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Ninth Circuit Holds SOX Gives SEC Power to Cause Executives to Disgorge Incentive Compensation Based on Others' Misconduct

    Client Alerts
  • September 26, 2016

Rule 13a-14 issued under the Sarbanes-Oxley Act (SOX) requires that Chief Executive Officers and Chief Financial Officers certify the accuracy of the public company’s financial statements. Section 304 of SOX states that CEOs and CFOs can be required to disgorge, or pay back, incentive and equity-based compensation if the financial statements are inaccurate. Last month, the Ninth Circuit Court of Appeals held that Section 304 allows disgorgement even in situations where the CEO and CFO were not directly involved in the alleged misconduct.

In U.S. SEC v. Jensen, the SEC alleged that the company recognized revenue from sales that were contingent or had not been finalized, resulting in an overstatement of earnings. The SEC sought return of incentive compensation paid to the CEO and CFO based on these earnings calculations. The district court dismissed this portion of the complaint, concluding that Rule 13a-14 and Section 304 only provide the disgorgement remedy in situations where the officers fail to make the required certifications, or personally participate in the underlying financial misconduct.

The Ninth Circuit reversed this portion of the decision, remanding it for trial on the merits of the claim. The court first read Rule 13a-14 to include a requirement that the officers providing financial certification represent that their contents contain truthful information. Second, the Ninth Circuit disagreed with the lower court’s assertion that Section 304 only allows disgorgement in the event that the officers making financial representations personally participated in the alleged misconduct. As long as the company is found to have engaged in financial misconduct, the CEO and CFO can be held personally responsible.

This decision takes a broad view of SOX’s remedial authority. It provides the SEC with expanded enforcement powers to hold corporate officers responsible for financial misconduct that benefited them, even in situations where they never personally participated in or knew of the misconduct. Federal courts can order recovery of proceeds of the misconduct regardless of personal culpability. This decision provides CEOs and CFOs with increased incentives to review the substance of financial information contained in reports certified by them.