This post was written by James A. Rolfes.

The Second Circuit Court of Appeals recently ruled that a corporation could not indemnify its CEO or CFO against liability arising under Sarbanes Oxley Act Section 304. The so-called Section 304 “clawback” provision requires a public company’s CEO and CFO to return bonuses, other equity-based incentive compensation and trading profits when “misconduct” leads to material noncompliance with financial reporting requirements (i.e., a financial statement restatement). This statute further gives the SEC the authority to enforce such clawbacks, and, importantly, to exempt CEOs and CFOs from its application. As a result, allowing a corporation to provide a release and indemnification for the clawback would “frustrate the power of a federal agency to pursue the public’s interests in litigation” and “[fly] in the face of Congress’s efforts to make high ranking corporate officers of public companies directly responsible for their actions that have caused material noncompliance with financial reporting requirements.” Cohen v. Viray.

This decision follows closely upon Congress’s call last summer for the SEC to get serious about the return of executive bonuses when a company restates its financial statements. In particular, in the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress expanded upon the SOX Section 304 compensation clawback provision, explicitly instructing the SEC to establish rules requiring exchange-listed public companies to recover the incentive-based compensation paid to corporate executives as a result of using erroneous financial statement data.

The decision also issues during a period in which the SEC has more aggressively used the SOX 304’s clawback provision in enforcement proceedings. Despite being on the books for over eight years, the SEC sparingly invoked the provision in enforcement actions, and then only when a CEO or CFO had direct involvement in causing a financial statement misstatement. Starting in 2007, however, the SEC more regularly has sought SOX 304 disgorgement, and, as the result of a controversial decision that split the Commissioners along party lines, has demanded the return of pay from CEOs and CFOs that unwittingly – as opposed to intentionally – benefitted from the accounting misconduct. (An interpretation recently endorsed by a federal court in SEC v. Jenkins.)

Many questions remain regarding the interpretation of SOX 304 – questions likely to be repeated as the SEC works its way through the rule making process Congress has demanded under Dodd-Frank Section 954. The issues range from what activity will trigger a disgorgement obligation, to whom the obligation will apply, to what payments or incentives will be covered, to what discretion will remain in the SEC’s enforcement of the executive compensation clawback provisions. See Rolfes, Dodd Frank Leaves Clawback Uncertainty, Compliance Reporter (Aug. 30, 2010). What remains clear, however, is that financial statement errors, even if unintentional, will put the earnings of CEOs and CFOs, as well as those of their C-level colleagues, at risk.