Securities Law - The SEC Uses Sarbanes-Oxley To Attack A CEO's Bonus

Apparently the SEC filed its first action under Section 304 of the 2002 Sarbanes-Oxley Act. It appears to represent the start of a more watchful and aggressive approach to regulation by the SEC.

Section 304 provides in part:

If there is material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the CEO and CFO of the issuer shall reimburse the issuer for (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever occurs first) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

The Chief Executive Officer of CSK Auto Corp., Maynard L. Jenkins, has been asked to return $4,000,000 he received in bonuses and stock sales while the company was allegedly committing accounting fraud. The action was filed in the United States District Court for Arizona. According to the Complaint, Jenkins, formerly the Chairman and CEO of CSK was engaged in accounting fraud which also involved many of its senior officers for the years 2002, 2003 and 2004.

CSK, a large distributor of automotive parts and accessories, was a retailer which purchased products from vendors that manufactured various parts. A portion of CSK’s income was obtained from allowances it received from its vendors. Vendor allowances are used to provide financial support to market the vendor’s product. Generally, CSK accounted for the allowances by reducing its costs of goods sold. The more vendor allowances earned, the lower the costs and correspondingly greater pre-tax income. There were millions in uncollectible vendor allowances recognized but were actually uncollectible. According to the SEC Complaint, CSK engaged in a scheme to hide the uncollectible receivables. Instead of writing off the uncollectible receivables and taking a reduction in pre-tax income, CSK concealed its uncollectible receivables by applying millions of dollars allowances earned and collected for later program years to prior program years. For this and similar schemes, CSK avoided writing off tens of millions of dollars of uncollectible receivables. As a result of the failure to properly account for the vendor failures, CSK filed its Form 10-K overstating 2003 pre-tax income by about $11,000,000. The SEC charged that CSK knew or was reckless in not knowing that it failed to write off uncollectible allowances. There were similar charges for later years.

As a result of this fraud, the SEC charged that CSK violated the Anti-Fraud Provisions of the Securities Laws, namely Section 17(a) of the Securities Act. Section 10(b) of the Exchange Act and Rule 10(b)-5 thereunder.

The SEC alleges in its complaint that during the 12 month period following the filing of the fraudulent Form 10-K’s, Jenkins received bonuses and other incentive-based and equity-based compensation from CSK. Jenkins never reimbursed CSK for any portion of the bonuses or other incentive-based and equity-based compensations or his stock sales profits.

The SEC seeks a judgment ordering Jenkins to reimburse CSK for any bonuses and other incentive-based and equity-based compensation and the profits of CSK stock sales pursuant to Section 304 of Sarbanes-Oxley. Section 304 of Sarbanes-Oxley does not permit the remedy of attaching salary, so it is possible that in the future corporate officers may want more of their compensation in terms of salary which cannot be affected by Section 304.

Doubtless, the action of the SEC is one further step in the promise by the new Chairman of the SEC, Mary Schapiro, to be more aggressive. The Maddoff Fraud was a serous blow to the agency which has over the years been considered responsive to investor protection. It appears. Schapiro will try to reverse at least some of the SEC’s prestige in failing to detect Maddoff’s massive fraud.

Edward X. Clinton, Sr.
Copyright 2009

Read More

United States v. Ruehle, 09-50161 (9th Cir. 2009)

CONFLICT
THE TREACHEROUS PATH

William Ruehle, the Chief Financial Officer of Broadcom, a California corporation, and Henry Nichols, a co-founder of Broadcom, were indicted by a Federal grand jury for conspiracy, securities fraud, false certification of financial statements, wire fraud and other crimes in the United States District Court for California. These charges arose from the alleged backdating of options granted to officers of Broadcom.
The story started from events commencing in May of 2006 when Irell & Manella, LLP, a prestigious California law firm, with about 220 lawyers, ranked 60th in a nationwide survey by Vault’s 2009 Guide To The Top 100 Law Firms, was retained by the Audit Committee of Broadcom to conduct an internal investigation concerning the backdating of stock options by Broadcom. It was also decided that the Board would not appoint a panel of independent outside directors to oversee the review. At the time Irell was personally representing Ruehle in civil litigation concerning the backdating of stock options by Broadcom. In June 2006, Irell lawyers, at the request of the Audit Committee, met with Ruehle who told them about the option practices of Broadcom. The Irell firm did not state to Ruehle that they were only representing Broadcom. Word of the backdating problem leaked out and civil suits were filed.

Irell lawyers claimed that they gave an oral Upjohn (Miranda) warning to Ruehle prior to or at the meeting. However, Ruehle does not remember receiving such a warning and the notes of the Irell lawyers do not reflect that a warning was given.
Ruehle, at the request of Irell, met with Broadcom executives and board members to discuss Irell’s internal review and it was agreed that the information would be turned over to the outside auditors, Ernst & Young.

Ruehle and Nichols were indicted in a 65 page indictment. Later, Broadcom told Irell to disclose Ruehle’s conversations about backdating options to the auditors of Broadcom, the SEC and the United States Attorney. Irell did not seek or get the advance consent of Ruehle.

The U.S. Attorney now argues that it can use Ruehle’s statements to Irell at Ruehle’s criminal trial. Ruehle objected at that point on the grounds of the attorney-client privilege because Irell was representing Ruehle in connection with certain civil cases involving those same options. In fact, Ruehle had a long relationship with Irell.
Apparently no one asked the Irell lawyers to get Ruehle’s consent to the dual representation, nor did they recommend that Ruehle get separate independent counsel.
Because of Ruehle’s objection, a couple of months later the District Court at the request of the U.S. Attorney, ordered an evidentiary hearing to determine whether, in fact, the attorney-client privilege, asserted by Ruehle at this point, should be recognized. The U.S. attorneys said that they can use the statements to Irell because an Upjohn (“Miranda”) warning was given by Irell to Ruehle. The District Court stated that it doubts that, in fact, an Upjohn warning was given. The Irell attorneys had no notes of such a warning and Ruehle said he did not remember receiving such a warning.

There was then an evidentiary hearing – some of it outside the presence of the U.S. Attorneys. At the conclusion of the hearing, the Court held that Ruehle reasonably believed that Irell was gathering facts for his defense. The Court went on to say that even if there was an oral Upjohn warning, it was not enough, because such a warning should have been in writing and acknowledged by Ruehle. The Court further stated that the subject of the attorney-client privilege and whether an Upjohn warning was given was very important because Ruehle faces a significant prison sentence if convicted in the criminal case. The Court found Irell breached its duties to Ruehle in disclosing information he told them. The District Court in its decision suppressed the statements of Ruehle to the Irell lawyers and referred the Irell Firm to the State Bar Disciplinary authorities.

The government sought, and was granted, an interlocutory appeal to the Ninth Circuit seeking to overturn the decision to suppress the Ruehle disclosures.

At the outset the Ninth Circuit acknowledged the “’treacherous’ path which Corporate Counsel must tread under the attorney-client privilege when conducting an internal investigation to advise a publicly traded company of its financial disclosure obligations.” Broadcom’s outside counsel recommended that Broadcom restate its earnings to account for 2.2 billion in additional stock-based compensation expenses.
The statements of Ruehle were not made in confidence but were for the disclosure to the corporate auditors. Ruehle never attempted to segregate what he considered what was privileged and what was not privileged with regard to the information furnished in his conversations with Irell.

The Ninth Circuit stated that the overwhelming evidence demonstrates that Ruehle’s statements to Irell lawyers were not made in confidence but rather for the purpose of outside disclosure.

The interlocutory appeal of the government was successful. The Order of the District Court suppressing Ruehle’s statements was overturned. The Ninth Circuit stated that the reference to the Bar authorities was not before it on appeal and therefore it did not enter into that area of whether that referral was appropriate. The case represents a series of questionable acts.

Why did an experienced corporate officer, Ruehle, proceed without clear written assurances from Broadcom, his employer, and Irell, his lawyer, in the option backdating cases that disclosures he might make were subject to the attorney-client privilege? Or, why did Ruehle not ask for separate counsel? Ruehle’s lapse is difficult to understand. The Indemnification By-laws of Broadcom undoubtedly provided that Ruehle could have retained separate counsel at least initially at the expense of Broadcom.

Why did Irell proceed with a dual representation without written acknowledgement by Broadcom and Ruehle that it was representing both, that a conflict might well develop and that such a conflict might involve Broadcom blaming Ruehle of the wrongful backdating. However, even if Irell had such acknowledgment, would its disclosures have breached Irell’s duty of loyalty to Ruehle? A lawyer cannot furnish adverse information about a client.

Why didn’t the General Counsel of Broadcom intervene and insist on a full disclosure of the conflict in the interests of his corporate employer, Broadcom?
Should Ruehle be found guilty following a trial, it seems to be a prime case for review by the United States Supreme Court.

Edward X. Clinton, Sr.
Copyright 2009

Read More