CEO or CFO against liability under Section 304.

Liability Shield

In Cohen v. Viray, the 2nd Circuit rejected the proposed settlement of a consolidated shareholder derivative action filed against former directors and officers of DHB Industries, since renamed Point Blank Solutions. The body armor company saw its stock price plummet following news its products were made of a material prone to rapid deterioration, which led to civil, SEC and DOJ actions. (In September, in the Eastern District of New York, the company’s former CEO and COO were convicted of fraud, insider trading and obstructing an SEC investigation.)

Both a shareholder and the U.S. government objected to provisions of the settlement that would specifically release and indemnify DHB’s former CEO and CFO from any future liability under Section 304. The challenged portions of the settlement “attempt an end-run around ? 304 that vitiates the SEC’s role and is inconsistent with the law,” the 2nd Circuit held. “If allowed to stand, it would effectively bar the relief the SEC is authorized to seek.”

The appeals court vacated a district court’s approval of the settlement and held there is no private right of action under Section 304–the SEC owns the right to the claim, and it follows that liability under the statute can’t be negotiated away in a private agreement.

As a result, “You won’t see the plaintiffs’ bar using Section 304 in private litigation,” says John Stigi, a partner at Sheppard Mullin Richter & Hampton. “But of course the flip side is that [a corporate executive] can’t use a settlement with a class plaintiff or derivative plaintiff to get relief under Section 304.”

Allowing such agreements would have created a “pretty bad incentive,” according to Gary Sesser, who represented the shareholder bringing the challenge. Under Section 304, because the company is the beneficiary but has no claim, plaintiffs lawyers don’t stand to collect on the claims–and in Viray, the SEC’s claim against former CEO David Brooks alone would have totaled $186 million.

“If the 2nd Circuit had affirmed the settlement, it would have encouraged the situation where class action counsel, in conjunction with derivatives counsel, could have negotiated away the right to a $186 million claim, which they’re not going to get any piece of, in order to get a lesser recovery, which they will get a piece of,” says Sesser, a partner at Carter Ledyard & Milburn. Specifically, plaintiffs attorneys stood to collect $9 million in fees through the proposed settlement, which insulated Brooks from the Section 304 liability if he agreed to purchase $22 million in company stock.

“It was a very sweet deal, and he was two steps ahead of everybody in this settlement,” Sesser says.

Settlement Strategies

In context, the 2nd Circuit’s ruling isn’t terribly surprising, according to Stigi. It’s long been the SEC’s policy not to allow indemnification of disgorgement the agency compels from a corporate executive in an enforcement proceeding. After all, it’s meant as a deterrent.

Going forward, companies dealing with such situations may have difficulty settling shareholder claims until the CEO or CFO knows the full extent of their SEC liability for incentive-based compensation and trading profits, says Mary O’Connor, a partner at Akin Gump.

“One incentive for the company to agree to a global settlement [as in Viray] is to cut off the money they have to spend on defense costs for all these executives,” O’Connor says. “If they enter a settlement without the CEO [or CFO], they still have to pay the legal fees in those instances–it’s not easy to come up with a strategy to settle without them. That’s really going to be the new horizon.”