seclogoFrom time to time, the SEC reiterates its view of the critical gatekeeper 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. But while these actions are rare, the agency does periodically bring enforcement actions against directors whom the agency contends shirked their duties.


For example, on September 9, 2015, the agency filed civil fraud charges against Stephen Pence, the former board Chair and majority shareholder of staffing services company General Employment Enterprises. As discussed in the agency’s press release about the enforcement action, which was accompanied by a separate enforcement action against GEE’s outside auditing firm and several of the audit firm’s partners, Pence, a former U.S. attorney and former Lieutenant Governor of Kentucky, allegedly made misleading statements to the auditors involving a supposed $2.3 million certificate of deposit investment of the company. (The bank that supposedly had issued the CD had no record of the transaction.) Pence also allegedly signed GEE’s 2009 annual report despite knowing that it contained misleading statements about the $2.3 million CD transaction and other related party transactions.


Pence allegedly undertook these actions while acting as a frontman for a convicted felon Wilbur Anthony Huff, who allegedly had funded Pence’s purported acquisition of a majority stake in the company and provided Pence with other financial benefits, as well as a Cadillac Escalade. In its action against Pence, the SEC is seeking permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest and penalties, and an officer-and-director bar. A copy of the SEC’s complaint against Pence can be found here. A September 9, 2015 Louisville Courier-Journal article about the SEC’s enforcement action can be found here.


According to an October 16, 2015 Law 360 memo by the Cahill Gordon law firm and entitled “A Brief History of SEC Enforcement Actions” (here, subscription required), while SEC actions against corporate directors are “rare,” they are a “key component of the SEC’s targeting of misconduct of gatekeepers.” According to its current Chair, Mary Jo White, the SEC seeks to put directors on notice that the SEC will pursue “those who should be serving at the neighborhood watch, but who fail to do their jobs.”


The law firm memo details several other recent SEC enforcement actions against corporate directors, including the March 2014 action the agency brought against Ivan Gothner, the audit committee chair for AgFeed Industries, Inc., who allegedly failed to appropriately investigate and disclose accounting fraud by executives at AgFeed’s China offices. Among other things, Gothner allegedly ignored repeated “massive red flags,” including email warnings and a recommendation from Chinese in-house counsel to engage a third-party to investigate the misconduct. The SEC’s March 11, 2014 press release involving its action against Gothner can be found here. My prior post about the Gothner enforcement action can be found here.


The SEC has brought other enforcement actions against corporate directors during White’s tenure as the agency’s Chair, including the 2013 action and negotiated settlement involving eight former directors of Regions Morgan Keegan, who allegedly did not fulfill their responsibilities to make fair-value determinations of securities held by the company, as required by the federal securities laws. The agency’s June 13, 2013 press release about the Regions Morgan Keegan directors’ action can be found here.


According to the law firm memo, even before the current agency chair emphasized the agency’s commitment to enforcing corporate directors’ gatekeeper role, the agency has “brought actions since the early 2000s against the directors who dramatically shirked their duties.” The memo cites as example several enforcement actions that the agency pursued in prior years. Among the other cases the memo cites is the enforcement action the agency brought against Shirley Kiang, the audit committee chairwoman of L&L Energy, whom the SEC alleged had signed annual and quarterly reports certifying compliance with Sarbanes-Oxley’s requirement that a company have an active CFO while aware that the company did  not have an active CFO. My discussion of the action against Kiang can be found here.


While directors may, as the law firm memo notes, find these agency actions to be “disconcerting,” it is important to note that the agency’s actions have “involved significant allegations of wrongdoing by directors.” Several of the actions, including the one filed recently against Pence, involve allegations of “intentional deception of auditors and glaring conflicts of interest”; in other enforcement actions filed against corporate directors, the SEC alleged that the directors involved had “completely failed to perform the duties required of [them] as an auditor and as a director.”


That is, the SEC’s enforcement actions have involved instances of a “significant departure from normal corporate governance and appropriate director conduct.” The SEC has demonstrated its willingness to “investigate board actions and inactions in the face of so-called red flags.”


The lesson for board members from these enforcement actions is that directors should spend appropriate time “learning about their gatekeeper obligations.” Certain issues, according to the law firm memo, merit special attention, including the importance of “setting and maintaining an effective tone at the top,” as well as “evaluating the substance and frequency of officer communications with the board.” In particular, “directors should take prompt action to investigate red flags and take decisive actions where misconduct has been identified.” The directors should also “periodically evaluate the independence of the controller function and adequacy of controls” and “have an open and robust dialogue with internal and external auditors.”


While, as the memo indicates, there are steps that corporate directors can take to reduce the possibility that they might become involved in an SEC enforcement action, directors will also want reassurance that they will be able to try to protect themselves if the SEC does file an action against them. A well-constructed D&O insurance program should provide the directors with a measure of protection, at least with respect to costs incurred in defending against an SEC enforcement action.


The typical D&O insurance policy will usually provide that covered loss under the policy does not include fines and penalties, so monetary amounts imposed in connection with an SEC enforcement action presumptively would not be covered. However, all else equal, the directors’ costs of defending the action typically will be covered.


It is important when considering these issues to take into account the fact that when these types of claims arise, there typically are multiple individual defendants involved, many or most of whom may also seek to access the proceeds of the insurance policy in order to defend themselves. There may also be related civil litigation pending as well. The presence of multiple parties and multiple actions can quickly erode the policy limits. These considerations have important implications for insurance buyers when analyzing limits selection issues – that is, when trying to decide how much insurance to buy. A well constructed insurance program should be built with an eye toward the possibility of the kind of catastrophic circumstance that could require substantial insurance simply in order to allow the targeted individuals and entities to be able to defend themselves.


Another implication from the possibility that multiple parties and multiple actions could put potentially competing demands on a company’s D&O insurance program is that outside directors may want their insurance arranged so that there is a layer or layers of insurance available only for the defense and indemnity obligations of the outside directors. A layer of excess Side A insurance where the only named insureds are the non-officer directors will provide the directors with an added layer of protection and provide some assurance that they will not find themselves with an insurance program that has been exhausted before all of the claims have been resolved.


Autumnal Sunday: North Chagrin Reservation, Willoughby Hills, Ohio, Sunday, October 18, 2015. Pictures: (1) Buttermilk Falls (2) Sunset Pond (3) Green Heron (4) Great Blue Heron

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