The Sarbanes-Oxley Act reaches its third birthday this month. Acknowledged as the most sweeping piece of corporate legislation in history, the statute could have been expected to foster a rush of litigation.
In fact, courts have seen very few SOX cases. The primary impact of the statute is in its prophylactic strictures concerning governance.
What litigation has SOX engendered, and what insight does that litigation shed on the nature of SOX as a regulatory scheme?
There is no litigation involving enforcement of SOX 1107, a criminal provision punishing by substantial fines (and up to 10 years in prison) retaliation of any nature (including employment action) against any person reporting information to a law enforcement officer regarding any federal criminal offense.
All litigation has arisen under the more prosaic provisions of Sox 806, which provides civil damages for any employee who suffered employment retaliation for providing information to law enforcement, government agencies, company supervisors or company investigators concerning acts of fraud, violations of SEC regulation or of any federal laws relating to fraud against shareholders.
Anomalously, there also have been no cases brought under SOX seeking to protect employees who decline to participate in unlawful practices, but do not report them. There is substantial question as to whether SOX provides any protection whatsoever for such honest employees, who presumably may be fired with impunity (at least under federal law) as a reward for keeping their mouths shut.
Most whistleblower litigation has arisen under adjudications by administrative law judges in the Department of Labor, to which initial enforcement of SOX 806 has been entrusted. Administrative law determinations in favor of employees (the vast majority of cases favor employers) have in one instance ordered reinstatement and in most other instances awarded lost salary and recovery of legal fees. (See “Most SOX Whistleblowers Not Faring Well So Far” in the April 2005 issue of In-House, generally surveying such cases.)
More interesting than the occasional recovery of back wages, however, is the way in which the administrative law judges interpret SOX 806. Under the statute, retaliation is prohibited only in instances where an employee blows the whistle on “fraud”: mail fraud, wire fraud, bank fraud, securities fraud, SEC anti-fraud rules or “any provision of federal law relating to fraud against shareholders.” Administrative law judges seem unimpressed by this requirement.
In Morefield v. Exelon Services, Inc., an executive was fired after complaining that management manipulated the company financial results. The company responded that no fraud could have occurred because manipulations never reached publicly disclosed financials and, further, the amounts involved were miniscule (less than 1/10,000 of 1 percent of consolidated revenues).
The administrative law judge, noting that the statute was to be broadly construed to prevent fraud against shareholders, concluded that whistleblowers were protected for reporting violations of internal accounting controls, sending a clear signal that whistleblowers will be protected in reporting violations of SOX 404. The judge also noted that fraud comes in all sizes and that any matter, no matter how small, falls under SOX 806.
In a case brought against American Airlines, an employee alleged retaliation for reporting a co-worker who created sculptures utilizing aircraft parts, in violation of Federal Aviation Administration and company regulations. Since the reporting employee reasonably believed the co-worker was committing fraud against airline shareholders, the administrative law judge allowed the case to proceed. The supposition appears that theft from a company constitutes a federally prohibited fraud against shareholders, certainly an expansive definition.
To similar effect is a case against Atlanta Coast Airlines Holdings, Inc., in which a manager reported that airline management paid pilots for time spent on union business. Concluding that “such a scheme, by its very nature, would involve the use of the mail and wires, and could constitute a fraud of the…shareholders,” an administrative law judge protected the employee from retaliation.
Does an undesirable activity ever not constitute “fraud” to the DOL? This is an evolving area, but in one case, ATK Tactical Systems, an administrative law judge recommended dismissal of a complaint where an employee had reported the release of a large quantity of sludge water into the ground water system.
In-house counsel interested in monitoring the ever-unfolding world of DOL can log onto the “Whistleblower Newsletter” published by the Office of Administrative Law Judges at www.oalj.dol.gov/PUBLIC/WBLOWER/REFRNC/wnew012005.htm.
In federal court, the SOX 806 landscape gets even more confusing.
When terminated employee Kenneth Boss brought suit against Salomon Smith Barney Inc. in the U. S. District Court for the Southern District of New York, the brokerage firm responded that the SOX retaliation claim was subject to mandatory arbitration (brokerage employees registered with the National Association of Securities Dealers file an application requiring arbitration of employment disputes).
The employee argued that SOX exclusively vested jurisdiction in the federal courts. The court disagreed, finding no evidence of congressional intent to preempt arbitration claims under SOX. (Presumably, initial administrative recourse to the DOL would not be preempted). Whether courts will enforce a mandatory arbitration provision – where arbitration is not extrinsically mandated (such as by the NASD) – remains to be seen.
Note that the court looked for legislative history concerning Congressional intent, in passing SOX, to preempt arbitration provisions. Since SOX has no useful legislative history, the court came back empty-handed.
In a December 2004 decision, the U.S. District Court for the Southern District of Florida resolved two matters of first impression arising in a whistleblower claim brought against WCI Communities, Inc.
Robert Hannah sued for punitive damages under SOX and under the Florida Whistleblower Act, claiming damages for injury to his reputation. (Many states have whistleblower statutes, some of which are broader than SOX 806, and those state statutes are not preempted by SOX.)
The court noted that punitive damages are unavailable under SOX, but treated Hannah’s claim for injury to reputation not as a claim for punition but rather as a reimbursement for reputational injury which diminished future earnings. As a matter of first impression, the court refused to strike Hannah’s demand for reputational damages.
A second, startling matter of first impression was whether Hannah was entitled to a trial by jury. The court noted denied defendant’s motion to strike the jury claim (but without prejudice to its right to later reassert the same motion).
A Birmingham, Ala. jury recently handed the SEC a significant defeat by acquitting HealthSouth CEO Richard Scrushy of criminal liability for violation of Section 906 of the Sarbanes-Oxley Act.
The Scrushy case was the first attempt by the Commission to convict a CEO of filing a false certification as to the accuracy of his company’s financial statements. Section 906 requires both the CEO and the CFO to certify categorically, in language that cannot be varied, that SEC-filed financials comply with law and present fairly the results of operations; willful and “knowing” violation can bring $5 million in fines and 20 years in prison.
Prior to trial, Scrushy twice unsuccessfully sought dismissal of the SOX-based portion of his indictment, alleging unconstitutional vagueness of SOX 906. The U.S. District Court judge overseeing the case ruled that the statute was sufficiently definite both to give notice of what conduct was forbidden and to avoid arbitrary enforcement.
Another aspect of SOX, Section 804, extended the statute of limitations for private securities fraud cases from the longer of one year from occurrence or three years from discovery to the longer of two years from occurrence or five years from discovery. Litigation, claiming that extended limitations could revive previously barred claims, continued until the December 2004 decision of the 2nd U.S. Circuit Court of Appeals in In Re: Enterprise Mortgage Acceptance Co. LLC.
In a decision now seemingly followed by all courts, it was noted that SOX did not expressly provide for retroactive application so as to revive stale securities fraud claims and, finding no legislative history bearing on the point, the 2nd Circuit refused to permit the revival of a defunct claim.
Citing the presumption against retroactive application of statutes, the court affirmed the dismissal of the plaintiffs’ claims. Plaintiffs had argued that Senator Patrick Leahy’s remarks on the floor of the Senate clearly evinced a Congressional intention to provide retroactive relief to defrauded individuals, but the court pointed to precedent denying weight to floor statements that do not find their way into formal legislative history.
Litigation continues in an effort to sort out whether particular cases fall factually into the pre-SOX time-barred category, or whether they have their own life under the new extended limitations. Some appellate courts send these cases back down for further factual analysis, as did the 11th Circuit on June 1 in Tello v. Dean Witter Reynolds, Inc.
Two federal district court cases from earlier this year give a glimpse of the types of issues that must be addressed. In March, a judge in the U.S. District Court for the Southern District of New York made clear (Small v. Arch Capital) that a securities law claim that was not time-barred on the date of SOX enactment did indeed enjoy the benefit of the extended limitations period – although the events giving rise to the claim occurred prior to SOX enactment and although the plaintiff had failed to bring litigation prior to that enactment.
Finally, in a February decision, the U.S. District Court for the District of Massachusetts dealt with the issue of whether litigation brought under SOX’s extended statute of limitations could be dismissed as time-barred because it was successor litigation to a complaint filed prior to SOX. The Court found in Quaak v. Dexia, S.A. that since the new complaint added an additional new defendant, the longer statute of limitations would be applied.
Two additional federal cases reflect the SEC’s activism in enforcing SOX.
In April 2005, the SEC obtained an order from the U.S. District Court for the Southern District of New York against AIG to protect the integrity of documents relating to the commission’s ongoing AIG investigation.
Although not a SOX-related case, it is interesting to consider this development in light of the extensive SOX prohibitions, imposing criminal penalties for obstruction, destruction, alteration and falsification (SOX 802, 807, 901 and 905). Commentators have suggested that, although the U.S. Supreme Court in May unanimously reversed the criminal conviction of Arthur Andersen for obstructing justice in connection with the systematic destruction of Enron files, that case might well have been resolved adversely to Arthur Andersen had the broad SOX prohibitions against document destruction been in force in 2001 (when the Enron destruction occurred).
Although Chief Justice William Rehnquist’s opinion in the case emphasized that jury instructions failed to “convey the requisite consciousness of wrongdoing,” and although SOX violations similarly require knowing action for criminal conviction, it is not hard to imagine the SEC urging an aggressive SOX enforcement regime in the right case.
The second case growing out of SEC activism is the 9th U.S. Circuit Court of Appeals decision in March in SEC v. Yuen. SOX 1103 gives the SEC the power to bar “extraordinary payments” to officers and directors (whether compensation or otherwise) whenever during an investigation of a public company it appears likely that the company will make such payments.
The SEC must ask a federal district court to escrow those funds in an interest-bearing account for 45 days, which may be extended for an additional 45 days for good cause. If prior to the termination of the order somebody is charged with a violation, the funds remain in escrow. If no charges are brought, the funds must be released.
At issue in the case were negotiated executive termination payments that were five or six times greater than the base salaries payable to the officers, and which were different from the amounts payable under existing contracts. The court noted that the bonuses appeared to be funded by the allegedly fraudulent financial results, and, further, that these extraordinary payments were not of the type expected to be paid from corporate assets to executives resigning from key positions while under investigation. This conclusion turns a conveniently blind eye to recent events at Disney and numerous other contemporaneous examples of corporate behavior.
The employees mounted an argument that SOX 1103 was unconstitutionally vague in that the term “extraordinary” was given no definition. The majority relied upon the remedial purpose of the statute to give broad meaning to the word, but two judges sought firmer footing for the definition. They would hold as extraordinary “all severance packages due top corporate officers and officials, and any other substantial non-routine payments to which they may be entitled.” Such a construction is itself extraordinary. Virtually all executives receive severance payments in the “ordinary” course, and if Congress had intended to permit the escrow of all severance payments it could easily have said so.
Some Concluding Thoughts
After three years, there is very little SOX-related litigation addressing the core of the statute’s governance provisions. Why?
SOX is “front end regulation.” Rather than establishing broad prohibitions, leaving wide areas for interpretation (and hence litigation), the statute is very specific. While SOX has been criticized for its level of detail in the control of corporate governance, this very level of specificity is not conducive to litigation.
Additionally, perhaps everyone really heard the message from Congress that SOX is remedial and to be broadly construed. Everyone walks on eggshells. What in-house counsel wants to risk, on behalf of one’s own company, testing the boundaries of SOX prohibitions?
Fear and draconian clarity have so far kept SOX out of the courts. Time will bubble up additional pockets of litigation, but (whatever else it is) SOX is not a font of litigation concerning corporate governance.
Stephen M. Honig, member of Duane Morris LLP’s corporate department resident in its Boston office, was assisted in this article by Elizabeth J. Dodson of Harvard Law School, summer clerk in Duane Morris’ Philadelphia office.