The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

One of the most basic notions in our legal system is that liability attaches only to those who act with intent or knowledge. But as detailed in a front-page September 27, 2011 Wall Street Journal article (here), Congress has in recent decades enacted numerous provisions imposing criminal liability regardless of intent. Among the many troubling aspects of this trend are the implications for corporate directors and officers, who often are the target of these strict liability provisions and who increasingly have liability imposed on them for matters in which they were not involved and of which they were not even aware.

As the Journal article explains, a “bedrock principle” of our legal system is that criminal liability cannot be imposed without “mens rea,” or a guilty mind. But as the article details, Congress has “repeatedly crafted laws that weaken or disregard the notion of criminal intent.” As a result, things that “once might have been considered simply a mistake” are “now sometimes punishable by jail time.”

The article cites a number of recently enacted criminal provisions, particularly certain enactments regarding wildlife issues and firearms violations. One example cited refers to the imposition of a 15-year criminal sentence for possession of a single bullet (in violation of firearms restrictions for convicted felons).

Among the areas the article references that have seen the enactment of these types of provisions is white collar crime. The article specifically cites the provisions of the Sarbanes Oxley Act that make it “easier for prosecutors to bring obstruction of justice cases related to the destruction of evidence.” The article explains how these provisions passed as part of the larger bill without full or appropriate consideration of the implications.

The Sarbanes Oxley Act provision cited is far from the only recent statutory enactment or judicial development that potentially imposes liability on corporate officials without culpability. Indeed, just a few days ago, on September 13, 2011, another Wall Street Journal article entitled “U.S. Targets Drug Executives” (here) described how federal regulators have increasingly been using the judicially developed “responsible corporate officer doctrine” to pursue criminal prosecutions against corporate executives for federal food and drug law violations.

As I discussed in my own earlier look at the “responsible corporate officer doctrine” (here), courts have the doctrine to impose criminal liability on corporate officials who were not involved in or even aware of the violations. (The word “responsible” in the name of the doctrine references responsibility for the corporation not for the conduct.) As the September 13 Journal article details, the use of this doctrine can not only result in the imposition of criminal fines and penalties, but the convictions obtained in reliance on the doctrine can then be used to exclude convicted executives from Medicare and Medicaid, in effect turning their conviction into “career-ending punishment.”

As discussed here, the doctrine’s application has not been limited just to food and drug violations but has also been extended to violations of environmental law as well, and also has been used as the basis for the imposition of civil liability as well as criminal liability.

Nor do these instances represent the only examples of imposition of liability without culpability – to the contrary, they are consistent with a growing willingness of government regulators and prosecutors to try to impose liability without regard to involvement in or awareness of the alleged wrongdoing. For example, there have been multiple instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged wrongdoing.

First, as described here, the SEC has now on several occasions used its authority under Section 304 of the Sarbanes-Oxley Act to “clawback” compensation corporate executives earned a time when their companies were committing accounting fraud. For example, most recently former Beazer Homes CFO James O’Leary was compelled to return $1.4 million in bonus compensation even though he was himself not charged with any wrongdoing in connection with the company’s accounting fraud. As I noted in my prior post, though the SEC’s implementation of the compensation clawback is statutorily authorized, the imposition of a forfeiture without culpability or fault raises troubling questions, including basic questions of fairness.

In a separate development discussed here, the SEC recently filed an enforcement action seeking to impose control person liability on two officers of Nature’s Sunshine Products for the company’s Foreign Corrupt Practices Act violations – even though the two officials were not alleged to have any involvement in or awareness of the wrongful conduct.

Unfortunately, this trend toward the expansion of liability without culpability seems to be growing. Indeed, the Dodd-Frank Act greatly expands the compensation clawback ,  by requiring the major exchanges to adopt requirements for all listed companies to adopt provisions for the recovery in the event of a restatement of bonus compensation from any current or former executive officer who earned bonus compensation during the three years preceding the restatement.

The September 27 Journal article suggests that Congress is creating these types of exposures simply because it is neglecting to consider traditional intent requirements. I am not so sure, particularly when it comes to liability for corporate officials, as there seems to be this pervasive notion that corporate officials deserve liability and are getting off “scot free” and this in turn is leading to an increasing willingness to impose liability because of the position rather than because of their culpability.  

In recent months, I have taken on several commentators who have tried to argue that corporate officials need to be held liable more often (here), or that there is something wrong with our legal system when corporate officials cannot be held liable more frequently (here). I am concerned that general presumption that corporate executives are somehow blameworthy and deserving of liability are behind this trend toward imposing liability on corporate executives without actual culpability.

There is an unfortunate trend in our society to assume that when something has gone wrong that somebody has to be punished. This general proclivity to look for someone to blame is exacerbated by a general willingness to demonize corporate “fat cats,” which in turn leads some to conclude that corporate executives deserve liability because of their position, without regard of whether they actually did anything culpable.

I appreciate that many believe corporate executives need to be held accountable. Nevertheless, I am concerned that as a result of the increased tendency to impost liability on corporate executives without culpability, there is a contrary danger that corporate executives could be held liable too frequently, or at least in instances when they have done nothing themselves to deserve it. Scapegoating any individual – even a corporate executive – for circumstances in which they were not involved and of which they were not even aware is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

Along with all the other concerns, these types of proceedings may also raise D&O insurance coverage issues. Corporate officials in most instances would not have insurance coverage for the various fines and penalties imposed in these actions or for disgorged compensation. But the executives might well seek insurance coverage of their legal fees incurred in defending themselves in these actions. One question that might be asked in many of these types of cases is whether or not the proceedings involve an alleged “Wrongful Act” as is required to trigger coverage. Should these questions arise, these executives will want to be able to argue that the applicable D&O policy in any event covers them for allegations against them in their capacities as directors and officers “and in their status as such.”

Bank Director and Officer Defenses: As I have noted in prior posts (most recently here), there are now a growing number of actions against the directors and officers of failed banks brought by the FDIC as the failed bank’s receiver. The defenses available for these individuals and related considerations (including indemnification and insurance) are discussed in a brief, useful (date) memo from the Dechert law firm, entitled “Bank D&O Defense Manual” (here). The memo provides background on the FDIC’s approach to director and officer liability, the well as on the legal theories on which the FDIC will proceed and the defenses available to the directors and officers.

Speakers’ Corner: On October 5 and 6, 2011, I will be in Cologne, Germany participating in C5’s Sixth European Forum on D&O Liability Insurance. I will be participating in a panel on the first day discussing the evolution of class actions in the U.S. and Europe. Joining me on the panel will be Rick Bortnick of the Cozen O’Connor law firm; Guillaume Deschamps of Marsh, S.A. (France) and Prof. Dr. Roderich Thümmel of the Thümmel Schültze law firm.  Background regarding the event, including the complete agenda and registration information, can be found here.

If you will be attending the conference, I hope you will take time to greet me, particularly if we have not previously met.

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Time-honored legal principles typically shield corporate officers and shareholders from direct personal liability for legal violations of the corporation itself, consistent with the notion that the corporation itself has a distinct and separate legal identity. However, as I noted in a prior post (here), courts have evolved a concept called "the responsible corporate officer doctrine," pursuant to which individuals can be held liable for corporate misconduct without involvement in or even awareness of the wrongdoing. Recent indications suggest that regulatory authorities may be planning a more aggressive use of this doctrine, a development that may have disturbing implications.

The responsible corporate officer doctrine was first articulated by the U.S. Supreme Court in the 1943 case of United States v. Dotterweich, in which corporate officers in positions of authority were held personally (and in that case, criminally liable) for violating strict liability statutes protecting the public welfare.

The Supreme Court approved the application of liability under the Food, Drug and Cosmetic Act (FDCA) in the 1975 case of United States v. Park holding that the FDCAs "requirements of foresight and vigilance" are "no more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and wellbeing of the public that supports them." The Supreme Court approved the imposition of liability in that case, though the defendant had no involvement in or personal knowledge of the violation.

The responsible corporate officer doctrine has been absorbed into environmental law as well, and, as discussed here, and has served as the basis of imposing liability in environmental enforcement actions.

According to a March 5, 2010 memo from the Skadden law firm entitled "FDA Announces New Push to Prosecute Corporate Officers and Executives for No-Intent Crimes" (here), the FDA, under fire for lack of active oversight of its office of criminal investigations, has advised Congress that it intends to "increase the appropriate use of misdemeanor prosecutions…to hold corporate officials accountable." The law firm memo suggests that this FDA statement to Congress is consistent with the "recent uptick" in prosecutions relying on the responsible corporate officer doctrine against pharmaceutical and medical device executives.

The responsible corporate doctrine unquestionably is a well-established tool for the imposition of liability on corporate officials in the context of public "health and wellbeing." But though well-recognized, it nevertheless has disturbing implications. The FDA’s apparent intention to use the responsible corporate officer doctrine more aggressively arguably is part of a larger and even more disturbing trend to try to hold corporate officers liable without regard to personal culpability.

First, the idea that liability can be imposed on an individual for corporate misconduct, in apparent disregard of the corporate form and without culpable involvement or even a requirement of a culpable state of mind, seems inconsistent with the most basic concepts surrounding the corporate form. The doctrine arguably imposes liability for nothing more than a person’s status. The word "responsible" in the doctrine’s name does not mean that the individual is responsible for the misconduct, but on that that the individual is responsible for the corporation.

Second, the application of the doctrine can have serious ramifications. The Skadden memo points out that in one recent FDCA prosecution, the individuals against whom liability was imposed on the basis of responsible corporate officer doctrine were required to pay criminal fines of $34.5 million (The imposition of liability is currently on appeal.) The imposition of criminal penalties of this extraordinary magnitude without any fault or even culpable state of mind seems fundamentally inconsistent with the fault-based framework of our criminal justice system.

But the most troubling thing about the responsible corporate office doctrine is that the apparently expanded willingness of regulators to use the doctrine to impose liability on corporate officials is entirely consistent with developments elsewhere that also suggest a willingness of government regulators to try to impose liability without regard to involvement of awareness of the alleged wrongdoing.

In that regard, there have been at least two instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged legal wrongdoing. Though these regulatory enforcement actions did not expressly rely on or even refer to the responsible corporate officer doctrine, the enforcement actions implicitly reflect a similar presumption, which is that in certain instances corporate officials can be held liable solely on the basis of their position without respect to the presence or absence of personal culpability.

First, as noted here, the SEC has initiated an enforcement action against the former CEO of CSK Auto, in which the SEC seeks to "clawback" compensation the CEO earned at a time with respect to which the company subsequently had to restate its financial statements. The SEC is pursuing this claim even though the former CEO is not only not charged with fraud, but is not even alleged to have had any involvement in or even awareness of the circumstances requiring the later restatement.

Similarly , the SEC more recently filed an enforcement action seeking impose control person liability on two officer of Nature’s Sunshine Products, in which the SEC sought to hold the individuals liable for the company’s Foreign Corrupt Practices Violation, though the individuals were not alleged to have had any involvement in or awareness of the wrongful conduct. The Nature’s Sunshine Products case is discussed here.

Though these recent SEC enforcement actions did not expressly rely on the responsible corporate officer doctrine, the SEC’s actions in these cases reflect a willingness – similar to that of the FDA and other regulatory authorities -- to impose liability on corporate officials without regard to fault or culpability. These regulatory actions raise a very disturbing specter of strict liability for executives.

Even if there are circumstances where, as the U.S. Supreme Court has long recognized, that public health and welfare may justify the imposition of liability without culpability under certain circumstance, the enormous burden this possibility would impose on the civil rights and liberties of the affected individuals would seem to argue that these principles be used to impose liability on individuals only in the rarest and most extreme purposes.

But rather than restrict its use of these principles out of an appropriate respect for basic notions of fairness and individual liberty, regulators are moving in the exact opposite direction and apparently seeking new opportunities to use these principles to expand their regulatory reach.

The regulators may well feel this approach may be justified in order to accomplish regulatory goals and ensure that somebody pays the price for wrongdoing. The problem is that scapegoating individuals for misconduct in which they were not involved and of which they were not even aware is fundamentally unfair. In my view, this approach is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

If there are circumstances where public health and welfare might sometimes require the imposition of responsibility on a strict liability basis, the use of those circumstances should be infrequent and unusual. Regulators should be looking for ways to avoid relying on these powers rather than looking to expand their use. The imposition of penalties without regard to fault or culpability is a fundamentally unfair practice that should be discouraged at every possible opportunity.

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