In the past two weeks, the U.S. Securities and Exchange Commission (“Commission”) announced enforcement actions against four independent directors at two publicly traded companies. While these actions reflect the Commission’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 One of the actions was brought as an administrative proceeding instead of as a complaint in federal court and illustrates how the Commission will 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 an Independent Director for Insider Trading
In an 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 following these charges. The Commission’s order instituting proceedings alleges that Gupta engaged in insider trading by disclosing material nonpublic information obtained in the course of his duties as a board member of both companies to Raj Rajaratnam. Rajaratnam, founder and manager of the hedge fund Galleon Management, is at the center of a sweeping insider trading investigation and currently is facing civil and criminal charges. The order further alleges that Rajaratnam in turn caused the Galleon funds to trade on the material nonpublic information to profit and avoid losses totaling over $15 million. Specifically, the Commission alleges that in September 2008, Gupta tipped Rajaratnam of an impending $5 billion investment in Goldman Sachs by Warren Buffett’s Berkshire Hathaway before the public announcement and in 2008 Gupta disclosed non-public financial results of Goldman Sachs and Proctor & Gamble to Rajaratnam. The order instituting proceedings against Gupta further alleges that he stood to profit from these trades because he was an investor in Galleon funds. Gupta, through his attorneys, has publicly denied the charges.
Action Against Independent Directors of DHB Industries
In the second action, 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 alleges 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. 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 and allowed DHB’s then-CEO David Brooks to divert corporate funds to a personally-controlled entity. The complaint further alleges that the three directors lacked independence because of their business relationships and decades-long social relationships with the CEO. The complaint alleges that the directors omitted from the official board minutes discussions of company expenditures that had no legitimate business purpose, such as 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 include, among other things, 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 the 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 the fraudulent activity by the CEO and other members of the senior management to continue unabated.
Also on February 28, 2011, the Commission filed a separate complaint against DHB, now under new management and with new board members, for securities fraud. DHB has settled the charges and agreed to a permanent injunction from future violations.
Other 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. The complaint alleged that, as chair of the Audit Committee, he was tasked by the Board of Directors in 2005 to investigate InfoGroup CEO Vinod Gupta’s personal expenses and related-party transactions, but he 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 alerting 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 a second case, the Commission filed a civil injunctive action in July 2007 against a former director and Compensation Committee member of Engineered Support Systems, Inc. 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 information that the company’s outside auditor would issue a “going concern” opinion to accompany the filing of the Form 10-K. One director consented to paying a $100,000 civil penalty and 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 recent DHB case, demonstrate the Commission’s willingness to pursue outside directors who the Commission determines have willfully disregarded their responsibilities.
What Do These Actions Mean for Directors?
Together, the most recent cases signal the Commission’s continued interest in bringing enforcement actions against the directors of publicly traded companies when they personally violate securities laws or egregiously disregard their duties.
In the press release announcing the complaint against the DHB independent directors, the Director of the Commission’s Division of Enforcement, Robert Khuzami, 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 is similar to the tone used by former Division of Enforcement Director Linda Chatman Thomsen in a May 2008 speech in which she said: “the Commission rarely sues directors solely in their capacity as directors. In fact in the last three years, during which we brought more than 1800 enforcement actions involving more than 3,000 defendants and respondents, the Commission has sued less than a dozen outside directors.” In all the cases discussed above against directors, the Commission alleged that the directors either knowingly permitted or facilitated violations of federal securities laws by recklessly disregarding their duties.
Although these cases represent allegations of significant abrogations of duty, they do highlight the importance of directors:
- establishing procedures for handling and following up on complaints or allegations against management;
- appropriately responding to warning signs of possible management misconduct;
- consulting with counsel when questions arise; and
- ensuring that, when investigations of management conduct are undertaken, they are independent and thorough.
The Commission’s novel decision to bring insider trading charges in the Gupta case as an administrative proceeding, rather than filing a complaint in federal court, and to seek newly available civil monetary penalties in that proceeding under the Dodd-Frank Act will likely become increasingly more common as the Commission seeks to litigate these 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 non-regulated 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 targets 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.
 SEC v. Raval, Civil Action No. 8:10-cv-00101 (D. Neb. Filed Mar. 15, 2010).
 SEC v. Shanahan, Civil Action 4:07-cv-1262 (E.D. Mo. Filed July 12, 2007).
 SEC v. Crusemann, Civil Action No. 06-CV-5969 (N.D. Ill., Filed Nov. 2, 2006).