Category: Compliance and Supervision

Update: Eleventh Circuit Affirms Dismissal of Claims for Declaratory Relief and Disgorgement in SEC v. Graham, __ F.3d __, No. 14-13562, 2016 WL 3033605 (11th Cir. May 26, 2016)

We previously wrote about a decision out of the U.S. District Court for the Southern District of Florida in SEC v. Graham, 21 F. Supp. 3d 1300 (S.D. Fla. 2014), which involved claims by the SEC in connection with an alleged $300 million real estate Ponzi scheme. Echoing the Supreme Court’s reaffirmation in SEC v. Gabelli, 133 S. Ct. 1216 (2013), of the importance of statutes of limitation “to the welfare of society,” the district court had held that the five-year statute of limitations in 28 U.S.C. § 2462 is jurisdictional rather than a “claim-processing rule” and that the limitations period provided by § 2462 applies not only to civil penalties but also to equitable relief including injunctions, declaratory relief, and disgorgement. On May 26, 2016, the Eleventh Circuit affirmed in part, reversed in part, and remanded this decision for further proceedings.

The Eleventh Circuit disagreed with the district court’s characterization of injunctive relief as “nothing short of a penalty” and therefore subject to the § 2462 time limit on actions “for the enforcement of any civil fine, penalty, or forfeiture.” Noting that it was bound by its previous holding that “[t]he plain language of section 2462 does not apply to equitable remedies,” United States v. Banks, 115 F.3d 916, 919 (11th Cir. 1997), the court additionally explained that injunctions are not “penalties” because they are forward-looking rather than backward-looking relief.

Nevertheless, the court affirmed dismissal of the SEC’s claims for declaratory relief and disgorgement. The court reasoned that unlike injunctive relief, declaratory relief is backward-looking and “operate[s] as a penalty under § 2462” because “[a] public declaration that the defendants violated the law does little other than label the defendants as wrongdoers.” With respect to disgorgement, the court held that there is “no meaningful difference” between the plain-language definitions of “forfeiture” as used in § 2462 and “disgorgement,” and the court rejected the SEC’s distinction of the terms as “technical definitions” that Congress cannot be assumed to have meant to apply in the absence of clear indication in the statute. Having determined whether § 2462 applies to injunctive relief, declaratory relief, and disgorgement, the court declined to reach the issue of whether the limitations period is jurisdictional in nature.

Although the court agreed with the SEC’s position on injunctive relief, this holding is likely to be of little comfort to the agency. While reasoning that it would be “premature to review the precise nature of” an injunction the district court had not yet issued, the court noted that the injunction requested in the Graham complaint was the type of “obey-the-law” injunction—that is, an injunction prohibiting “the defendants from violating federal securities laws”—it has consistently held to be unenforceable. While the court reasoned that the issue was appropriate for consideration because it “is at least possible that the SEC could seek injunctive relief that would be specific and narrow enough that the parties would be afforded sufficient warning to conform their conduct,” it offered no opinion on what enforceable injunctive relief might look like.

SEC Opens New Funding Options with Regulation A+

Regulation A+ goes into effect June 19, 2015, allowing funding of companies by non-accredited investors. Smaller companies can offer and sell up to $50 million of securities in a 12-month period, subject to eligibility, disclosure, and reporting requirements. See Amendments for Small and Additional Issues Exemptions under the Securities Act.

The regulations allow two tiers of potential offerings. Tier 1 allows security offerings of up to $20 million in a 12-month period. Tier 2 allows security offerings of up to $50 million in a 12-month period but also requires audited financial statements, annual, semi-annual, and current-event reports, and a limitation on the amount of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth. Tier 1 limits offers to not more than $6 million by selling security holders that are affiliates of the issuers, and Tier 2 limits offers to not more than $15 million.

All offerings under Regulation A+ will still require electronic filing of offering materials and other current practices for registered offerings under Regulation A. Offerings will also permit companies to submit draft offering statements for non-public review by SEC staff and allow companies to use solicitation materials after filing the offering statement.

The states of Montana and Massachusetts have both challenged Regulation A+ as arbitrary under the Administrative Procedures Act. Regulation A+ exempts offerings sold under Tier 2 from state blue sky laws. The SEC denied a stay to the implementation of the rules pending the outcome of these challenges. The rules could still be overturned in court, although agencies are given great deference under the Administrative Procedures Act so the success of these challenges is doubtful.

These rules were adopted pursuant to Title IV of the Jumpstart Our Business Startups (JOBS) Act of 2012. The SEC plans to adopt crowdfunding rules pursuant to Title III later in 2015 or 2016. Title III will allow startups to solicit as many unaccredited investors as they wish, though solicitations will be limited to $1 million annually.

Smaller companies may view Regulation A+ as a way to broadly raise funds without undergoing the rigorous requirements of registration under the Securities Act. However, companies need to remember that any offerings will still be subject to various federal laws and regulations and could open up companies and individuals to SEC investigations. Any disclosure statements must be accurate and truthful. Any misleading or incomplete offering materials or disclosures could result in civil enforcement proceedings by the SEC and/or prosecution by the Department of Justice pursuant to criminal fraud statutes.

Regulation A+ expands on Regulation A, a longstanding but rarely used exemption to registration under the Securities Act of 1933. Part of the reason that Regulation A has been so rarely used is because of the significant costs associated with compliance with SEC regulations. Although Regulation A+ allows access to a broader range of individuals as investors, the compliance costs will still be high.

Numerous SEC investigations and enforcement actions in this area are likely. In adopting these rules, the SEC is going to conduct a study and provide a report within five years “on the impact of both the Tier 1 and Tier 2 offerings on capital formation and investor protection.” See SEC Press Release: SEC Adopts Rules to Facilitate Smaller Companies’ Access to Capital. A higher degree of protection may be needed for the non-accredited investors who will be participating in these offerings. It is very likely that offerings under Regulation A+ will face close scrutiny.

The SEC has published a Small Entity Compliance Guide to assist companies in raising funds under Regulation A+.

SEC Awards More Than One Million Dollars to Compliance Officer

On April 22, 2015, the SEC announced an award of between $1.4 million and $1.6 million to a compliance officer who provided original information to the SEC that led to the successful enforcement of a covered action. Exchange Act Rel. 74781 (Apr. 22, 2015). The Dodd-Frank Whistleblower rules generally exclude information that is obtained by an “employee whose principal duties involve compliance or internal audit responsibilities … .” 17 C.F.R. § 240.21F-4(b)(4)(iii)(B). This rule would ordinarily prevent those employees from qualifying as a Whistleblower. An exception applies, however, when the employee has “a reasonable basis to believe that disclosure of the information to the Commission is necessary to prevent the relevant entity from engaging in conduct that is likely to cause substantial injury to the financial interest or properly of the entity or investors … .” 17 C.F.R. § 240.21F-4(b)(4)(v)(A).

The SEC determined this exception was applicable here. According to Andrew Ceresney, Director of the SEC’s Division of Enforcement, “This compliance officer reported misconduct after responsible management at the entity became aware of potentially impending harm to investors and failed to take steps to prevent it.” Press Rel. 2015-73. Despite the limitation on compliance and audit employees to qualify as Whistleblowers, this is the second time the SEC has relied on the exception to make an award to an employee with compliance or audit responsibilities. Last August, the SEC announced an award of more than $300,000 to an employee who performed compliance and audit functions. Press Rel. 2014-180.

SDNY Judge Deals Rejects Constitutional Challenge to SEC’s Use of Administrative Proceedings

A former executive of Standard & Poor’s (S&P) Rating Services has lost an early constitutional challenge to the SEC’s use of administrative proceedings.

Barbara Duka filed suit in federal court in January, following the SEC’s decision to bring charges against her for violating Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, which prohibits fraudulent conduct in the offer and sale of securities. Duka, formerly a co-manager of the commercial mortgage backed securities group of S&P’s Rating Services initiated the suit to prevent her from being compelled to submit to allegedly unconstitutional proceedings. Duka sought a preliminary injunction, arguing that administrative law judges (ALJs) who preside over administrative proceedings, are unlawfully insulated from oversight by the President in violation of Article II of the Constitution. Last week, District Judge Richard M. Berman of the Southern District of New York rejected Duka’s request.

Duka presented her claim as a facial challenged to the constitutionality of SEC ALJ proceedings, which aided the court’s determination that it had subject matter jurisdiction to entertain the suit.

Duka’s constitutional challenge was premised on the argument that SEC ALJs are “inferior officers” protected from removal by at least two levels of good-cause tenure protection and therefore the President cannot oversee ALJs in accordance with Article II. In considering the likelihood of success on the merits of Duka’s constitutional claim, the court rejected the argument that the Supreme Court’s decision in Free Enterprise Fund v. Public Accounting Oversight Board, 561 U.S. 477 (2010), supported the conclusion that SEC administrative proceedings are unconstitutional. In Free Enterprise Fund, the Supreme Court decided that the SEC’s Public Company Accounting Oversight Board created by Sarbanes-Oxley violated Article II because the act provided for dual for-cause limitations on the removal of board members. The Supreme Court held that “such multilevel protection from removal is contrary to Article II’s vesting of the executive power in the President” and that the President “cannot ‘take Care that the Laws be faithfully executed’ if he cannot oversee the faithfulness of the officers who execute them. Id. at 484.

Judge Berman noted that the issue of whether ALJs are “inferior officers” is subject to dispute, but he did not need to resolve that question because it concluded that the level of tenure protection afforded to ALJs was permissible. The court reasoned that the Supreme Court in Free Enterprise Fund addressed the narrow issue of whether Congress may deprive the President of adequate control over the board. The court also noted that ALJs were specifically excluded from the reach of the Free Enterprise Fund holding. Id. at 507 n.10 (“For similar reasons, our holding also does not address that subset of independent agency employees who serve as administrative law judges.”). In addition, the court noted, the decision in Free Enterprise Fund “supports the conclusion that restrictions upon the removal of agency adjudicators, as opposed to agency officials with ‘purely executive’ functions, generally do not violate Article II.” Op. at 19. Here, the court concluded, ALJs perform “solely adjudicatory functions, and are not engaged in policymaking or enforcement.” Id. at 20.

The Duka decision is a setback for defense bar challenges to the SEC’s use of administrative proceedings. As we have written in the previous post: “SEC Faces New Constitutional Challenge to Administrative Proceedings Based on Tenure Protection of Administrative Law Judges,” the SEC has faced a flurry of challenges to the use of administrative proceedings, which provide fewer protections to litigants than those provided in cases brought in federal court. Despite the decision, it is likely that the SEC will continue to face such challenges as they make their way through the federal appellate courts.

SEC Uses Books and Records and Internal Control Regulations to Extend Reach of Actions Beyond Fraud

Last year, we predicted that the SEC would increase its use of administrative proceedings to enforce strict liability violations such as books and records and internal controls. See Mary P. Hansen & William L. Carr, The Future of SEC Enforcement Actions: Negligence Based Charges Brought in Administrative Proceedings, The Investment Lawyer, Vol. 21, No. 9 (September 2014). In a recent action, announced on April 1, 2015, the SEC did just that.

According to the SEC, Timothy Edwin Scronce, the majority owner and CEO of privately held TelWorx Communications, LLC (“TelWorx”), falsified TelWorx’s books to inflate its revenues leading up to and after the acquisition of TelWorx by a public company, PCTEL, Inc. (“PCTEL”). Exchange Act Rel. No. 74626 (Apr. 1, 2015). In particular, prior to the acquisition, Scronce directed TelWorx’s Controller, Michael Hedrick, to inflate the value of certain inventory and to invoice certain orders before they had shipped and then reverse the invoices so they could be invoiced again during the subsequent quarter. After the acquisition, Scronce instructed Hedrick to create dummy invoices for orders that Scronce himself intended to make to further conceal his conduct. In addition, once Scronce learned that a large order that had been postponed would not be placed in time to help meet the quarterly results, he instructed the Vice President of Sales and Tech Services, Marc J. Mize, to solicit a straw vendor that would purchase the product on an intermediate basis with the intent to prematurely recognize the income from this sale. The timing on this transaction ultimately would not obtain the benefit Scronce intended, and he instructed Mize and another employee to reverse the invoice and to enter a revised, false purchase order into the system. All of these actions caused PCTEL to materially overstate its income during the relevant period.

Based on these allegations, the SEC instituted proceedings against Scronce for violation of (1) “Section 10(b) of the Exchange Act and Rule 10b-5 thereunder which prohibit fraudulent conduct in connection with the purchase or sale of securities”; (2) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (3) “Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading”; (4) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (5) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act.” Without admitting or denying the findings, Scronce agreed to disgorgement in the amount of $376,007; prejudgment interest in the amount of $29,212.47; and a civil monetary penalty in the amount of $140,000, and to a ten-year ban on acting as an officer or director of any issuer.

The SEC did not stop there, though. It also charged Hedrick and Mize for violation of (1) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (2) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (3) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act,” none of which requires the SEC to prove that an individual acted with scienter. In addition, the SEC charged Hedrick with causing Scronce’s violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder and with causing “PCTEL’s violations of Section 13(a) of the Exchange Act and rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading.”

Hedrick and Mize, like Scronce, agreed to resolve the charges without admitting or denying the findings. Each of them agreed to pay civil monetary penalties in the amount of $25,000. Notably, these sanctions do not reflect that Hedrick was charged with causing Scronce’s and PCTEL’s fraud violations, while Mize was only charged with strict liability violations.

We expect the SEC to continue using books and records and internal control charges to pursue companies and senior executives who play a role in fraudulent schemes, even where an individual did not act intentionally or even recklessly.

SEC Uses Its Powers under the Dodd-Frank Whistleblower Provisions to Warn Employers Against Attempting to Restrict Employees’ Ability to Report Potential Violations

On April 1, 2015, the SEC announced a settled enforcement proceeding against KBR, Inc., a publicly traded, Houston-based technology and engineering company, for including “restrictive language” in confidentiality agreements used in the course of internal investigations. This is the first time the SEC has used its enforcement powers under Rule 21F-17 of the Whistleblower provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Rule 21F-17 provides that “[n]o person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement … with respect to such communication.”

The language to which the SEC took exception appeared in confidentiality agreements KBR used in connection with internal investigations. The statement, which investigators required employees to sign before the interview, was included in the Company’s Code of Business Conduct Investigations Procedures manual. The statement read:

I understand that in order to protect the integrity of this review, I am prohibited from discussing any particulars regarding this interview and the subject matter discussed during this interview, without the prior authorization of the Law Department. I understand that the unauthorized disclosure of information may be the grounds for disciplinary action up to and including termination of employment.

It does not appear that the policy specifically referenced reporting to the SEC or any governmental authority. Moreover, it seems likely that the Company’s intent was to prevent employees from discussing the matter with each other. The SEC admitted that it had no evidence KBR ever prevented an employee from communication with the SEC staff or that KBR took any action to enforce the confidentiality provision. Nevertheless, the SEC posited that the language undermined the purpose of Section 21F and Rule 21F-17(a), which is to “encourage individuals to report to the” SEC.

The SEC indicated its approval of KBR’s amended policy by quoting it in the Order. The new policy provides:

Nothing in this Confidentiality Statement prohibits me from reporting possible violations of federal law or regulation to any governmental agency or entity, including but not limited to the Department of Justice, the Securities and Exchange Commission, the Congress, and any agency Inspector General, or making other disclosures that are protected under the whistleblower provisions of federal law or regulation. I do not need the prior authorization of the Law Department to make any such reports or disclosures and I am not required to notify the company that I have made such reports or disclosures.

While the Order imposes a modest civil penalty of $130,000, KBR is also required to contact KBR employees who signed confidentiality statements from August 21, 2011, to the present and to provide them with a copy of the Order and a statement that they do not need permission from KBR to communicate with any governmental entity.

This case of first impression underscores the SEC’s commitment to the Whistleblower program and its intent to punish employers that, intentionally or not, restrict an employee’s ability to report potential violations to the SEC. There has been much press about such restrictive language in employment agreements, not just related to the SEC, but also related to the National Labor Relations Board and other federal agencies. It is clear the SEC will consider such restrictive language wherever it may be found. By virtue of this Order, companies will have to manage protecting the integrity of internal investigations and avoiding accusations that it discouraged employees from going to the SEC. It also remains to be seen whether the SEC will take the position that companies are required to affirmatively inform employees of their ability to make reports to the SEC or other governmental bodies or whether employees must merely refrain from discouraging such activity. Because the Whistleblower provisions apply to both private and public companies, it seems a prudent course of action for all employers to review employment and confidentiality agreements.

Whistleblower Award Update

There was not much activity from the SEC Office of the Whistleblower (OWB) in the months since it announced the highest whistleblower award to date in September 2014, but that changed in February when it issued a number of denials. The following is a summary of what’s happened since our last whistleblower award update:

Awards:

In the Matter of the Claim for Award, Exchange Act Rel. No. 72947. On August 29, 2014, the SEC issued its first award under the Dodd-Frank Act to an employee who performed audit and compliance functions. The employee, who had compliance responsibilities, received an award of $300,000. Generally, information provided to an individual with compliance responsibilities is not considered “original.” Such an employee is entitled to an award, however, if they first report the misconduct to the company and it subsequently fails to take action within 120 days. See 17 C.F.R. §§ 240.21F-4(b)(4)(iii)(B),v(v). This exception applied to the claimant because he reported the conduct to his supervisor 120 days prior to submitting it to the Commission.

In the Matter of the Claim for Award, Exchange Act Rel. No. 73174. In September 2014, the SEC announced a record-breaking whistleblower award of $30 million. The significance of this award was discussed in a previous blog post. See SEC Announces Highest Whistleblower Award to Date.

In the Matter of the Claim for Award, Exchange Act Rel. No. 74404. The SEC did not announce its next whistleblower award until March 2015. This award was the first ever to a former corporate officer who learned of a violation as a result of another employee reporting misconduct through corporate and compliance channels. Typically, officers who learn about fraud through another employee or through a compliance process are not eligible for an award under the whistleblower program. See 17 C.F.R. § 240.21F-4(b)(4)(iii)(A). However, the SEC’s bounty rules provide an exception that makes an officer eligible for an award if he or she provides the information to the SEC more than 120 days after other responsible personnel possessed the information and failed to adequately act on it. See 17 C.F.R. § 240.21F-4(b)(4)(v)(C). The former corporate officer fell within that exception and the SEC awarded the officer between $475,000 and $575,000 for reporting original, high-quality information regarding misconduct under the Dodd-Frank Act.

Denials:

In the Matter of Pipeline Trading Systems LLC, Notice of Covered Action 2011-194. Pipeline Trading Systems LLC (“Pipeline”) and two of its top executives agreed to pay $1 million for the company’s failure to disclose to customers that a majority of orders placed on its “dark pool” trading platform were filled by a trading operation affiliated with Pipeline. The SEC denied the claimant an award because he did not meet the definition of a “whistleblower” under the Exchange Act. (Denial Order Aug. 15, 2014).

In the Matter of the Claim for Award, Exchange Act Rel. No. 72947. On August 29, 2014, the SEC denied an award to a second claimant because the information provided did not lead to the successful enforcement of the covered action and did not contribute to the ongoing investigation.

SEC v. James Roland Dial, Case No. 4.12-CV-01654 (S.D. Tex. 2012), Notice of Covered Action 2012-66. The defendants caused Grifco International Inc. to issue more than 13 million unrestricted securities to themselves and then sold the securities shortly after into a rising artificial market (caused by their dissemination of false and misleading information). The defendants were ordered to pay disgorgement and prejudgment interest. The SEC denied the claimant an award because (1) claimant did not provide “original information” within the meaning of Section 21F(a)(1) of the Exchange Act and Rule 21F-4(b)(1)(iv), (2) the information provided by claimant did not lead to successful enforcement of a covered judicial or administrative action within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a) and 21F-4(c), and (3) claimant was not a “whistleblower” within the meaning of Section 21F(a)(6) of the Exchange Act and Rule 21F-2 because he did not provide information relating to a possible violation of the federal securities laws in accordance with the procedures set forth in Rule 21F-9(a) under the Exchange Act. (Denial Order Feb. 13, 2015).

SEC v. Harbert Management Corporation, HMC-New York, Inc. and HMC Investors, LLC, 12-cv-5029 (S.D.N.Y. 2012), Notice of Covered Action 2012-89. Here, the SEC denied the claimant an award because (1) he did not provide information that led to the successful enforcement within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a)(3) and 21F-4(c), and (2) he failed to submit information in the form and manner that is required under Rules 21F-2(a)(2), 21F-8(a) and 21F-9(a) & (b) of the Exchange Act. (Denial Order Feb. 13, 2015).

SEC v. Kenneth Ira Starr, 10 civ 4270 (S.D.N.Y. 2010), Notice of Covered Action 2012-129. On March 3, 2011, Starr was sentenced to 90 months in prison, ordered to pay more than $30 million in restitution, and ordered to forfeit more than $29 million in connection with his misappropriation of investor funds in connection to a series of cases filed against him by the government, which included charges of money laundering, wire fraud, fraud by an investment advisor, and misappropriation of client funds. This specific action arose from Starr’s misappropriation of at least $8.7 million of his clients’ money. The SEC denied the claimant an award because he or she did not provide information that led to the successful enforcement within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a)(3) and 21F-4(c). (Denial Order Feb. 13, 2015).

SEC v. George Wesley Harris, No. 3:09-cv-01809-M (N.D. Tex. 2009), Notice of Covered Action 2011-206. The Northern District of Texas entered a $4.8 million judgment against Harris and his co-defendants for operating a fraud scheme that promised returns for investing in oil drilling projects in Texas and New Mexico. The SEC denied the award because (1) claimant did not provide information that led to the successful enforcement within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a) and 21F-4(c), and (2) claimant also did not provide the Commission with original information within the meaning for Section 21F(b)(1) of the Exchange Act because Claimant’s submission was not derived from claimant’s independent knowledge or independent analysis. The SEC further noted that the claimant made a false statement on the Form WB-APP, which was signed under penalty of perjury, by stating he or she was “the 44th President of the United States.” (Denial Order Feb. 13, 2015).

The OWB denied two other claims, one on February 13, 2015, and one on February 16, 2015, in orders that make it impossible to tell the name or nature of the underlying action. Both claims were denied, however, because the information provided by the whistleblowers did not provide information that led to the successful enforcement of an action within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a)(3) and 21F-4(c). Specifically, the information did not (1) cause the Commission to (i) commence an examination, (ii) open or reopen an investigation, or (iii) inquire into different conduct as part of a current Commission examination or investigation under Rule 21F-4(c)(1) of the Exchange Act; or (2) significantly contribute to the success of a Commission judicial or administrative enforcement action under Rule 21F-4(c)(2) of the Exchange Act.

Finally, the Second Circuit upheld the SEC’s denial of an award to a whistleblower who provided information to the SEC before the enactment of the Dodd-Frank Act in July 2010. Styker v. S.E.C., No. 13-4404-ag, 2015 U.S. App. LEXIS 3765 (2d Cir. Mar. 11, 2015). The whistleblower submitted information from 2004-2009 to the SEC, which eventually led to a $24 million settlement with Advanced Technologies Group. The Second Circuit rejected the whistleblower’s argument that the SEC went beyond its congressionally mandated authority, and it deferred to the SEC’s interpretation of the law that information submitted prior to July 2010 does not qualify for an award. Id. at *8-9.

SEC “Claws Back” Bonuses and Stock Sale Profits From CFOs of Public Company Charged With Accounting Fraud

On February 10, 2015, the SEC announced settlements with two former chief financial officers of Saba Software, a Silicon Valley software company, that require the CFOs to repay Saba more than $500,000 in bonuses and profits from stock sales earned subsequent to Saba’s false filings. Notably, the SEC did not allege that either former officer violated the federal securities laws in any fashion, nor was there evidence of either officer’s knowledge of, or complicity in, the underlying conduct that prompted the company to settle accounting fraud charges lodged against it by the SEC in September 2014. See Press Release, SEC Announces Half-Million Dollar Clawback from CFOs of Silicon Valley Company that Committed Accounting Fraud (Feb. 10, 2015).

The first CFO, William Slater, a former accountant who served as CFO from November 2011 through February 2013, and the second, Peter E. Williams III, a California attorney who served as CFO from March 2004 through July 2007 and again on an interim basis from October 2011 through January 2012, agreed to reimburse the company approximately $337,000 and $142,000, respectively, pursuant to Sarbanes-Oxley Section 304(a).

Section 304(a) provides that in the event an “issuer,” as defined under the Securities and Exchange Act of 1934, is required to issue a restatement of its accounting records as a result of misconduct under the securities laws, the issuer’s CEO and CFO “shall reimburse the issuer” for any bonus, “incentive-based,” or “equity-based” compensation, or for the profits from the officers’ personal sale of any of the issuer’s securities during the 12-month period following the first issuance of each allegedly violative financial statement. See 15 U.S.C. § 7243(a).

In September 2014, the SEC charged Saba with accounting fraud, and the company agreed to a settlement. The company was required to restate its financial records for the years 2008–2011 and for parts of 2012. In connection with the settlement with Saba, the SEC alleged that two Saba vice presidents had overseen a practice of misstating the hourly work of international consultants, both pre-booking and underbooking time statements, in order to adhere to prearranged time estimates. The practice violated GAAP and allegedly led to an overstatement of Saba’s revenues by approximately $70 million. The vice presidents responsible for the misconduct agreed to a collective disgorgement of approximately $55,000 and a collective penalty of $100,000, while the company agreed to pay a $1.75 million fine. At the time of the settlement, Saba’s CEO agreed to reimburse the company for more than $2.5 million in bonus, incentive, and equity-based pay that he received during the 12-month periods following the original issuance of the financial statements containing the alleged fraud. See Press Release, SEC Charges Software Company in Silicon Valley and Two Former Executives Behind Fraudulent Accounting Scheme (Sept. 24, 2014).

The SEC claims that “Section 304 does not require that a chief financial officer [or chief executive officer] engage in misconduct to trigger the reimbursement requirements.” William Slater, CPA and Peter E. Williams, III, Securities & Exchange Act of 1934 Release No. 74240, File No. 3-16381 (Feb. 10, 2015) at 5. Indeed, despite no evidence of fault or liability, Mr. Williams, who served as interim CFO for only four months between 2011 and 2012, was forced to reimburse the company for more than $140,000 in compensation he had received as a result of the allegedly violative financial statements.

This draconian clawback provision went into effect in 2002, although the SEC declined to actively enforce it until 2009. That year, the enforcement division settled accounting fraud charges with CSK Auto and four of its former executives, but in that case, it did not stop there. As former SEC Director of Enforcement Robert Khuzami announced in a December 8, 2009 speech, the SEC sought “to clawback more than $4 million in bonuses and stock sale profits from the former CEO, despite the fact that he was not alleged to have personally participated in the underlying financial wrongdoing.” Khuzami noted that, going forward, the SEC would use this “powerful enforcement tool” in “appropriate circumstances” in order to prevent CEOs and CFOs from “personally profit[ting] from misstated financial filings” and to incentivize these officers “to ensure the accuracy of [their] compan[ies’] financials.” Robert Khuzami, Remarks at AICPA National Conference on Current SEC and PCAOB Developments (Dec. 8, 2009).

Though Khuzami touted the new priority of the enforcement of this provision in another speech, see Robert Khuzami, Remarks at AICPA National Conference on Current SEC and PCAOB Developments (Aug. 5, 2009)  (“This is the first Section 304 action seeking to clawback compensation from an officer that was not alleged to have personally participated in the underlying financial wrongdoing.”), it is unclear when and why the staff will deem officers “appropriate” targets for clawbacks. In fact, because the provision requires no proof of culpability on the part of the corporate officers, the employment of this enforcement tool is particularly difficult to forecast.

Looking ahead, because Section 304(a) does not provide for a private right of action that would allow shareholders to seek reimbursement from CEOs and CFOs, see Cohen v. Viray, 622 F.3d 188, 193-194 (2d Cir. 2010), the SEC remains the exclusive enforcement entity of this powerful provision. There is some indication that we may see an expansion of requirements related to companies’ internal clawback policies through the implementation of Dodd-Frank, see Kara M. Stein, Remarks at the “SEC Speaks” Conference (Feb. 21, 2014) (“We also need to finalize rules about executive compensation, including provisions requiring issuers to have policies in place to claw back compensation.”), but in the meantime, enforcement will remain at the SEC’s whim.

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