SEC Officer – Director Bars: By What Standard?

Sometimes it can be difficult to determine if you actually won. This may be the case for the SEC with the Second Circuit’s ruling in SEC v. Bankosky, Docket No. 12-2943-cv (Decided May 14, 2013). The Circuit Court affirmed the issuance of a director-officer bar by the district court against a corporate executive who settled an insider trading case. This is what the SEC requested. Yet the Court refused to update the out of date test by the district court to issue its order and to adopt the standard advocated by the agency, leaving the test for such orders in flux.

The ruling is based on a settled insider trading case against executive Brent Bankosky. He was employed at pharmaceutical company Takeda Pharmaceuticals International, Inc. as director of global licensing and later a senior director during the period January 2008 through May 2011. Those positions gave him access to inside information concerning transactions in which the company was involved. Contrary to company policy, Mr. Bankosky purchased call options in the shares of four entities involved in deals with Takeda prior to the public announcement.

In March 2012 the SEC and Mr. Bankosky settled this action which was based on the four trades. Without admitting or denying the facts alleged in the complaint he consented to the entry of a permanent injunction. He also agreed to pay disgorgement of $63,000, prejudgment interest, and a civil penalty equal to the amount of the disgorgement.

Following the settlement the Commission moved for the imposition of an officer-director bar. The motion was supported by: 1) a stipulation that for purposes of the motion the facts in the complaint were true; 2) excerpts from Mr. Bankosky’s investigative testimony denying insider trading; and 3) e-mails demonstrating that he had inside information. The district court granted the motion and imposed a 10 year bar, citing the standard in SEC v. Patel, 61 F. 3d 137 (2nd Cir. 1995).

In affirming the district court, the Second Circuit began with Exchange Act Section 21(d)(2) which governs the entry of such orders. The statute states in part that “the court may prohibit . . . any person who violated section [10(b)] . . . from acting as an officer or director of any issuer . . . if the person’s conduct demonstrates unfitness to serve as an officer or director . . . “ the “unfitness” standard was adopted in 2002 in the Sarbanes-Oxley Act, the Court noted. Previously, the standard had been “substantial unfitness.” It was altered to lower the burden of proof.

Patel utilizes a six factor test to determine if the bar should be entered. Under that test the Court considers: “(1) the egregiousness of the underlying securities law violation; (2) the defendant’s repeat offender status; (3) the defendant’s role or position when he engaged in the fraud; (4) the defendant’s degree of scienter; (5) the defendant’s economic stake in the violation; and (6) the likelihood that misconduct will recur.” The test was drawn from an article by Professor Jayne W. Barnard titled When is a Corporate Executive “Substantially Unfit to Serve,” 70 N.C.L. Rev. 1489, 1492-93 (1992).

On appeal the SEC argued that the bar should be affirmed but stated that the Patel standard is no longer applicable because of the change in the statute. The Commission argued that the six factor test used by the Court in Steadman v. SEC, 603 F. 2d 1126 (5th Cir. 1979) which govern the propriety of issuing injunctive relief should be considered. That test consideres: 1) the egregiousness of the conduct; 2) if it was isolated or recurrent; 3) the degree of scienter; 4) assurances against future violations; 5) the defendant’s recognition of the wrongful nature of the conduct; and 6) the likelihood that the defendant’s occupation will present opportunities for future violations.

The Court concluded that the application of Patel is not erroneous. If the conduct met the pre-amended statutory standard there can be no doubt that the bar should issue under the new, lower standard the Court reasoned. Furthermore, the test is flexible and no single factor is dispositive or even mandatory. Likewise other courts have continued to rely on Patel.

In reaching this determination the Court did not adopt the Steadman standard, which it found to be similar to Patel or the new nine factor test proposed in a post-Sarbanes-Oxley article by Professor Barnard titled Rule 10b-5 and the “Unfitness” Question, 47 Ariz. L. Rev. 9, 46 (2005). Indeed, the SEC opposed the adoption of the new test crafted by Professor Barnard. Here, in view of the record, it is clear that the district court’s decision was not clearly erroneous, the Circuit Court determined. Accordingly, it was affirmed.

While the reasoning of the Second Circuit is undoubtedly correct – if the higher standard is met it follows that the lower one has also been established – it leaves the law in the circuit in a state of flux. Patel is clearly dated and not correct as the SEC acknowledged. Steadman, advanced by the SEC, is similar to Patel as the Court stated and risks diminishing the unfitness standard by turning it into a rubber stamp – if an injunction is entered an officer-director bar seems likely to follow if the same standard is used. That is not the intent of the statute. This is particularly true in view of the severe impact such an order can have on the ability of a defendant to pursue a career. While Professor Barnard’s new proposed nine factor test might have provided some guidance, it was rejected by both the Court and the SEC. In the end, while the ruling gives the SEC the relief it sought, it leaves the agency with a test crafted to fit a different standard and no clear standard to follow when seeking an officer/director bar in the future.

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