On March 22, 2005, an en banc panel of the U.S. Court of Appeals for the Ninth Circuit, in a 10 to 1 decision, affirmed a district court’s order freezing more than $37.6 million in payments to Gemstar-TV Guide International, Inc.’s former Chief Executive Officer, Henry Yuen, and former Chief Financial Officer, Elsie Leung. Securities and Exchange Commission v. Yuen, et al., No. 03-56129 (9th Cir. March 22, 2005, available online, pdf format). The negotiated payments had been designed to compensate the executives for termination pay, unpaid salary, unused vacation time, shares of restricted stock, and bonuses. The Ninth Circuit concurred with the SEC’s proposed broad and flexible standard for defining "extraordinary payments" under Section 1103 of the Sarbanes-Oxley Act. As put by Judge Stephen S. Trott in writing the majority opinion, "The district court had it exactly right in reading the statute, not technically and restrictively, but flexibly to effectuate its remedial purposes."
Congress enacted Section 1103 in response to the recent highly publicized corporate and accounting scandals (e.g., Enron, Tyco, WorldCom, and Adelphia) and to prevent dissipation of corporate funds by so-called "corporate scoundrels." During the pendency of a lawful investigation into possible federal securities law violations, Section 1103 gives the SEC the ability to petition a federal district court for a temporary 45-day freeze (which can be extended up to an additional 45 days) on any "extraordinary payments" likely to be made to corporate executives, employees or insiders of a company under investigation. If the SEC commences litigation, the freeze becomes permanent (unless specifically ordered otherwise by the court) until the litigation is concluded.
In Yuen, the district court concluded that the payments to the former executives, which were negotiated as part of a corporate restructuring, were "extraordinary" under Section 1103 based on several facts, including that they were "five and six times greater than Yuen’s and Leung’s base salaries," and contained "lump sum payments different than the amounts due under their employment agreements." Gemstar did not oppose the order, because it separately sought recovery from Yuen and Leung, but Yuen and Leung oppose it. In ordering the freeze, the district court reasoned that, when viewed in light of the circumstances, including an existing SEC investigation, and the purpose and size of the payments, the payments were "anything but ordinary."
On appeal, a three-member panel of the Ninth Circuit reversed the district court’s ruling reasoning that "extraordinary" is a comparative adjective, and has meaning only in relationship to the ordinary and usual. The panel concluded that the SEC had failed to provide any evidence as to what constitutes an ordinary restructuring payment under the same or similar circumstances, such as by looking outside of the company under investigation for objective comparative evidence. The panel held it could not objectively determine that the payments were extraordinary where the SEC failed to present relative or comparative evidence of the ordinary.
On rehearing, the en banc panel concurred with the district court, holding that "extraordinary," when viewed in the context of Section 1103’s aim of preventing the raiding of corporate assets, means "a payment that would not typically be made by a company in its customary course of business." Under this standard, the basis for evaluation or comparison is the company’s normal or regular behavior and not the behavior of companies that find themselves in similar situations. The Court refused to "shield such payments from escrow simply because an ousted insider at some other corporation has been similarly enriched."
The Court enumerated several non-exclusive factors, such as the size and purpose of the payments, the circumstances, the connection of the payments to the alleged wrongdoing, and perceived deviation from industry norms, as evidence of the unusual and extraordinary. Applying this standard, and in light of the facts of the case, the Court held that the payments to be made to Yuen and Leung were "not business as usual." Judge Stephen Reinhardt (joined by Judge Graber), in the concurring opinion, went so far as to say that all non-routine severance packages provided to corporate officials under investigation should be labeled "extraordinary." Judge Carlos Bea, was the lone dissenting judge.
There have been few reported court challenges to the SEC’s use of Section 1103, with Yuen standing as the only published judicial interpretation. The Yuen decision is a strong arrow in the SEC’s quiver, and likely will result in increased efforts to freeze bonuses and severance packages to executives of companies under investigation.