SEC Enforcement Actions Against Outside Directors Offer Reminder for Boards

In recent months, the U.S. Securities and Exchange Commission has brought two enforcement actions against independent directors of two publicly traded companies. While the commission historically has not pursued public company directors, it does so when it deems the directors to have knowingly permitted or facilitated violations of the securities laws. This report discusses these recent cases in light of the SEC’s historical position on such offenses and offers recommendations for how board members can mitigate their risks.

The SEC enforcement actions were against four independent directors at two publicly traded companies. While these actions reflect the SEC’s interest in bringing actions against these types of directors, they are consistent with the commission’s historical practice of pursuing cases against independent directors only when it believes that they personally have engaged in violative conduct or have repeatedly ignored significant red flags (see “Historical SEC Actions against Outside Directors” below). One of the actions, which was brought as an administrative proceeding instead of as a complaint in federal court, illustrates how the commission may choose to use some of its new enforcement powers under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).

Action Against Independent Directors of DHB Industries

On February 28, 2011, the commission filed a complaint in federal court against three former “independent” directors of DHB Industries, Inc. (“DHB”), now known as Point Blank Solutions, Inc., who had served as members of the audit committee. The complaint alleged that the three former board members—Jerome Krantz, Cary Chasin, and Gary Nadelman—facilitated DHB’s securities violations through their “willful blindness to red flags signaling fraud” between 2003 and 2006. [1] Their actions allegedly allowed senior management to file materially false and misleading filings with the commission and use corporate funds to pay for personal expenses. The complaint also alleged that the directors’ actions allowed DHB’s then-CEO David Brooks to divert corporate funds to a personally controlled entity. The complaint further alleged that the three directors lacked independence because of their business relationships and decades-long social relationships with the CEO. The complaint alleged that the directors omitted from the official board minutes discussions of company expenditures that had no legitimate business purpose (e.g., paying for prostitution services), made little or no effort to understand their audit committee responsibilities, and “turned a blind eye to numerous, significant, and compounding red flags.” The red flags included, among other warning signs, the following:

• the August 2003 issuance of a material weakness letter to the audit committee concerning DHB’s internal controls over financial reporting by DHB’s then-auditor Grant Thornton LLP and its subsequent resignation;
• numerous concerns reported to the audit committee by DHB’s new auditors Weiser LLP (“Weiser”) in March 2004;
• concerns raised with Weiser by the company’s controller and the controller’s intention to resign over inventory overvaluation;
• Weiser’s recommendation to the audit committee to investigate the inventory overvaluation issue;
• Weiser’s objection to the filing of DHB’s 2004 annual report and a March 2005 material weakness letter issued by Weiser, followed by its resignation;
• the January 2004 resignation of Gibson, Dunn & Crutcher LLP (“Gibson Dunn”), which had been hired as outside counsel to investigate potential related-party transactions between the CEO and an entity allegedly controlled by the CEO;
• the CEO’s insistence that he oversee any future investigation of related-party transactions by the law firm Pepper Hamilton LLP and the consulting firm FTI Consulting, Inc. (“FTI”), hired after the resignation of Gibson Dunn, and the subsequent firing of FTI by the CEO after FTI began to question the CEO’s corporate expenses; and
• an April 2006 statement to the audit committee by DHB’s new auditors Rachlin Cohen and Holtz, P.A., detailing DHB’s inventory manipulations in the first three quarters of 2005.

The complaint alleged that the three audit committee members systematically and repeatedly failed to investigate these and other red flags, failed to address specific concerns, and allowed fraudulent activity by the CEO and other members of the senior management to continue unabated.

The same day the SEC filed its complaint against the three directors of DHB, the commission filed a separate complaint against the company, which is now under new management and led by new board members, for securities fraud. DHB has settled the charges and agreed to a permanent injunction from future violations. [2]

Action Against an Independent Director for Insider Trading

In the second action, announced on March 1, 2011, the commission brought an administrative cease-and-desist proceeding against Rajat K. Gupta, an independent director of The Goldman Sachs Group, Inc., until March 2010, and of Proctor & Gamble Co. until his resignation on March 1, 2011 following these charges. [3] The commission’s order instituting proceedings alleged that Gupta engaged in insider trading by disclosing to Raj Rajaratnam, founder and manager of the hedge fund Galleon Management, material nonpublic information obtained in the course of his duties as a board member of both companies. [4] The order further alleged that Rajaratnam in turn instructed the Galleon funds to trade on the material nonpublic information to profit and avoid losses totaling over $17 million. [5] Specifically, the commission alleged that Gupta tipped Rajaratnam of an impending $5 billion investment by Warren Buffett’s Berkshire Hathaway in Goldman Sachs before the public announcement of the transaction and that Gupta disclosed nonpublic financial results of Goldman Sachs and Proctor & Gamble to Rajaratnam. The order instituting proceedings against Gupta further alleged that he stood to profit from these trades because he was an investor in Galleon funds.

Gupta, through his attorneys, denied the charges and, on March 18, 2011, sued the commission to demand a jury trial and to stop any administrative actions. He alleged that the SEC had violated his constitutional right to due process and a jury trial by applying the civil penalty provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) retroactively and by seeking to apply those provisions administratively.

Other recent actions against directors Over the past several years, the commission has brought several other enforcement actions against directors alleging either intentional violations of the securities laws or egregious failures to act. In March 2009, the commission filed a settled action against Vasant Raval, the former chairman of the audit committee of InfoGroup, Inc., now known as infoGROUP Services Group. [6] Raval, as chair of the audit committee, was tasked by the board of directors in 2005 to investigate InfoGroup CEO Vinod Gupta’s personal expenses and related-party transactions. The complaint alleged that Raval submitted a report to the board that omitted critical facts and failed to report specific communications from the company’s internal auditor and the company’s disclosure counsel that alerted Raval to improper payments and transactions. Raval paid a $50,000 civil monetary penalty and consented to an injunction against violations of the securities laws and a bar against serving as an officer or director of a public company for five years.

In another case, the commission filed a civil injunctive action in July 2007 against a former director and compensation committee member of Engineered Support Systems, Inc. [7] In that case, the director, who also was the son of the company’s CEO, allegedly participated in a stock options backdating scheme with his father to grant over $20 million in fraudulent stock options to themselves and other employees. The case was dismissed in February 2010 after a federal district court ruled that the commission failed to present sufficient evidence at trial for a jury to find the director liable.

In November 2006, the commission filed settled charges against two directors serving on the audit committee of Spiegel, Inc., who allegedly participated in a decision not to make required timely filings of the company’s 2001 Form 10-K and first quarter 2002 Form 10-Q filings to conceal the “going concern” opinion of Spiegel’s outside auditor. [8] One director consented to pay a $100,000 civil penalty and receive an injunction against future violations of the securities laws. The other director consented to the entry of a cease and desist order from committing future violations of the reporting provisions of the securities laws.

These cases, along with the DHB case, demonstrate the commission’s willingness to pursue outside directors who it determines have willfully disregarded their responsibilities.

What do the SEC’s recent actions mean for directors? When taken together, the cases signal the commission’s continued interest in bringing enforcement actions against directors of publicly traded companies who personally violate securities laws or egregiously disregard their duties.

In the press release announcing the complaint against the DHB independent directors, Robert Khuzami, the director of the commission’s division of enforcement, stated, “We will not second-guess the good-faith efforts of directors. But in stark contrast, Krantz, Chasin, and Nadelman were directors and audit committee members who repeatedly turned a blind eye to warning signs of fraud and other misconduct by company officers.” This approach is similar to the one outlined by Linda Chatman Thomsen, former division of enforcement director, in a May 2008 speech: “The commission rarely sues directors solely in their capacity as directors. In fact, in the last three years, during which we brought more than 1,800 enforcement actions involving more than 3,000 defendants and respondents, the commission has sued less than a dozen outside directors.” In all of the cases discussed above, the commission alleged that the accused directors either knowingly permitted or facilitated violations of federal securities laws by recklessly disregarding their duties.

While directors can take some comfort from both the egregiousness of the acts in the most recent cases and statements by SEC officials about the rarity of court cases, members of the board still need to be vigilant in addressing their responsibilities. In this regard, there are several steps that directors can take to mitigate the risk of government enforcement action.

As a preliminary matter, a potential board member should conduct thorough due diligence before joining a board of directors to make sure that he has sufficient time to fulfill his board responsibilities, familiarize himself with the issues facing the company, and decide if he is interested in the company’s industry. Since the passage of the Sarbanes-Oxley Act in 2002, board duties, and audit committee duties in particular, have expanded and include, among other responsibilities, meeting separately with company management and external auditors and overseeing the company’s internal audit function, control environment, risk profile, and whistleblower procedures.

A potential board member also should consider the available indemnification, exculpation and insurance protections. [9] And, once serving on the board, directors should be aware of any changes to those protections and policies. Indemnification protections and D&O insurance are complex. For example, D&O insurance policies may not provide coverage of expenses incurred in the initial stages of a government investigation. Moreover, depending upon a company’s certificate and bylaws, separate indemnification agreements for directors may be appropriate. Directors should consider periodically requesting a comprehensive analysis of their liability protections and D&O insurance program.

Another aspect of diligence, which continues to be relevant on an ongoing basis, is examining the composition of the board, and, specifically, whether the board’s committees are sufficiently independent, have qualified members with the requisite skills and experience, and are dedicated to fulfilling their responsibilities. Several laws and regulations, as well as case law, govern the independence of directors and the related issue of disinterested directors under state corporate law. While the majority of the board of a public company generally should be independent, there is a role for management directors as well.

The New York Stock Exchange and NASDAQ listing standards both define director independence and require that a majority of the members of the boards of listed companies is independent. These listing standards also require that audit committees, compensation committees, and nominating and corporate governance committees be composed solely of independent directors.

Other statutes and rules govern the composition of the board. For example, Section 162(m) of the Internal Revenue Code and the regulations thereunder require that awards of performance-based compensation to top executives must be approved by a compensation committee comprised only of “outside directors” to be tax-deductible. Additionally, Rule 16(b)-3 under the Securities Exchange Act of 1934 (“Exchange Act”) provides an exemption from the Section 16(b) prohibition on short-swing profits for a transaction approved by the full board or a committee composed exclusively of “non-employee directors.” Finally, proxy advisory services, such as Institutional Shareholder Services, and some institutional investors have their own standards for director independence.

There also are additional requirements under federal law and stock exchange listing standards requiring that members of certain board committees meet heightened independence requirements. For example, SEC Rule 10A-3 under the Exchange Act mandates that stock exchanges adopt listing standards that require that each member of the audit committee of a listed company has (1) not received compensation from the issuer other than for board services and (2) is not an “affiliated person” of the issuer that either controls, is controlled by, or is under common control with the issuer. [10] Similar to the heightened requirements for audit committee composition, the Dodd-Frank Act mandates that the SEC adopt rules requiring stock exchanges to adopt listing standards requiring listed companies to have independent compensation committee members. On March 30, 2011, the SEC proposed rules mandating the stock exchanges to require that each member of the compensation committee of any listed company be independent according to standards adopted by the stock exchanges. Relevant factors include the sources of the board member’s compensation (including any consulting, advisory, or other compensatory fees paid) and whether the member is affiliated with the issuer. [11]

Related to director independence is the concept of disinterestedness that arises under state corporate law in the context of board committees tasked with overseeing certain extraordinary matters, such as special litigation committees. While the Delaware Supreme Court has previously ruled that a mere personal friendship or outside business relationship with a member of the senior management does not raise a reasonable doubt about a director’s disinterestedness, particularly significant relationships with specific factual allegations can raise questions. [12] One example of a potentially problematic relationship from March 2010 was a real estate partnership between a director of Black & Decker Corp. and the CEO of the company. [13] The New York Stock Exchange said that the company should have considered that business relationship when considering the director independent for purposes of serving on a special committee to evaluate a potential merger. Additionally, in an April 2011 decision about whether a director was disinterested under Delaware law, the Sixth Circuit Court of Appeals ruled that the recusal by a board member of Abercrombie & Fitch Co. from a special litigation committee with respect to one of the defendants named in a derivative lawsuit compromised the independence of that committee. [14] Consequently, the Sixth Circuit reversed the district court’s dismissal of the derivative suit, which had been based on the special litigation committee’s report concluding that there was no evidence to support the derivative suit.

Directors and director nominees also need to consider the experience and skills of board members. In 2009, the SEC adopted rules enhancing the information provided to shareholders in company proxy statements concerning the qualifications of directors. [15] Proxy statements now must include disclosures concerning the specific experience, qualifications, attributes, and skills of directors and director nominees that led the board to conclude that the person should serve as a director. The commission’s proxy access rules relating to the ability of shareholders to include director nominees in company proxy statements, which are now stayed pending litigation, will cause additional attention to be focused on individual directors. [16]

As part of their ongoing oversight of the company’s compliance program, board members should respond appropriately to warning signs of possible management misconduct through prompt investigation and escalation if credible evidence of misconduct is found. For example, in the case against the directors of DHB, the commission based its allegations, in part, on the directors’ failure to investigate compliance concerns raised by multiple outside advisors, including auditors and outside counsel. Serious red flags should not be ignored or given only cursory attention. In this regard, board members should establish procedures for handling and following up on complaints or allegations against management, with independent directors managing and overseeing any investigation implicating senior management.

Finally, board members should consult with counsel when questions arise about the formulation of an appropriate response and receive legal guidance when compliance concerns have been raised regarding the actions of management or when board members have questions regarding their legal obligations. Counsel should be given access to the necessary documents and information to fully understand and assess the situation.

What is the Significance of Charges Being Brought in an Administrative Proceeding?

The commission’s novel decision to bring insider trading charges in the Gupta case as an administrative proceeding, and thereby seek newly available civil monetary penalties under the Dodd-Frank Act, rather than file a complaint in federal court will likely become increasingly more common as the commission seeks to litigate or threatens to litigate cases in what is widely perceived to be a more friendly forum. Prior to the Dodd-Frank Act, the commission could only seek civil monetary penalties against regulated entities in its administrative proceedings, and if the commission wished to pursue that sanction against unregulated entities, it had to file a complaint in federal court. Additionally, Section 925 of the Dodd-Frank Act now permits the commission to seek a collateral bar prohibiting the target from serving as an officer or director of any public company or of being associated with regulated entities. An administrative proceeding is disadvantageous to directors, who have not previously been subject to such proceedings, because it affords no discovery other than the commission’s investigative file, and ensures a bench trial before the commission’s own administrative law judges rather than a jury trial. In related public comments in April 2011, Judge Jed Rakoff, who was presiding over Gupta’s lawsuit seeking to force the commission to bring its enforcement action in district court, stated, “One concern I have about Dodd-Frank is that it puts more adjudication into the hands of the SEC and its administrative judges.” [17]

Conclusion

The SEC’s recent enforcement actions against the directors of two public companies highlight the need for directors to be mindful of their responsibilities, but these actions should not discourage committed individuals from board service. In this regard, the commission has brought proceedings against directors only when the allegations involve knowingly permitting or actively facilitating violations of the securities laws. Accordingly, directors should exercise due diligence before agreeing to serve on a board, stay informed about the company and its industry and respond to red flags.

Endnotes

[1] SEC v Jerome Krantz, Cary Chasin and Gary Nadelman, filed February 28, 2011 (www.sec.gov/litigation/complaints/2011/comp21867-directors.pdf).
(go back)

[2] SEC v DHB Industries Inc. n/k/a Point Blank Solutions Inc., filed February 28, 2011 (www.sec.gov/litigation/complaints/2011/comp21867-dhb.pdf).
(go back)

[3] SEC Administrative Proceeding File No. 3-14279, filed March 1, 2011 (www.sec.gov/litigation/admin/2011/33-9192.pdf).
(go back)

[4] On May 11, 2011, Rajaratnam was convicted of 14 counts of securities fraud and conspiracy after a two-month trial.
(go back)

[5] SEC Administrative Proceeding File No. 3-14279, filed March 1, 2011 (www.sec.gov/litigation/admin/2011/33-9192.pdf) at page 2.
(go back)

[6] SEC v. Raval, Civil Action No. 8:10-cv-00101 (D. Neb. Filed Mar. 15, 2010).
(go back)

[7] SEC v. Shanahan, Civil Action 4:07-cv-1262 (E.D. Mo. Filed July 12, 2007).
(go back)

[8] SEC v. Crusemann, Civil Action No. 06-CV-5969 (N.D. Ill., Filed Nov. 2, 2006).
(go back)

[9] Section 102(b)(7) of the Delaware General Corporate Law generally provides that corporations may eliminate or limit the liability of a director for breaching his duty of care.
(go back)

[10] SEC Releases No. 33-8220; 34-47654 (April 25, 2003).
(go back)

[11] SEC Releases No. 33-9199 and 34-64149 (March 30, 2011).
(go back)

[12] Beam v. Stewart, 845 A.2d 1040 (Del. 2004).
(go back)

[13] Lorraine Mirabella, “NYSE rebukes Black & Decker, says firm should have considered partnership,” Baltimore Sun, March 10, 2010 (articles.baltimoresun.com/2010-03-10/business/bal-black-decker-board-0309_1_stanley-black-decker-nolan-d-archibald-stanleyworks).
(go back)

[14] Booth Family Trust v. Jeffries, No. 09-3443 (6th Cir. April 5, 2011).
(go back)

[15] SEC Releases No. 33-9089; 34-61175 (Dec. 16, 2009).
(go back)

[16] SEC Releases No. 33-9136; 34-62764 (Aug. 25, 2010) (Adopting the final proxy access rules). SEC Releases No. 33-9149; 34-63031 (Oct. 4, 2010) (Notice of stay of the effective date of the final proxy access rules).
(go back)

[17] Carolyn Kolker, “Gupta judge expresses ’concern’ over SEC courts,” April 12, 2011 (www.reuters.com/article/2011/04/12/us-securities-courts-idUSTRE73B78A20110412).
(go back)

Historical SEC Actions Against Outside Directors

(go back)