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SEC Files SOX Clawback Case Against Former CEO and CFO of Surgical Products Manufacturer

Posted in Compensation Matters, Executive Officer Matters, Sarbanes-Oxley Act, SEC Enforcement Cases

On Monday, April 2, 2012, the SEC announced that it has filed suit in federal court in Austin, Texas against Michael A. Baker, the former CEO of ArthroCare Corporation, and Michael Gluk, the former CFO, to recover bonus compensation and stock sale profits they received during an accounting fraud at the company. As the SEC pointed out in its press release, the two men "are not charged with personal misconduct, but they are still required under Section 304 of the Sarbanes-Oxley Act to reimburse ArthroCare for bonuses and stock profits that they received after the company filed fraudulent financial statements during 2006, 2007, and the first quarter of 2008."

ArthroCare, a surgical products manufacturer based in Austin, had settled an enforcement action with the SEC in February 2011. In addition, in July 2011, two other former executives settled charges of perpetrating a fraudulent scheme to overstate the company’s revenues and earnings. The Commission alleged that the two executives, John Raffle and David Applegate, caused ArthroCare to improperly record revenue from shipments of spine products to distributors between 2006 and 2008, even when the distributors did not need the products or have the ability to pay for them (and that most of the improper transactions occurred at or near the end of quarters and were intended to enable ArthroCare to satisfy external revenue and earnings targets). The Commission claimed that as a result, ArthroCare’s publicly reported revenue and earnings were materially misstated – total revenue was overstated by more than $72 million and net income overstated by more than $53 million.

This week’s case against Messrs. Baker and Gluk was brought under Section 304 of the Sarbanes-Oxley Act, which provides for reimbursement by certain senior executives of certain compensation and stock sale profits which they received while their companies were in material non-compliance with financial reporting requirements due to misconduct (even in situations where the individual is not personally charged with the underlying misconduct). The Commission seeks entry of a Judgment "ordering each Defendant to reimburse ArthroCare for all SOX 304 compensation and profits realized from his sales of ArthroCare stock during the relevant statutory time periods," but does not identify that amount. Unlike the proceeding against the company and the case against Messrs. Raffle and Applegate, this case was not settled at the outset and remains in litigation.

The SEC has had some difficulty resolving some clawback cases in the past. In July 2011, the SEC’s Commissioners rejected a proposed settlement to "claw back" a portion of the bonuses and stock sale profits Maynard L. Jenkins, the former chief executive officer of CSK Auto Corporation received, as discussed here. Those negotiations failed when the SEC rejected the settlement proposed by its own enforcement staff which would have recovered less than half of the amount sought in the Complaint. The Commission ultimately resolved the case in November 2011, when Mr. Jenkins agreed to re-pay approximately $2.8 million of the over $4 million he received, as discussed here.

Despite the difficulties in the Jenkins case, this case against Mr. Baker and Mr. Gluk reflects one of the powerful weapons the Commission has at its disposal. The Director of Enforcement, Robert Khuzami, said "[c]lawback of incentive compensation and stock sale profits as authorized under the Sarbanes-Oxley Act is yet another reason for CEOs and CFOs to be vigilant in preventing misconduct and requiring that companies comply with financial reporting obligations." In short, those individuals who have no role in the misconduct may still face action and must take steps to prevent violations.