Ninth Circuit Permits SEC to Assert Standalone Claim for False Sarbanes-Oxley Certification, Confirms Disgorgement Remedy Against CEO and CFO Despite Lack of Personal Involvement
In Securities & Exchange Commission v. Jensen, No. 14-55221, 2016 WL 4537377 (9th Cir. Aug. 31, 2016), the United States Court of Appeals for the Ninth Circuit broke new ground by providing the Securities & Exchange Commission (“SEC”) with a new independent cause of action under SEC Rule 13a-14, 17 C.F.R. § 240.13a-14, against a CEO or CFO who certifies false or misleading statements. The Court also held that the disgorgement remedy authorized under Section 304 of the Sarbanes-Oxley Act, 15 U.S.C. § 7243 (“SOX 304”), applied regardless of whether a restatement was caused by the personal misconduct of an issuer’s CEO and CFO or by other issuer misconduct. The majority opinion left some important questions unanswered, but Judge Bea, who concurred with the majority’s analysis and holding, wrote separately to clarify the intended scope of the new legal rules announced by the Court’s opinion.
Defendants were the CEO and CFO of the now-defunct Basin Water, Inc., a company that manufactured water treatment units to provide municipalities with clean drinking water. The SEC filed suit against the Defendants in 2011 alleging that they had participated in a scheme to defraud Basin investors by reporting millions of dollars in revenue that were never realized. After the CEO and CFO left the company in 2008, Basin restated its financial statements for the preceding year-and-a-half. The SEC alleged the defendants fraudulently overstated Basin’s financial results because they failed to comply with GAAP in financial reports, which were accompanied by certifications from the defendants. According to the SEC, revenue was incorrectly recognized from sales that were contingent or had not yet been finalized, as well as from sales where Basin had loaned money to the purchaser to make the purchase but had no expectation of ever being paid back for the loan. Furthermore, the SEC alleged that the CEO and CFO received incentive- and equity-based compensation during the restated time period. The SEC brought a civil enforcement action in the United States District Court for the Central District of California against the CEO and CFO, asserting a number of claims, including false certification in violation of Rule 13a-14 and failure to reimburse in violation of SOX 304.
Rule 13a-14 requires that for every report filed under Section 13(a) of the Securities Exchange Act of 1934, 15 U.S.C. § 78m(a), including Forms 10-Q and 10-K, the CEO and CFO of the issuer sign a certification as to the accuracy of the financial statements within the report. The district court agreed with the defendants that Rule 13a-14 “creates a cause of action against CEOs and CFOs who do not sign or file certifications but does not create a cause of action based on false certifications independent of the existing provisions in the Exchange Act that prohibit fraudulent statements.” Because it was undisputed that the defendants had indeed signed and filed certifications, the district court granted partial summary judgment for defendants and dismissed the SEC’s Rule 13a-14 claim.
SOX 304 provides that “[i]f 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,” then the CEO and CFO of the issuer must reimburse the issuer for any incentive- or equity-based compensation or any profits realized from the sale of securities of the issuer during the twelve months following the beginning of the restated period. The district court held that the disgorgement remedy of SOX 304 was not available because Basin’s restatement was not caused by the personal misconduct of the CEO and CFO.
The Ninth Circuit reversed on both counts. Citing the dictionary definition of “certify,” the Court observed that “one cannot certify a fact about which one is ignorant or which one knows is false.” Analogizing to its own holdings on other similar rules, the Court concluded that Rule 13a-14 “includes an implicit truthfulness requirement.” So, despite an apparent redundancy with other sections of the Securities Exchange Act that explicitly prohibit false or misleading statements, such as Section 10(b), 15 U.S.C. § 78j(b), and its implementing regulation, SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, the Court, through the implicit truthfulness requirement of Rule 13a-14, provided the SEC a separate and additional avenue to challenge false or misleading Sarbanes-Oxley certifications. In doing this, the Court apparently rejected the notion that Rule 13a-14 and Rule 10b-5 could be interpreted to serve two distinct functions: one to require a statement (as opposed to remaining silent) and the other to determine the truthfulness of a statement and culpability for its falsity.
In announcing its new rule, the Court expressly “decline[d] to reach the question of the mental state required for a violation of Rule 13a-14” because the parties did not present arguments on the issue and the Court determined that “a rule on mental state is not needed to resolve the case before us.” This leaves open the question of whether scienter is a required element to prove a false or misleading Sarbanes-Oxley certification under Rule 13a-14. In his concurring opinion, Judge Bea recognized this open issue and sought to clarify the scienter element of the new cause of action: “Specifically, I would hold 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.”
Turning to the SOX 304 claim, the Ninth Circuit analyzed the plain language of the statute, as well as the statute’s legislative history, concluding that “[t]he clause ‘as a result of misconduct’ modifies the phrase ‘the material non-compliance 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, therefore, held that, “SOX 304 allows the SEC to seek disgorgement from CEOs and CFOs even if the triggering restatement did not result from misconduct on the part of those officers.”
Here, too, the majority left an important question unanswered, indicating that it “decline[d] to reach the issue of the meaning of ‘misconduct’ under SOX 304” because the issue was not presented or argued on appeal and because it went beyond what was needed to resolve the case. Pointing out that “[n]either [the Ninth Circuit], nor the SEC, have previously explained what qualifies as ‘misconduct’ as necessary to trigger disgorgement under SOX 304,” and noting that this question will “likely be determinative on remand,” Judge Bea again sought to provide additional clarification in his concurring opinion. Judge Bea explained that, “[i]n [his] 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.”
The Court’s decision establishes important new rules by (1) creating an independent claim for relief by the SEC under Rule 13a-14 for certification of a false or misleading statement and (2) confirming that the disgorgement remedy of SOX 304 against a CEO or CFO is available even if the CEO and CFO were not personally involved in the misconduct that caused a restatement. Although the majority left some questions unanswered, Judge Bea sought to provide clarification in his concurring opinion by indicating that he would require scienter in proving a false certification and by defining misconduct to require an intentional violation of a law or standard.