The U.S. Court of Appeals for the Ninth Circuit held today that the Sarbanes-Oxley Act’s disgorgement provision – which requires disgorgement of certain CEO and CFO compensation when an issuer restates its financial statements “as a result of misconduct” – applies even if the CEO and CFO were not personally involved in the misconduct. Although several district courts had previously reached that conclusion, the Ninth Circuit’s decision in SEC v. Jensen appears to be the first appellate ruling on the issue.

The Ninth Circuit also held in Jensen that the SEC’s Rule 13a-14 – which requires CEOs and CFOs to certify the accuracy of the issuer’s financial statements – provides the SEC with a right of action against officers who certify false or misleading financial statements.

Factual Background

The SEC brought an enforcement action against the former CEO and CFO of a company that had restated its financial statements after the executives’ departure from the company. The SEC maintained that the restatements had resulted from misconduct.

The SEC asserted that the CEO and CFO had violated Securities Exchange Act Rule 13a-14, which requires that each principal executive officer and principal financial officer of an issuer sign a certification as to the accuracy of the financial statements. The Commission also sought disgorgement of the CEO’s and CFO’s bonuses, incentive compensation, and stock profits under § 304 of the Sarbanes-Oxley Act (“SOX”), which provides that the issuer’s CEO and CFO “shall reimburse the issuer for” such compensation if the 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” (emphasis added).

In response to the SOX § 304 disgorgement claim, the CEO and CFO contended that they themselves had not engaged in any misconduct and that they therefore could not be subject to a disgorgement remedy. And in response to the SEC’s Rule 13a-14 claim, the CEO and CFO argued that the Rule creates a right of action only for a CEO’s or CFO’s failure to sign or file the required certification – but does not create a right of action based on false certifications independent of the Exchange Act provisions that prohibit false statements.  The district court agreed with the defendants on both points, but the Ninth Circuit reversed.

Ninth Circuit’s Decision

SOX § 304 Disgorgement

The Ninth Circuit held that SOX § 304 “is concerned not with individual misconduct on the part of the CEO and the CFO, but rather with the misconduct of the issuer.”  The court deemed that reading consistent with the statute’s plain language, in which “[t]he clause ‘as a result of misconduct’ modifies the phrase ‘the material noncompliance of the issuer,’ suggesting that it is the issuer’s misconduct that matters, and not the personal misconduct of the CEO or CFO.”  The court also construed the statute’s legislative history as supporting that conclusion.

The Ninth Circuit noted that it was not aware of any other circuit court that had addressed the issue, but “most district courts to have examined it have concluded that SOX 304 does not require CEOs or CFOs to have personally engaged in misconduct before they are required to disgorge profits under that statute.”

The majority opinion expressly declined “to reach the issue of the meaning of ‘misconduct’ under SOX 304.” A concurring judge, however, would have adopted “a plain language understanding of the word, which Merriam Webster defines as ‘1. mismanagement’ or ‘2. intentional wrongdoing; specifically: deliberate violation of a law or standard. . . .’”  In the concurring judge’s view, “‘misconduct’ requires an intentional violation of a law or standard (such as GAAP) on the part of the issuer, which can be shown by evidence that any employee of the issuer (not only the CEO or CFO), acting within the course and scope of that employee’s agency, intentionally violated a law or corporate standard.”

SEC Rule 13a-14

The Ninth Circuit held that CEOs and CFOs who are required to certify financial statements are responsible not only for submitting the required certifications, but also for the accuracy of the financial statements they certify. “[S]igners of documents should be held responsible for the statements in the document. . . .  [T]he affixing of a signature is not a mere formality, but rather signifies that the signer has read the document and attests to its accuracy.”  As the court observed, “one cannot certify a fact about which one is ignorant or which one knows is false.”

The Ninth Circuit’s ruling appears to apply not only to Rule 13a-14, but also to other certification requirements. “Rule 13a-14, like other rules promulgated under Section 13 of the Exchange Act, includes an implicit truthfulness requirement.  It is not enough for CEOs and CFOs to sign their names to a document certifying that SEC filings include no material misstatements or omissions without a sufficient basis to believe that the certification is accurate.”

The majority opinion declined “to reach the question of the mental state required for a violation of Rule 13a-14,” although it cited a Second Circuit decision holding that “rules promulgated under Section 13 – including rules that apply to persons and not to the issuers themselves – do not incorporate a scienter requirement.” The concurrence, in contrast, would have held that “liability for false certification under Rule 13a-14 may lie only where a CEO or CFO acts with knowledge or at least recklessness as to the falsity of a certification.”

Jensen’s Implications

The Jensen decision appears to be the first appellate ruling on whether SOX § 304 disgorgement can apply to a CEO or CFO who did not personally engage in any misconduct that had occurred at the issuer.  The decision might therefore carry weight when the issue arises in subsequent cases – and might increase the risk that the SEC will seek disgorgement of incentive compensation and stock profits even from innocent CEOs and CFOs if those executives’ companies restate their financial statements as a result of some other corporate employee’s misconduct.

The Jensen decision also leaves open both the meaning of “misconduct” under SOX § 304 and the mental state (if any) required for liability under Rule 13a-14, although the concurring judge addressed both issues.  Those issues could become grounds for litigation in future cases – and in the remand of the Jensen case.