THE SEC AND THE DUTIES OF OFFICERS AND DIRECTORS

The Commission filed four actions centered on million of dollars in undisclosed compensation and related party transactions by former InfoGROUP, Inc. (now infoUSA, Inc.) Chairman and CEO, Vinod Gupta. A settled action was filed against Mr. Gupta, SEC v. Gupta, Civil Action No. 8:10-cv-00100 (D. Neb. filed Mar. 15, 2010). Another was against the former chairman of the audit committee, Vasant Raval, SEC v. Raval, Civil Action No. 8:10-cv-00101 (D. Neb. Filed Mar. 15, 2010). A third case, which is in litigation, named the two former CFOs, Rajnish Das and Stormy Dean, SEC v. Das, Civil Action No. 8:10-cv-00102 (D. Neb. Filed Mar. 15, 2010). The company settled an administration proceeding, In the Matter of infoUSA Inc., Adm. Proc. No. 3-13815 (Mar. 15, 2010). The actions should serve as a warning not just to overreaching controlling shareholders, but to directors and officers who fail to fulfill their duties. See also Litig. Rel. 21451 (Mar. 15, 2010).

The case against Mr. Gupta alleges that he received approximately $9.5 million in unauthorized and undisclosed compensation over a four year period beginning in 2003. During that same period, the company also engaged in undisclosed related party transactions with two companies controlled by Mr. Gupta. Those transactions involved $9.3 million.

Defendant Gupta is the founder of InfoGROUP’s predecessor. That company went public in 1992. Mr. Gupta is the largest shareholder. Essentially, the complaint alleges that Mr. Gupta used the company as his personal piggy bank. He exempted himself from company policies for travel and entertainment which required a valid business purpose as well as proper documentation. The expenses he charged to the company included: personal jet travel for his family and friends; service for his yacht; payment of personal credit cards; costs for homes in California, Aspen, Hawaii and Washington, D.C.; expenses for personal employees; upkeep for twenty cars; membership dues for 28 clubs; premiums for two personal life insurance policies; and office space for two companies he controlled, Annapurna and Aspen Leasing. Although Mr. Gupta signed and certified the company annual reports during the period, none of these expenses were disclosed.

The undisclosed related party transactions were with Annapurna and Aspen Leasing. Those transactions included lease payments for the aircraft made to Annapurna and to the aircraft leading company as well as payments for the homes and yacht to that company and payments to Aspen Leasing for the fleet of automobiles. Portions of these transactions, according to the complaint, were structured to conceal. For example, Annapurna leased aircraft which in turn were leased to InfoGROUP. The payments by the company were split, part to Annapurna and part to the other company.

In early 2005, Mr. Gupta expressed interest in having the company acquire ORC. Before informing the board, Mr. Gupta purchased shares in ORC and then had InfoGROUP purchase shares. In June 2005, when the board approved pursuit of a deal with ORC, Mr. Gupta did not disclose the fact that he held a stake in the company. Later, when the board learned that he owned shares in ORC, it demanded that he turn over the profits from sales and the remaining shares to the company.

Mr. Gupta settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, proxy and reporting provisions. He also agreed to the entry of an order directing him to pay disgorgement of about $4 million along with prejudgment interest and a civil penalty of approximately $2.2 million. The order will bar him from serving as an officer or director and place restrictions on his voting rights in company shares.

The action against Mr. Raval centers on his failure to carry out his duties as chairman of the audit committee. According to the complaint, in January 2005 as part of installing a new related party transaction policy, the board became aware of payments to Annapurna, including the monthly expenditures for several of the homes. Mr. Raval, as chairman of the audit committee, was directed to conduct an internal investigation.

Mr. Raval failed to take any meaningful action. In addition, he ignored other information about improper payments obtained from the internal auditor. Although Mr. Raval continued to receive similar information he did not take action.

The SEC’s complaint charged Mr. Raval with violations of the antifraud, proxy and reporting provisions. To resolve the case the defendant consented to the entry of a permanent injunction prohibiting future violations of each provision, agreed to pay a $50,000 civil penalty and to be barred from serving as an officer or director for five years.

The action against the two former company CFOs, Messrs. Das and Dean, is based on the same conduct. It alleges that the two men improperly approved expenses for Mr. Gupta despite the lack of proper documentation and a failure to comply with company policies. In addition, the two men were reckless in not knowing of the related party transactions. This case is in litigation.

Finally, the company agreed to settle in an administrative proceeding. That proceeding charged violations of the books, records and proxy provisions. It was resolved with the entry of a cease and desist order. The Commission considered the cooperation of the company in resolving the case. In what appears to be a continuing trend which should give guidance to others, the Commission detailed the efforts of the company which earned it cooperation credit. Those included replacing officers and directors, creating a new position of executive vice president for business conduct and general counsel, instituting mandatory director and executive officer training programs and hiring an independent compensation consultant and implementing new controls.

SEC v. TAMBONE — THE QUESTION OF PRIMARY LIABILITY

The distinction between primary and secondary liability in securities fraud suits has been a key issue since the Supreme Court handed down its decision in Central Bank of Denver v. First Interstate, 511 U.S. 164 (1994). Although the SEC had its authority to bring Section 10(b) fraud actions based on an aiding and abetting theory restored the next year with the passage of Exchange Act Section 20(e) as part of the PSLRA, Congress has declined requests to extend such liability to private damage actions.

Despite the legislative fix, the distinction between primary and secondary liability remains critical to the SEC. The circuits are split over the appropriate standard with some following a version of the “bright line” test, while others opt for an approach based on the notion of “substantial participation” as discussed here. While these tests have largely been developed in private damage actions, the dispute is impacting SEC enforcement cases as discussed here.

Many observers hoped the First Circuit’s en banc decision in SEC v. Tambone, No. 07-1384 (March 10, 2010) would bring clarity to the area. In its opinion, however, the court declined the opportunity to consider the issue. At the same time, it did comment on the question, if only in dicta.

The facts to Tambone are straightforward. James Tambone and Robert Hussey were senior executives of a registered broker dealer, Columbia Funds Distributor, Inc. The SEC’s complaint against the executives contains allegations based on Securities Act Section 17(a), Exchange Act Section 10(b) and aiding and abetting. In essence, the Commission alleges that the two men engaged in fraud in connection with the sale of mutual fund shares tied to market timing claims. The prospectuses for the funds told investors that market timing was not permitted. A number of customers were, however, permitted to market time. According to the SEC, the two defendants were responsible for the false statements in the prospectuses, having commented on the market timing passages prior to their inclusion in the documents.

The prospectuses were not prepared by, or the responsibility of, the broker dealer which employed the two defendants. The broker-dealer is owned by Columbia Management Group, Inc. The broker served as the primary underwriter and distributor of over 140 mutual funds in the Columbia mutual fund complex. The prospectuses for those funds were the responsibility of another entity, Columbia Management Advisors, Inc. Like the broker dealer, Columbia Management was also a wholly owned subsidiary of Columbia Management.

The district court granted a motion to dismiss the complaint. On the Section 10(b) claims, the court applied the bright line test followed by the Second Circuit, as well as others. Under this test, mere participation in the drafting process is insufficient to establish primary liability. The court also dismissed each of the other claims.

The SEC appealed the dismissal of its Rule 10(b)-5(b), Section 17(a)(2) and aiding and abetting claims. The panel reversed. That decision was withdrawn, however, and en banc review was granted on the Rule 10(b)-5(b) claim only.

In its March 10 opinion, the court reversed the panel decision, affirming the district court’s dismissal. Since the court did not reconsider the other claims, the initial panel decision as to those was reinstated.

The court parsed the question for review in two parts: The first is whether a securities professional can be said to “make” a statement which can result in Rule 10(b)-5(b) liability as a result of statements used to sell securities which were prepared by others? The second is if selling securities on behalf of an underwriter is an implied statement by the person, does he have a reasonable basis for believing that the statements in the prospectus were truthful and complete? The court’s answer to each question is “no.”

The court’s conclusion is based largely on the literal language of Rule 10(b)-5(b) and the meaning of the word “make.” In the context of this subsection, the rule is based on phrases such as “to make a statement” and “statements made.” Since the Rule does not define the word, its plain dictionary meaning applies. That definition is inconsistent with the gloss proposed by the SEC which would include statements by others within the meaning of the word “made.” The court buttressed its conclusion by looking at the overall structure of the rule and its enabling section. There, words such as “use” or “employ” are written into the text which give other sections a different and broader reading. In subsection (b), however, the drafters selected the word “make” as in “to make a statement.” The court found this deliberate word choice revealing.

The court rejected the SEC’s argument that the reach of the subsection is coextensive with that of Section 10(b). While clearly the rule cannot be broader than the section, that does not mean that every subsection of Rule 10(b)-5 must be coextensive with Section 10(b). If that were true there would be no need for the subsections. Indeed, when Rule 10(b)-5 was crafted, the drafters had before them Section 17(a)(2) which employs the word “use,” which is broader. This again suggests a deliberate selection of words resulting in a different standard. The court also rejected the SEC’s argument that “it is self-evident” that the language of the subsection should include the implied statements here. The only point which is self-evident the court held is that the plain meaning of the words selected governs.

The SEC’s proposed reading of the Rule would also undermine the Supreme Court’s decision in Central Bank, the court concluded. That decision squarely held that aiding and abetting liability does not fall within the text of Section 10(b). Yet, adopting the SEC’s proposed theory of liability here would bring conduct within the reach of the statute, which is at most aiding and abetting. After Central Bank that cannot be done.

Finally, while there is a split in the circuits over the proper test of primary liability, that issue need not be resolved in this case, the court concluded. Rather, the decision in this case is straightforward and based on the literal reading of the text of the rule, according to the court.

In concluding that it need not resolve the question of what constitutes primary liability, the court did note, however, that “these tests [bright line and substantial participation] are designed for private litigation, and, thus, poorly suited to public enforcement actions . . .” In a footnote, the court elaborated on this thought, noting that the bright line test is based in part on the need to prove reliance in private actions. Nevertheless, some courts, such as the district court in this case, continue to apply the concepts in SEC enforcement actions. The question now is whether the SEC will appeal this decision to the Supreme Court to try and obtain clarity on that issue.