In the latest of a series of victories for the SEC under Section 304 – the
compensation clawback provision – of the Sarbanes-Oxley Act of 2002 (Section
304), the U.S. Court of Appeals for the 2nd Circuit has ruled, in a case of
first impression, that a company may not agree to indemnify its CEO or CFO for
any compensation or stock sale profits that the officers are required to
disgorge under Section 304.
Although the facts in the case involved an indemnification provision in a
settlement agreement, the logic of the ruling could extend to indemnification
provisions in companies’ charter documents and in directors’ and officers’
liability insurance policies as well.
Section 304 requires that a CEO or CFO of a public company reimburse the
company for any incentive compensation received or stock sale profits recognized
during the 12-month period following the filing of a financial statement that is
subsequently required to be restated as a result of misconduct.
The underlying case – In re: DHB Industries, Inc. Derivatives Litigation
– arose when the stock price of DHB Industries, a body armor manufacturer,
collapsed in late 2005 following revelations that DHB had used an inferior
material to manufacture its products. In 2006, civil and criminal cases were
filed against DHB’s former CFO and COO, alleging widespread accounting fraud at
the company in the years leading up to the collapse in its share value.
In 2007, DHB restated its annual financials for 2003, 2004 and 2005, and soon
afterward civil and criminal cases were filed against DHB’s former CEO David H.
Brooks as well. In its civil complaint against Brooks, the SEC alleged that the
former CEO had violated various securities laws and demanded disgorgement of
more than $186 million in stock sale proceeds and bonuses under Section 304.
In 2008, the federal district court, overseeing the consolidated derivative
and class action suits against the company, approved a settlement under which
DHB agreed to indemnify Brooks and DHB’s former CFO from any liability under
Section 304. The United States objected to the settlement on several grounds,
including that it undermined the SEC’s ability to hold Brooks and the former CFO
accountable under Section 304, and appealed the settlement to the 2nd Circuit.
On September 30, 2010, the 2nd Circuit overturned the settlement, ruling in the
government’s favor that a company may not agree to indemnify its CEO or CFO from
potential Section 304 liability.
In reaching its decision, the 2nd Circuit held (consistent with other courts
that have examined the issue) that private parties may not sue to enforce
Section 304. Since only the SEC can enforce Section 304, the court reasoned,
only the SEC should be permitted to settle a Section 304 claim as well – and the
indemnification agreement was effectively an attempt to settle Brooks’ Section
304 liability (at $0). Brooks’ counsel argued in vain that the indemnification
agreement – a private contract that didn’t bind the SEC – had no effect at all
on the SEC’s ability to pursue its Section 304 claim against him. The court’s
underlying policy concern appears to have been that the SEC would be less likely
to vigorously pursue Section 304 claims if it knew the company had agreed to
indemnify the executive, indirectly letting executives off the hook.
Although barred from indemnifying Section 304 liabilities, it seems parties
may achieve the same practical outcome by adjusting the settlement amount the
executive otherwise agrees to pay the company. For example, in the case at hand,
it might be expected that the parties (ignoring any credit risk) would react to
the 2nd Circuit’s ruling by reducing the settlement amount that Brooks
previously had agreed to pay the company by the present value of $186 million,
the approximate amount the company could now expect to receive from Brooks in
the future if the SEC were to be successful in its Section 304 claim.
This case should be distinguished from other recent notable cases under
Section 304 in which the SEC has pursued Section 304 claims against CEOs and
CFOs who were not alleged themselves to have engaged in any personal misconduct.
The SEC was recently successful in persuading a federal district court in
Arizona of the merits of this position in SEC. v. Jenkins, decided last
June. Here, Brooks and DHB’s former CFO were alleged to have personally violated
various securities laws in addition to Section 304. In combination, however, the
cases suggest that not even “innocent” CEOs and CFOs may be indemnified for
potential Section 304 liabilities.
This case also has potential implications for the compensation clawback
provisions in the recently enacted Dodd-Frank Wall Street Reform and Consumer
Protection Act (the Dodd-Frank Act). Under the Dodd-Frank Act clawback
provision, which will become effective once the SEC issues final rules (proposed
rules are expected in the second quarter of 2011), every public company will be
required to adopt a clawback policy that will require all current or former
executive officers (not just CEOs and CFOs) to repay any erroneously paid
incentive compensation received during a three-year period preceding a financial
The SEC’s position in the DHB case suggests that it may be inclined to take a
similar position against company indemnification of executive clawback
liabilities when it tackles the rules for the Dodd-Frank Act clawback provision,
although – based on the 2nd Circuit’s rationale, at least – this may depend on
whether the Dodd-Frank Act clawback provision permits private rights of action
(a question that is yet to be determined).