Strike One, Strike Two, Strike 304
Two recent cases seeking to recoup bonuses and profits from corporate executives under Section 304 of Sarbanes-Oxley strike out in the federal courts.
Recently, two federal courts rejected claims under Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”), which provides for the forfeiture of certain bonuses and profits by CEOs and CFOs when their companies are required to restate financials as a result of misconduct.[1] In In re Digimarc Corporation Derivative Litigation, the U.S. Court of Appeals for the Ninth Circuit ruled that Section 304 does not create a private right of action on the part of shareholders of affected corporations.[2] The next day, the U.S. District Court for the Eastern District of Missouri held in SEC v. Shanahan that Section 304 does not provide even the SEC a right of action if the corporation has not actually filed an accounting restatement.[3] In both cases, the courts narrowly construed Section 304 and strengthened a trend limiting the utility of Section 304 to plaintiffs in securities litigation.
In re Digimarc
Back in September 2004, Digimarc Corporation publicly announced that it had overstated earnings for six quarters due to “accounting errors,” resulting in Digimarc’s restatement of its financial results for the affected fiscal periods. The restatement spawned numerous shareholder lawsuits, including a derivative action in the U.S. District Court for the District of Oregon. The derivative action asserted California state-law claims and — under SOX Section 304 — sought disgorgement of profits, bonuses and other incentive-based compensation earned by Digimarc executives during the relevant period.
The Section 304 claim was the sole basis for plaintiff’s assertion of federal-question jurisdiction. The District Court granted Digimarc’s motion to dismiss for lack of jurisdiction, ruling that Section 304 does not create a private right of action, and that there was no diversity jurisdiction. The Ninth Circuit affirmed the Section 304 ruling, but reversed the district court on the issue of diversity and remanded the case.
Section 304 provides:
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 under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for —
(1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer 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; and
(2) any profits realized from the sale of securities of the issuer during that 12-month period.
The question of whether Section 304 confers a private right of action was a question of first impression in the Ninth Circuit. The court noted that numerous district courts around the country have ruled against a private right of action, and the District of Columbia Circuit concurred with those rulings in dictum.[4]
In analyzing Section 304, the Ninth Circuit echoed Supreme Court precedent on private rights of action: “‘The fact that a federal statute has been violated and some person harmed does not automatically give rise to a private cause of action in favor of that person.’ Instead, the statute must either explicitly create a right of action or implicitly contain one.”[5] The court noted that “Section 304 does not explicitly create a private right of action” and thus “any private right of action within section 304 must be implied from the statute’s language, structure, context and legislative history.”[6]
The touchstone of the Ninth Circuit’s inquiry was congressional intent, which the court found “weighs decisively against finding a private right of action.”[7] The court determined that the “language and structure” of Section 304 itself “do not indicate congressional intent to create a private right of action,” and then proceeded to examine the broader statutory scheme, focusing on analogous provisions of Sarbanes-Oxley.
Plaintiffs pointed to two sections of SOX that expressly negate private enforcement: Section 303, which prohibits officers and directors from fraudulently influencing an independent accountant to create misleading financial statements; and Section 804, concerning statutes of limitations. But the Ninth Circuit dismissed the argument that “by making clear it did not intend to create a private right of action in sections 303 and 804, Congress affirmatively intended to create rights of action in sections where it omitted such an express denial.”[8]
The court agreed with defendants that the most analogous provision is SOX Section 306, which generally prohibits directors and executive officers from trading in the company’s securities during a pension-fund blackout period.[9] Unlike Section 304, Section 306 expressly provides for a private right of action on the part of the corporation to recover profits. That disparity led the court to conclude that the silence in Section 304 could not have been intended by Congress to create a private right of action where Congress “was not silent in creating such a right to similar equitable remedies in other sections of the same Act.”[10]
S.E.C. v. Shanahan
Shanahan was an options-backdating case and another case of first impression under Section 304. The question presented was whether Section 304 requires the “actual filing of restated accounting reports” before its provisions apply. In line with the Ninth Circuit in Digimarc, the district court in Shanahan construed Section 304 narrowly, and ruling against the SEC, found that an actual filing indeed is required.
In Shanahan, the SEC alleged that Engineered Support Systems, Inc., with the “participation, knowledge and consent” of its CEO and Chairman Shanahan, issued backdated stock options having an exercise price lower than the price of the company’s stock on the actual award date — in violation of the company’s shareholder-approved stock-option plans. According to the Commission, the options backdating rendered Engineered Support’s SEC filings over a five-year period materially false and misleading because they concealed material amounts of executive compensation, in the form of the backdated, in-the-money options. The SEC claimed that Shanahan knew or was reckless in not knowing that the SEC filings were false and misleading. Among other remedies, the Commission sought disgorgement of Shanahan’s bonuses and profits from trading in Engineered Support’s securities during the relevant time period, under Section 304.[11]
Shanahan argued that since Engineered Support never actually filed restated financial statements, Section 304 did not apply. Thus, the court was called upon to interpret the opening words of Section 304: “If the issuer is required to prepare an accounting restatement ….” Does that mean: (a) that the issuer is obligated to prepare an accounting restatement under generally accepted accounting principles; or (b) that the issuer is directed to prepare an accounting restatement and actually files restated financials?
The SEC argued that the primary purpose of Section 304 is to penalize misconduct, not the act of restating financials. It protested that an actual-filing requirement “would undermine the remedial purposes of the statute, by enabling chief executive officers and chief financial officers to shield themselves from Section 304 liability simply by refusing to restate financial statements and continuing to conceal their misconduct.”[12]
But the district court sided with Shanahan, holding that “the ordinary, contemporary, common meaning of Section 304 is that, before penalties may be imposed, an issuer must be compelled or ordered to prepare a financial restatement, and must actually file the restatement.”[13] The court granted Shanahan’s motion for partial summary judgment, dismissing the Section 304 claim.
Conclusion
In these times of corporate turmoil, heightened scrutiny of executive officers, and pressure on the SEC enforcement staff in light of the Madoff scandal, it is not unreasonable to anticipate an even greater volume of shareholder litigation and SEC enforcement actions alleging accounting irregularities or other securities-law violations by those responsible for guiding corporate issuers. Shareholder plaintiffs and the SEC often have an array of remedies to pursue. But the decisions in Digimarc and Shanahan — denying a private right of action under SOX Section 304, and holding that a restatement must be filed before Section 304 is triggered — may go a long way toward foreclosing a remedy under Section 304, and potentially other statutes for which plaintiffs claim a private right of action.
The information contained in this publication is not intended as legal advice or as an opinion on specific facts. For more information about these issues, please contact Craig Tzvi Gherman. The invitation to contact is not to be construed as a solicitation for legal work. Any new attorney/client relationship will be confirmed in writing.
[1] 15 U.S.C. § 7243.
[2] 549 F.3d 1223 (9th Cir. 2008).
[3] 2008 WL 5211909 (E.D. Mo. Dec. 12, 2008).
[4] 549 F.3d at 1230 (citing cases).
[5] Id. at 1229-30 (quoting Touche Ross & Co. v. Reddington, 442 U.S. 560, 568 (1979)).
[6] Id. at 1230.
[7] Id. at 1231.
[8] Id. at 1232.
[9] Section 306 (15 U.S.C. § 7244) provides that “it shall be unlawful for any director or executive officer … to purchase, sell or otherwise acquire or transfer any equity security of the issuer … during any [pension fund] blackout period with respect to such equity security if such director or officer acquires such equity security in connection with his or her service or employment as a director or executive officer.… Any profit realized by a director or executive officer … shall inure to and be recoverable by the issuer.”
[10] 549 F.3d at 1233.
[11] 2008 WL 5211909, at *2-*4.
[12] See SEC’s Response to Shanahan’s Motion to Dismiss, Strike or for Partial Summary Judgment, 2008 WL 4671246 (Sept. 26, 2008).
[13] 2008 WL 5211909, at *5 (emphasis added).
This SWA publication is intended for informational purposes and should not be regarded as legal advice. For more information about these issues, please contact Craig Gherman at cgherman@swalegal.com or (646) 328-0788.
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