From time to time, the SEC reiterates its view of the critical role companies’ outside directors play in safeguarding investors’ interests. Nevertheless, it has been relatively rare for SEC to pursue enforcement actions against outside directors based on an alleged failure to fulfill that role, at least in connection with disclosure violations. A recent enforcement action in which the SEC charged an outside director as a primary violator for the company’s financial disclosures may suggest that the SEC is taking a more active enforcement approach against outside directors.


As reflected in the SEC’s March 15, 2010 press release (here), the SEC filed enforcement actions against three former senior executives and a former director of InfoGROUP. A copy of the enforcement complaint against the former director can be found here.


The actions arose out of allegations that the company’s CEO had used nearly $9.5 in corporate funds for a variety of personal expenses and that the company had entered into an undisclosed $9.3 million transaction with companies in which the CEO had a personal stake. The alleged personal expenses included personal travel on private jets; expenses related to the CEO’s yacht; personal credit card expenses, and other items.


The former director against whom the SEC pursued an enforcement action, Vasant Raval, had been chair of the board’s audit committee. Beginning in January 2005, Raval became aware of "red flags" concerning the CEO’s expenses and the related party transactions. The board asked Raval, in his capacity as audit committee chair, to investigate.


Ravel conducted his own investigation, without the assistance of independent counsel. His investigation revealed information suggesting inadequate documentation and explanations for many of the expenses and the related party transactions. He also received an unsolicited document from the company’s director of internal audit that questioned the business purpose of certain of the expenses. The SEC alleged that despite this information, "Ravel failed to take meaningful action to further investigate [the CEO’s] expenses."


Less than 2 weeks after beginning his investigation, Ravel presented he company’s board and its outside counsel the results of what he described as his "in-depth investigation," which, according to the SEC, failed to advise the board that he (Ravel) was aware of insufficient documentation for certain expenses.


During summer 2005, Ravel received additional information from the company’s new director of internal audit questioning some of the CEO’s expenses. The SEC alleged that Ravel failed to inform the board of these questions or to further investigate the issues himself.


The SEC alleged that Ravel had a duty to ensure the accuracy and completeness of the statements in the company’s SEC filings, but that he "failed to take appropriate action with respect to significant red flags" concerning the CEO’s expenses and the related party transactions. The SEC alleged that these improper expenses and transactions could have been uncovered sooner had Ravel further investigated the red flags or hired outside counsel or others to do so.


Ravel agreed to a bar to serving as an officer or director of a public company for five years and to pay a $50,000 civil penalty.


As discussed in a March 31, 2010 memo from the Bingham McCutchen law firm discussing this enforcement action (here), even though this case involves "particularly egregious allegations," it nevertheless represents "an important precedent." Though the case does not mean that "an outside director has a duty to investigate and verify all facts contained in SEC filings," it "certainly indicates that were a director is aware of ‘red flags’ concerning potential improper conduct, the director must conduct a thorough investigation."


It is not unprecedented for the SEC to pursue enforcement actions against outside directors. Among other things, the SEC has pursued claims for insider trading and other violations on numerous occasions. The SEC even pursued options backdating related allegations against three former directors of Mercury Interactive (about which refer here).


It is, however, unusual for the SEC to pursue enforcement actions against outside directors for primary violations based on disclosure obligations. The SEC did, as discussed here, pursue an enforcement action against outside directors of Spiegel for actively and knowing participating in a decision to withhold filing the company’s 10-K, out of concern over revealing the company’s "going concern" audit opinion. That case also involved rather egregious facts (for example, there were facts suggesting the directors supported efforts to withhold the filing even after having been informed that withholding the filing might violate federal securities laws).


Though enforcement actions against outside directors for disclosure related issues may be relatively rare and may also involve unusual and arguable egregious circumstances, they nevertheless represent significant instances where outside directors faced significant exposures. The Bingham memo expresses the concern that the action against Ravel, and particularly the harshness of the sanctions imposed against him "may indicate a new aggressiveness by the SEC in its enforcement program against outside directors."


Though these examples of SEC enforcement actions against outside directors involve unusual circumstances, they do underscore the fact that outside board service does involve potential liability exposures for the outside board members. Among other implications from these exposures is the critical importance of the D&O liability insurance available to protect outside board members in the event these kinds of issues should arise.


The typical D&O policy would not provide coverage for the penalties that Ravel paid in resolution of the enforcement action against him. However, he undoubtedly incurred significant defense expense in connection with the SEC action. A director’s defense expenses incurred under these circumstances typically would be covered, at least with respect to expenses incurred in the enforcement action itself as well as in connection with any formal investigation preceding the action.


However, when a company encounters significant problems of the kind leading to SEC enforcement actions or even private securities litigation, there often are many demands on the D&O insurance policy. The concern that there will be sufficient funds available to protect outside directors when problems do arise raises very important implications about policy structure, as I discuss at greater length here.


The bottom line is that insurance questions surrounding these issues are critically important and they underscore the importance of having a knowledgeable and skilled insurance professional involved in the D&O insurance transaction.