Part III: How Corporate Officials Can Get A Good Night’s Sleep Despite Current SEC Enforcement Trends

This is the third in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Directors and officers (cont)

While enforcement officials are focusing on the duties and obligations of directors in cases such as Krantz, they are also concentrating on ways to expand their reach. Negligent fraud, as in the Dell case, is one way. Another is through the use of Exchange Act Section 20(a), control person liability. This provision, which permits liability to be imposed on certain executives for failing to properly oversee operations, has been sporadically used over the years. Now, however, enforcement officials are using the provision to broaden the reach of SEC enforcement while avoiding the complexities of proving primary or aiding and abetting liability.

The cases brought the against executives of Nature’s Sunshine Products, Inc are illustrative of this new trend. There the first FCPA case imposing Section 20(a) liability was brought against company CEO, Douglas Faggioli and CFO, Craig D. Huff. SEC v. Nature’s Sunshine Products, Inc., Case No. 09CV672 (D. Utah Filed Jul. 31, 2009). The claims are based on payments made in 2000 and 2001 by the Brazilian subsidiary of the company to local regulators to circumvent new import restrictions. The company was charged with FCPA violations. The two officers were charged under Section 20(a) as “control persons.”

To resolve the case, the three defendants consented to the entry of permanent injunctions prohibiting future violations of the antifraud and books and records and internal control provisions of the federal securities laws. The company agreed to pay a civil penalty of $600,000. Messrs Faggioli and Huff each agreed to pay a civil penalty of $25,000. See also SEC v. SinoTechEnergy Ltd., Civil Action No. 2:12-cv-00960 (W.D. LA. Filed April 23, 2012)(Chairman and controlling shareholder alleged to have control person liability); SEC v. Harbert Management Corp., Civil Action No. 12 Civ. 5092 (S.D.N.Y. Filed June 27, 2012)(Funds charged with control person liability for failing to prevent controlled entities from engaging in manipulation).

Finally, the Commission is using a strict liability approach in clawback actions to recoup certain incentive based compensation of CEOs and CFOs. The cases here are being brought despite the fact the executive was not involved in any wrong doing.

Sarbanes-Oxley or SOX Section 304 and Dodd-Frank Section 954 each provide for the clawback of certain executive incentive based compensation when there is a restatement. Section 304 requires the repayment of certain CEO and CFO incentive-based compensation and stock trading profits when the company must restate its financial statements because of misconduct. The Section does not specify that the misconduct be that of the CEO or CFO.

Dodd-Frank Section 954, now Exchange Act Section 10D, is similar. It expands the class of those at risk using the undefined term “executive officers.” It also expands the time period from the one year in SOX to three while dropping the requirement that wrongful conduct cause the restatement. The remedy is more limited however, apparently being restricted to disgorgement. The requirement will be implemented through exchange listing standards under a yet to be written Commission rule.

The SEC has adopted a strict liability approach in SOX 304 cases. See, e.g., SEC v. Jenkins, Case No. CV 09-01510 (D. Ariz. Filed July 22, 2009); SEC v. O’Del, Civil Action No 1:10-CV-00909 (D.D.C. Filed June 2, 2010). Indeed, the complaints typically state that the defendant was not involved in the underlying wrongful conduct which may be the subject of a separate SEC and/or DOJ action. While the wisdom of the SEC’s view might be debatable, its position has been upheld by the Second Circuit. Cohen v. Viray, Case No. 3860-cv (2nd Cir. Sept. 30, 2010).

Collectively, these cases represent not just an aggressive approach to executive liability but one which is expanding and in some instances easing the SEC’s burden of proof. To be sure, cases such as Kravitz are based extreme sets of facts. Yet when viewed in the context of the expanding reach of SEC enforcement in this area there should be little doubt that in the future directors and officers need to be particularly cognizant of their monitoring obligations as good corporate stewards.

Next:Employees, the company and insider trading

Part II: How Corporate Officials Can Get A Good Night’s Sleep Despite Current SEC Enforcement Trends

This is the second in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Directors and officers

Traditionally, the duties and obligations of corporate directors and officers are a function of state corporate law defined in decisions such as In re Caremark International, Inc. Derivative Litigation, 698 A. 2d 959 (Del. Ch. 1996). SEC enforcement officials are, however, giving increasing scrutiny to their role and duties in select circumstances. At the same time the Commission is expanding its reach while easing its proof standards in these actions.

The oversight duties of directors have being scrutinized in cases such as SEC v. Krantz, Civil Action No. 0:11-cv-60432 (S.D. Fla. Filed Feb. 28, 2011). There the Commission named as defendants the outside directors of DHB Industries, at one time the largest manufacturer of bullet proof vests. The complaint is based on a massive financial fraud orchestrated by the former CEO, CFO and others. See, e.g., SEC v. DBH Industries, Inc., Civil Action No. 0:11-cv-60431 (S.D. Fla.). Former CEO David Brooks and CFO Sandra Hatfield were both charged and convicted criminally in connection with the looting of the company. U.S. v. Schleged, Case No. 2:06-cr-00550 (E.D.N.Y).

Each defendant in the Commission’s action is an outside, independent director. Yet the Commission’s complaint makes the unusual allegation that none of the defendant directors is in fact independent. Each is alleged to lack the impartiality to serve as independent board or audit committee members. This allegation is based on the fact that each was a longtime friend or neighbor of the former CEO or had personal relationships with him. As a result, according to the complaint, the directors willfully ignored a series of red flags about the conduct of the former CEO as he looted the company. The complaint alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)B) and 14(a). This case is in litigation.

Another case focused on the duties of directors is SEC v. Kohavi, Case No. 08-43-48 (N.D. Cal. Sep. 17, 2008). It is an option backdating case against three outside directors. While the complaint does not claim that the directors lacked independence as in Krantz, it allege claim that the directors failed in their duties, essentially deferring to management. From 1997 through 2002 the directors approved 21 separate backdated option grants at the behest of management, according to the complaint. In approving the options the directors are alleged to have ignored a series of “red flags” which should have alerted them to the wrongful conduct they were approving. Each defendant settled, consenting to a fraud injunction and paying a civil penalty of $100,000. See also SEC v. Mercury Interactive, LLC, Case No. 07-2822 (N.D. Cal. May 31, 2007).

The SEC is also broadening the theories it is utilizing while in some instances easing its burned of proof in complex cases. One theory being increasingly utilized is negligent fraud based on Securities Act Sections 17(a)(2) and (3). This approach was a staple of SEC enforcement prior the Supreme Court’s decisions in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1978) and Aaron v. SEC, 446 U.S. 680 (1980). Following those decisions the theory has been used in a limited number of cases as the enforcement program shifted focus to scienter based cases.

Recently, however, the Commission has returned to negligent fraud theories which effectively broadens it reach while easing its burden of proof. For example, SEC v Dell Inc., Civil Action No. 1:10-cv-01245 (D.D.C. Filed July 22, 2010) is a financial fraud case based on negligent fraud theories. The defendants include Chairman and CEO Michael Dell and former CEO Kevin Rollins.

The case centers on claims of false statements regarding the key source of revenue and growth for the company. For years Dell had picture perfect financial results, but largely from what investors were not told. A major source of revenue for a period of years was payments by Intel Inc. to Dell not to use the chips manufactured by a competitor. As those payments increased over time Dell’s revenues and profits rose. The company credited its management systems and efficiencies for those increases. Dell did not disclose the payments. When the payments decreased and eventually terminated the revenues of the computer giant tumbled along with this stock price.

The complaint was based on a negligent rather than a scienter based fraud theory. Since proving complex accounting cases and the requisite scienter of each individual can be difficult, crafting the complaint in this manner has the effect of easing proof requirements for the Commission while enabling the agency to write a complaint alleging fraud.

Charging negligence can also induce settlement, as here, by side stepping the difficulty many defendants may have to resolving a case in the face of claims that they intentionally defrauded the shareholders and the public. Here Messrs. Dell and Rollins settled by consented to an entry based in negligence since it is tied to Securities Act Sections 17(a)(2) & (3) but which still gives the Commission a fraud injunction. See also SEC v. Citigroup Global Markets, Inc., Civil Action No. 1:11-cv-07387 (S.D.N.Y.)(market crisis action charging negligent fraud in which court refused to enter the injunction in the settlement, a question which is on appeal).

Next:Directors and officers (cont.)