Should there be anxiety in the boardroom concerning SEC enforcement?  Consider the following:

  • Traditionally the duties of directors have been a function of state law.  SOX changed that.  As SEC Commissioner Paul S. Atkins noted in a March 25, 2006 speech:  “Sarbanes-Oxley . . . represents. . . an unimaginable incursion of the U.S. federal government into the corporate governance arena.”
  • Gatekeepers such as corporate directors and lawyers continue to be a focus of the enforcement staff.  As Enforcement Chief Linda Thomsen noted a few months ago: “The Securities and Exchange Commission continue to look at so-called gatekeepers, such as lawyers and corporate directors . . “  Thomsen Says Lawyers, Directors Are Under SEC Enforcement’s Gaze, 38 Sec. Reg. & L. Rep. (BNA) No. 36, at 140 (Nov. 20, 2006).
  • Cases against directors have typically been based on intentional or reckless conduct.  Consider for example the complaint filed in SEC v. Collins & Aikman Corp., et al., Civil Action No. 1:07-CV-2419 (LAP)(S.D.N.Y. March 26, 2007).  That action was brought against the company, its CEO David A. Stockman and eight other former directors and officers.  The complaint alleged a financial fraud to inflate the reported income of the company. 
  • Consider also Hollinger International.  There a criminal prosecution of former Hollinger International chairman Conrad Black, who is defending criminal charges from over $60 million taken from the company with board approval is in progress.  The SEC enforcement staff issued a Wells Notice to the Hollinger audit committee noting its intent to recommend an enforcement action against each of the directors.  The crux of the case may have been summarized by former Illinois governor and Hollinger International audit committee member Jim Thompson who testified for the government at Mr. Black’s trial noting that while he only skimmed the disclosure documents for the company he read “every word” of the Wells notice.
  • Traditionally the SEC has brought actions against another gatekeeper group – attorneys – based on intentional conduct.  However in In re Weiss  a negligence standard was used.  Initially an administrative proceeding was brought against attorney Weiss for issuing an opinion stating that the interest on bonds in an offering were tax exempt which the IRS later said was wrong.  The administrative proceeding brought based on claimed violations of Securities Act, Section 17(a) and Exchange Act Section 10(b) was dismissed by the ALJ after a hearing.  On appeal the Commission reversed, finding Mr.Weiss liable under Section 17(a)(2) &(3). (Feb. 25, 2005).
  • After Weiss  directors must wonder if the standards of liability are shifting.   This is a particularly important question moving forward as the SEC considers what to do with its 140 back dated options cases and its insider trading campaign.  Directors could be key targets in each area.

  • Directors of course are typically involved in the option issuance process.  In discussing the potential liability of directors  SEC Commissioner Roel Campos cautioned in an August 15, 2006 speech:   “As yet, we have charged only officers in option backdating cases.  However, if the facts permit – and I want to emphasize that all of our Enforcement cases are very fact specific – it wouldn’t surprise me to see charges brought against outside directors.  Directors also are involved in trading the stock of their companies.  Many directors sell shares under the safe harbor of Rule 10b-5-1 plans which are suppose to insulate them from insider trading charges.  Directors however may want to recall Enforcement Chief Thomsen’s recent warning that the staff is looking hard at the safe harbor provided directors and officers who sell shares under Rule 10b-5-1 plans for insider trading.  Those remarks are based on an academic study which suggests that directors trading under these plans are doing better than the market – precisely the type of study which triggered the options backdating scandal.  Collectively, these events  represent an unprecedented federal intrusion in the board room, increased scrutiny, potentially shifting standards and huge areas of potential liability.  No wonder there is increasing anxiety in the boardroom.  

One can only wonder where the SEC is heading.  Consider a few recent events: 

1)  Recent new articles suggest that the SEC is considering a proposal under which corporations could limit their liability in securities class actions.  The proposal would require that shareholders bring any claim they have in arbitration.  As we have previously noted in this blog on 4/18/07, the proposal seems directly contrary to the SEC’s long stated position that private damages actions are a necessary supplement to its enforcement actions.  If adopted, this would represent a change in a long held position for the SEC. 

2)  Last week the head of the Senate Judiciary Committee wrote SEC Chairman Cox asking to end the authorization that permits brokers to require customers to waive their rights to file court actions and resolve any claim from their securities trades in arbitration,  according to an article by Gretchen Morgenson in the New York Times on Sunday.  The courts of course have long upheld the position of the brokerage industry that it can require customers to waive their rights to bring actions in court in favor of mandatory arbitration.  The SEC has long agreed with this position.  In doing so, however, as Ms. Morgenson notes in her article, that the SEC has repeatedly made it clear that this position is limited to customer/broker arbitrations.  To adopt the position suggested by the Senator would be a change in a long held position for the SEC. 

3)  In light of the SEC’s brief in Tellabs, Inc. v. Makor Issues & Rights, Ltd., (No. 06-484), the private securities damage action currently pending before the Supreme Court, many SEC observers believe that the agency took a position contrary to its usual investor/shareholder focus.  That case involves pleading standards in private securities actions focused on the definition of what constitutes a “strong inference of scienter.”  In its amicus brief, the SEC took a position which many believe supports the defense.  If so, that would suggest a change in position for the agency.  

4)  At the end of March, the Supreme Court agreed to hear an appeal from the Eighth Circuit Court of Appeals in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., (No. 06-43).  That case involves a key question in private securities damage actions concerning the scope of liability.  This has been a critical issue in these cases since the Supreme Court’s 1994 decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), which held that there is no aiding and abetting liability in securities fraud actions.  In Stoneridge, the question is what constitutes “scheme” liability under the antifraud provisions, Exchange Act Section 10(b) and Rule 10(b)-5 thereunder.  At stake is who can be held liable in securities class actions – only the primarily violator, such as the company involved or others who may have had some role in the challenged transaction for example accounting firms, bankers and others.  Reportedly the plaintiff’s class action bar has been heavily lobbying the SEC to take a supportive view.  The SEC has not yet taken a position in this case.  In 1995, however it obtained authority to bring cases using an aiding and abetting theory from Congress. 

5)  Reportedly the five SEC commissioners are split over the use of financial penalties against companies.  One view argues that they are a deterrent.  Another argues that they only punish shareholders who have already suffered a loss from the fraud at the company and the enforcement action brought against the firm by the SEC.  This split seems to be the moving spirit behind the new settlement procedures adopted by the agency in cases where a corporation is the potential defendant and a penalty may be imposed.  Under those new procedures the staff can no longer negotiate a settlement with a company that includes a monetary fine and submit it for Commission approval – a long used procedure.  Now the staff must first submit the case to the Commission for authority to impose a penalty and if so how much, then negotiate with the defendant and then go back to the Commission for final approval.  While Chairman Cox argued in announcing this procedure that it would speed up settlements, as we previously noted 4/19/07 that seems unlikely.  Rather, it appears to be a mechanism for the commissioners to try and coordinate their views.  In an agency that is already far to slow in most instances, these additional procedures appear to just be another impediment.  This is a change for the SEC, which will probably slow and already slow process. 

6)  In some instances the agency can move with extraordinary speed.  The SEC obtained an asset freeze in SEC v. Kan King Wong and Charlotte Ka On Wong Leung, 07 Civ. 3628 (SAS) (S.D.N.Y. filed May 8, 2007), just a week after the announcement of News Corp.’s bid for Dow Jones.  Viewed by any standard this suit was brought very quickly.  This is a welcome change from many of the agency’s traditional cases, which are brought years after the events involved.  

All of this simply leaves one wondering about the SEC’s direction and the speed at which it will proceed.  In many instances the agency moves very slowly, as in the cases involving corporate penalties.  In others it is capable of swift action in certain instances when the focus is clear, such as in the recent insider trading case.  In some key instances it seems to be changing or at least considering a change in long held positions.  Is the SEC in fact changing focus or is what we are seeing a traditionally apolitical agency caught in political and philosophical cross currents?