A Neer Miss for CFOs and CEOs — Federal Court Finds No Private Right of Action Under Sarbanes-Oxley Section 304

In the first case to directly address the question, a federal district court has held that private parties have no right to enforce Section 304 of the Sarbanes-Oxley Act of 2002. Neer v. Pelino, No. 04-CV-04791-SD (E.D. Pa. Sept. 27, 2005). Instead, the court held that only the SEC can enforce Section 304.

Since Congress enacted the Sarbanes-Oxley Act in 2002, plaintiffs and their counsel have aggressively sought to exploit the Act for their own benefit. Among other things, they have asked courts to imply private rights of action that would allow private shareholders to recover damages under various provisions of the Act.

The Neer decision is important because it rejects a common claim often made by private plaintiffs under the Act. Had the court ruled the other way, it would have established a troubling precedent and would have provided a new claim for private plaintiffs to assert in derivative actions against CEOs and CFOs of companies that restate their financial statements. Limiting enforcement authority to the SEC deprives private plaintiffs of such claims.

Officers of a company that issues a restatement may still face claims from shareholders for damages under state law or other provisions of the federal securities laws. CEOs and CFOs may also face Section 304 claims asserted by the SEC. But the Neer decision protects CEOs and CFOs from private claims under Section 304, and provides a useful precedent for opposing other attempts to imply private rights of action under the Sarbanes-Oxley Act.

This Update summarizes key highlights from the Neer decision and offers practical guidance.

Section 304 of the Sarbanes-Oxley Act

Section 304 of the Sarbanes-Oxley Act requires the CEO and CFO of a company to disgorge their bonuses and other incentive compensation where (i) the company must prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, and (ii) the noncompliance results from misconduct. While Section 304 expressly permits the SEC to exempt any person from this disgorgement requirement, it does not explicitly state whether the authority to enforce Section 304 is limited to the SEC or whether private parties may also enforce Section 304.

The Court's Decision — No Private Right of Action Under Sarbanes-Oxley Section 304

In Neer, a shareholder of Stonepath Group, Inc., sued 14 of Stonepath's current and former officers and directors in a derivative action. In addition to asserting state law claims such as breach of fiduciary duty, the shareholder alleged violations of Section 304 by the company's CEO and CFO. The defendants moved to dismiss the Section 304 claim, arguing that Section 304 does not provide a private right of action.

The court agreed with the defendants and dismissed the claim. The key issue for the court was legislative intent. The court examined the text, structure and legislative history of the Sarbanes-Oxley Act and concluded that Congress did not intend to create a private right of action under Section 304. The court rejected the plaintiff's argument that the text of the Act itself creates an implied right of action. It noted that the remedy provided by Section 304 – disgorgement – is an equitable remedy designed to deprive the wrongdoer of the benefits of wrongdoing, not to benefit shareholders or companies. Moreover, the fact that Section 304 gives discretion to the SEC to exempt a CEO or CFO from liability under Section 304 weighs against creation of a private remedy. The exercise of that discretion does not require the involvement of a private litigant.

The court also considered the fact that Congress created an explicit private right of action in Section 306 of the Sarbanes-Oxley Act, which prohibits directors and executive officers from buying or selling equity securities during a pension fund blackout period if such securities were acquired in connection with the director's or executive officer's employment. Section 306 allows the owner of any security to bring an action to recover profits in the name of the company if the company fails to do so within 60 days of the director's or officer's purchase or sale of the company's securities during a blackout period. Both Sections 304 and 306 address the wrongdoing of officers and directors and provide for reimbursement to the company, yet only Section 306 creates a private remedy. The court found that the absence of an express private remedy in Section 304, in light of the existence of one in Section 306, was deliberate.

Finally, the court examined the legislative history of the Act. It found that the legislative history reflects a consensus that only the SEC would have the right to seek disgorgement under Section 304.

Practical Effect of the Neer Decision

Neer does not change the substance of Section 304: CEOs and CFOs may still be required to disgorge certain bonuses and other incentive compensation when their companies restate their financial statements. The SEC has authority to sue to compel such disgorgement, and to exempt any person from this disgorgement requirement. Thanks to the court's decision in Neer, the plaintiffs' bar will be unable to use Section 304 as an additional claim in derivative litigation against officers of public companies.

Additional Information

This Update highlights key issues in the decision of the U.S. District Court for the Eastern District of Pennsylvania in Neer v. Pelino, No. 04-CV-04791-SD (E.D. Pa. Sept. 27, 2005). You can find discussion of other recent cases and other topics of interest on our website.