CFOs of publicly held companies could be in greater danger these days of having their bonus and incentive pay clawed back, judging by signals from the Securities and Exchange Commission.

At issue is the definition of “misconduct.” Section 304(a) of the Sarbanes-Oxley Act of 2002 requires clawbacks of bonuses and incentive-based compensation for CEOs and CFOs when misconduct leads to restated financials. But the law does not define what constitutes misconduct, and the SEC has broad authority to determine when enforcement is appropriate. Right now, it looks ready to take the position that simple negligence is enough to trigger a clawback.

Until 2009, the SEC brought 304(a) cases against CFOs and CEOs only when it accused those executives themselves of engaging in “intentional and pervasive accounting fraud,” according to Junaid Zubairi, chair of the government enforcement and special investigations group at law firm Vedder Price.

That year, the commission sued Maynard Jenkins, former chief executive of CSK Auto Corp., to force him to return $4 million in bonus compensation and stock profits he received while the company was committing accounting fraud. Jenkins was not accused of personally engaging in misconduct, but the SEC successfully argued that if fraud occurs while a CEO or CFO is “driving the bus,” reimbursement should be required under Section 304. Jenkins agreed to return $2.8 million under a 2011 settlement.

Since then, the SEC has used that argument in numerous clawback cases. In some cases only the CEO was charged, but CFOs named in so-called “innocent-executive” cases have included James O’Leary of Beazer Homes USA and Fred Hite of Symmetry Medical Inc. Those two, both of whom have left those respective companies, agreed to repay $1.4 million and $185,000, respectively, although charges in a number of other cases were ultimately dropped.

Even where top executives have not personally engaged in misconduct, in every case there has been underlying egregious misconduct by one or more employees. Now, though, the SEC appears ready to expand its definition of misconduct once again.

“What the SEC wants to do is push the envelope of Section 304 further, and the next horizon appears to be negligence-based cases without regard to fraud,” says Zubairi, who was an attorney with the SEC’s enforcement division before joining Vedder Price in 2008. “As the SEC staff has made clear in litigation filings and during the investigative phases of these matters, there are ongoing discussions about whether mere negligence is enough to trigger a clawback, and the staff is taking the position that it is.”

No cases have yet been filed using the negligence standard. Zubairi says the SEC is probably looking for an appropriate case where the degree of negligence is sufficient to accept the litigation risk the case would surely entail. His expectation is that if the commission does file and successfully prosecute such a case, it will be emboldened to pursue others where the negligence is perhaps not so pronounced.

A defendant’s strongest argument will be a policy-based one, Zubairi suggests. That is, a CEO or CFO who can show that the company had good internal controls against fraud, hired good outside auditors and had good internal auditors will be more likely to prevail. “Executives need to show they promoted a culture of compliance and ethical behavior,” he says.

He also notes that executives can act in advance to take the teeth out of a potential future 304(a) proceeding by structuring their compensation packages to be more salary-based, as salary is not subject to clawback. However, since the mid-1990s there has been an ongoing trend toward senior executives’ pay being less salary-based. In part that’s been a response to IRS Section 162(m), under which companies cannot take a tax deduction for the amount of such an executive’s salary that exceeds $1 million. “I’m not suggesting that is the right approach or the only one, but it’s a consideration an executive probably should be thinking about when negotiating a financial package,” Zubairi says.

Another argument that could prove useful is that Sarbanes-Oxley was enacted as a direct response to the egregious malfeasance of Enron, Worldcom and other public companies in the plethora of accounting scandals that took place 10 to 15 years ago.

Exposing executives to clawbacks for simple negligence “would not only defy the apparent legislative intent behind Section 304, it would also increase the likelihood of a successful Constitutional challenge,” Zubairi says. “Moreover, such an interpretation would improperly convert the executive into a ‘guarantor’ of an issuer’s financial statements, rather than one held accountable for implementing effective internal controls reasonably designed to detect fraud.”

Many investors, though, are unlikely to be swayed by such arguments. For example, pressure from investors recently led six of the biggest U.S. drug makers to revise their compensation policies to make it easier to recover payouts from executives even where financial results were not restated and things just didn’t go well for the company.

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