Board Member Liability in SEC Matters.

The SEC regularly brings enforcement actions against public company directors, as well as public companies and senior corporate executives. In civil SEC enforcement matters, the SEC can target individual board members, regardless of their title or position, and can seek disgorgement, civil penalties, and other sanctions.

Parallel to civil SEC enforcement matters, the DOJ can also conduct federal securities fraud investigations. Board members facing potential liability may find themselves at the center of parallel federal criminal and civil proceedings.

A director’s exposure to federal securities liability depends on the elements of the invoked statute or rule. These elements can range from failure to supervise to knowing and willful securities fraud.

For federal securities claims involving a required mental state, having a title of director or board member is not sufficient to establish scienter or acting with knowledge or reckless disregard.

If a director’s company’s Delaware charter or bylaws exculpate the board from liability for breaches of duty of care under Section 102(b)(7) of the Delaware General Corporation Law, this doesn’t block federal securities enforcement actions under the federal securities laws.

In addition to government enforcement, individual board members can also face private civil litigation under SEC Rule 10b-5, which prohibits (among other things) the use of any manipulative or deceptive device in connection with the purchase or sale of any securities.

Finally, there are also state-law derivative claims against board members, most notably Delaware Caremark oversight claims, which are based on board members’ fiduciary duty to exercise reasonable oversight. These claims are brought under state fiduciary duty law rather than the federal securities laws.

What Must the SEC Prove Against a Director?

The SEC is not a state authority. A breach of a director’s fiduciary duty is not, by itself, sufficient to establish liability. It is possible to breach a fiduciary duty without violating the federal securities laws, and it is possible to violate the federal securities laws without breaching a director’s fiduciary duty.

For board members and companies facing SEC enforcement matters, it is important to identify specifically what the SEC is alleging. The evidence required to prove scienter, negligence, or a failure to exercise proper oversight varies significantly among the different federal securities laws that the SEC enforces.

Here are some examples of what the SEC must prove to establish liability for directors in several different types of SEC enforcement matters:

Exchange Act Section 10(b) and Rule 10b-5

The SEC can bring enforcement actions involving these two provisions in the following circumstances:

• (i) making false or misleading statements (or failing to disclose material information) in connection with the purchase or sale of a security, (ii) engaging in schemes to defraud, and (iii) using manipulative devices.

In all of these cases, a key element of an SEC enforcement action under Exchange Act Section 10(b) and Rule 10b-5 is the director’s mental state. Specifically, scienter, acting with knowledge or intent to defraud, is required. A finding of scienter will necessarily exclude directors who acted by mistake or through negligence.

Securities Act Sections 17(a)(2) and 17(a)(3)

Sections 17(a)(2) and 17(a)(3) of the Securities Act also impose liability, in the offer or sale of securities, for “obtain[ing] money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading” and for “engag[ing] in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.”

To establish scienter, the SEC must show that a director acted knowingly or recklessly. However, unlike Exchange Act Section 10(b) and Rule 10b-5, a finding of negligence is sufficient to establish liability for the SEC under Securities Act Sections 17(a)(2) and 17(a)(3), and the SEC regularly pursues enforcement actions where it alleges negligence.

Securities Act Section 11

Securities Act Section 11, “Civil Liabilities on Account of False Registration Statement,” expressly imposes liability on those who are directors of an issuer at the time a registration statement becomes effective. Unlike in cases involving Section 17(a) or Rule 10b-5, liability under Section 11 is not dependent on a director’s knowledge or intent, and a director can be found liable without having personally contributed to the registration statement’s inaccurate or incomplete disclosure.

Rule 10b-5(b)

Under Rule 10b-5(b), a director (or any other person or entity) is only liable for making an untrue statement of a material fact, or omitting a material fact, if the director made the statement or omission. This means that a director who did not make the statement, because another individual or entity, such as a colleague or executive, held ultimate authority over its content and over whether and how to communicate it, is not primarily liable under Rule 10b-5(b), although that director may still face exposure under other provisions, including the scheme-liability subsections of Rule 10b-5 or aiding-and-abetting liability.

Aiding and Abetting

Under Exchange Act Section 20(e), directors can be held liable for “aiding and abetting” violations by issuers, other directors, or officers. To establish liability for aiding and abetting, the SEC must show that the director knowingly or recklessly provided “substantial assistance” with the commission of a violation, which again requires that the SEC prove scienter.

Control-Person Liability

Exchange Act Section 20(a) imposes control-person liability, but this also requires proof of scienter. In order to establish liability under Section 20(a), the SEC must show that the director did not act in good faith or did not believe that there was no violation. The SEC must also show that the director “directly or indirectly” controlled the entity that committed the violation; the director’s title of director, board member, or chair of the board is not enough.

Does independent or audit committee status increase SEC liability?

Documenting the Board Member’s Participation (or Lack Thereof)

The federal securities laws imposed upon directors and companies can impose broad liability, making it difficult to fully evaluate a director’s exposure in the absence of a clear understanding of what the SEC is alleging. To assist with our representation, we recommend that directors and companies take a proactive approach to preserve the evidence that will be most relevant for the defense.

For directors, this often means identifying relevant board minutes, audit-committee meeting minutes, reports of independent consultants and/or attorneys, and other records that document the director’s participation on the board, questions asked, recommendations made, information received, follow-up conducted, and all other pertinent facts and circumstances.

If the SEC is targeting individual directors, particularly for their failure to oversee an issuer’s financial reporting and other compliance obligations, audit-committee directors can be expected to receive scrutiny beyond that focused on other members of the issuer’s board of directors. For audit-committee directors, this will necessarily involve examining, among other things, the extent of auditors’ warnings regarding inaccuracies or incomplete disclosures and the extent to which whistleblowers made complaints regarding the issuer’s internal controls over financial reporting (and how the issuer’s audit committee responded to such complaints).

Proactive Preservation of Documented Questions, Follow-Up, and Oversight

While documentation of an issuer’s failures can contribute to an allegation that the SEC has the evidence it needs to prove its case, the opposite can also be true. The same records that document a director’s failures can be used to demonstrate the extent of the director’s questions, concerns expressed, requests for information and/or internal investigations, follow-up requests, and overall oversight efforts. Contemporaneous records of the questions that directors ask, the requests they make, and the follow-up they conduct, can demonstrate that they are taking their duties seriously.

Along with board minutes and other pertinent documents, preserving emails, messages, notes, and other contemporaneous records that document a director’s concerns, questions, requests, follow-up, and oversight will be important.

Assessing Independence

While independent status alone is not sufficient to establish a federal securities violation, independent status (and lack thereof) can be a factor that plays into the SEC’s investigation. For example, if a director who claimed to be independent fails to exercise independent judgment with respect to the issuer’s compliance obligations or financial reporting, this can trigger scrutiny of the director’s independence.

Undisclosed personal relationships can undermine a director’s status as independent. Even if undisclosed personal relationships do not make a director-and-officer (D&O) questionnaire false on its face, they can serve as evidence of improper influence over the director’s decisions, and SEC investigators may use this evidence to support an enforcement action.

In SEC investigations and subsequent enforcement proceedings, this type of evidence can be used to challenge a director’s assertions of independence, and it can provide support for challenging the effectiveness of a board’s audit committee’s oversight.

For public companies and listed companies, the following are additional types of documentation of which directors and companies should be mindful when preserving evidence.

• Rule 10A-3 (Listing Standards Relating to Audit Committees): This rule requires the audit committee of a listed company to be directly responsible for the appointment, compensation, retention, and oversight of the company’s external auditors, who must report directly to the audit committee, and it requires that each member of the audit committee be independent. The rule is implemented through the national securities exchanges, which must prohibit the initial or continued listing of any issuer that does not comply, so the consequence of noncompliance is denial of listing or delisting of the issuer rather than an SEC enforcement action against the audit committee or its members.
• Director and Officer Questionnaires: While director and officer questionnaires are internal compliance documents, they can be used as evidence in an enforcement proceeding involving a director’s independent status or any other type of disclosure violation.

Preserving Electronic Evidence

What happens after the SEC starts investigating a director?

The SEC’s Investigative Process

When SEC staff opens an investigation under a formal order of investigation, the order designates certain staff to handle the investigative matter and authorizes them to issue subpoenas.

Under Exchange Act Section 21(b), any member of the Commission or any officer designated by it is empowered to administer oaths and affirmations, subpoena witnesses, compel their attendance, take evidence, and require the production of any books, papers, correspondence, memoranda, or other records that the Commission “deems relevant or material to the inquiry.”

SEC investigative testimony is common, and in most cases, it is conducted under oath and transcribed by court reporters.

When SEC staff decides to recommend enforcement action at the conclusion of an investigation, the first step is usually to issue a Wells notice to the board members and companies under investigation. A Wells notice explains that the staff believes there are sufficient grounds to recommend enforcement action in the matter. However, the notice does not formally authorize the issuance of charges and does not bind the Commission to the staff’s recommendation.

In the issuance of a Wells notice, the SEC staff also will indicate what additional information the board members and companies should be prepared to provide in the event of an SEC enforcement action.

In an SEC enforcement action, the SEC staff will make the recommendation that the Commission approve the enforcement action. The Commission will then authorize the filing of civil enforcement action(s), either in federal district court or in an administrative proceeding.

When Does an SEC Investigation End?

The SEC does not follow the timeline of a criminal proceeding. There is no universal deadline for the conclusion of an SEC investigation. An SEC investigation can last for months, years, or longer. It is important to keep in mind that while the SEC’s investigation doesn’t have a specific deadline for completion, the SEC staff will continue to make substantive findings on the matters under investigation and will file SEC charges based on their findings.

Once the SEC staff believes that it has made conclusive findings to justify an enforcement action, it will seek authorization from the Commission to file charges.

Do I Need to do Anything Proactive with Respect to the Seaboard Report?

The SEC’s Seaboard framework, set out in a 2001 report of investigation issued under Exchange Act Section 21(a), is a series of considerations intended to guide the Commission and its enforcement staff in determining whether to pursue an enforcement action and, if so, what charges and remedies are warranted. When investigating board members or companies, the SEC can pursue enforcement actions for failing to establish effective internal controls over financial reporting and for failing to comply with auditors’ warnings, whistleblower complaints, and other “red flags.”

When assessing the appropriate enforcement measures to take, the SEC considers the board member’s or company’s efforts to self-police, self-report, remedy, and cooperate in relation to the matters under investigation.

When facing an SEC investigation, directors and companies can need to take additional steps that are necessary for the best defense possible, and this includes protecting relevant and/or exempt electronic information and ensuring the timely collection and preservation of relevant evidence.

Directors and companies will need to document their efforts to affirmatively respond to the SEC’s investigative demands and avoid sanctions that the SEC is authorized to seek in case of non-compliance with the agency’s subpoena authority.

When taking these and other additional defensive steps, it is important to engage experienced counsel who can advise on the steps required, defend against undue scrutiny from the SEC, and maintain the appropriate balance between cooperation and self-preservation.

How Do I Know if the SEC is Investigating Me?

The SEC may start its investigative process in one of two ways: (i) an informal inquiry or (ii) a formal investigation.

During an informal inquiry, the SEC does not have the authority to subpoena documents or testimony. Instead, the agency will rely on voluntary disclosures from the entities under investigation. While an informal inquiry is voluntary, it can often precede a formal investigation in which enforcement of the agency’s requests become mandatory.

Todd Spodek and the attorneys at Spodek Law Group handle federal cases of this kind from New York, Brooklyn, Queens and Los Angeles.

When should a director retain separate SEC counsel?

Company Counsel and Privilege

While the company ordinarily controls the privilege covering communications between the company’s attorneys and individuals who assist with their representation, in some cases, it will be important to preserve any existing privilege. This includes the attorney-client relationship and work-product privilege.

When company counsel conducts internal interviews for the corporate investigation, the interviews will typically include “Upjohn warnings,” meaning the attorney has been appointed by the company’s board to represent the company and not the individual being interviewed.

A common-interest (or common-defense) arrangement may be appropriate when individuals and companies are both facing liability. These arrangements protect privileged information that is shared between parties with a common interest and ensure that information is not inadvertently made discoverable. However, a common-interest arrangement does not create privilege when none exists, and it does not establish an attorney-client relationship between company counsel and the board member.

When to Retain Separate SEC Counsel

Regardless of the existence of a common-interest arrangement, substantial conflicts can exist between the interests of the company and those of individual board members. In most cases, separate counsel will be necessary for board members, audit-committee directors, and any other individuals who are facing liability in parallel SEC and DOJ matters.

Asserting the Fifth Amendment Privilege

While board members may have the right to assert the Fifth Amendment privilege in their company’s internal investigation, it is important to keep in mind that the Fifth Amendment generally only applies to criminal cases. If a board member asserts the Fifth Amendment in a civil enforcement matter, the factfinder may be permitted to draw an adverse inference based on this assertion.

Furthermore, if the DOJ is conducting a parallel criminal investigation, the SEC may share the director’s investigative testimony with the prosecutors. As a result, board members should be extremely careful when speaking to corporate counsel in the case of a criminal investigation. Statements made during these interviews that are not privileged can be used to pursue charges for violations such as false statements under 18 U.S.C. §1001.

Additionally, if a board member intentionally withholds relevant information or provides false or misleading information in connection with an internal investigation, this can expose the director to civil and criminal liability.

Independent Internal Investigations

Because of potential conflicts between the interests of the company and those of individual board members, issuers will typically have the audit committee, or a special board committee, oversee the company’s internal investigation. Board members may also face direct claims of breach of fiduciary duty, or separate criminal enforcement actions, in addition to the company’s SEC enforcement action.

D&O Insurance Coverage and its Limitations

Like other forms of coverage, D&O insurance coverage does not cover all types of losses or legal expenses. Some of the most important exclusions for D&O insurance coverage include the following:

• Fraud and intentional misconduct: These are among the most common exclusions in D&O policies, and they generally prevent coverage of legal expenses and indemnification in the event of a finding (or admission) of fraud or intentional misconduct.
• Covered losses: While listed companies’ D&O policies usually provide coverage for civil and administrative proceedings, they may exclude coverage in the event of criminal proceedings.
• Public policy exclusions: Like all other forms of insurance, D&O policies do not cover losses or legal expenses for claims arising from a violation of public policy.

When determining the scope of the coverage, it is important to analyze the policy’s wording carefully. For example, the insurance policy may state that a final adjudication is required to determine if an exclusion applies. This means that, in the absence of a final judgment or admission, the insurer may be required to provide coverage regardless of any evidence of fraud or intentional misconduct.

Another important consideration when determining the scope of the coverage is whether the policy’s limits of liability “erode” for claims expenses. If they do, the insurer’s liability for the company’s and its directors’ and officers’ defense expenses will erode the coverage limits that are available for indemnification.

Advancement and Indemnification

In most cases, directors and officers are entitled to defense cost advancement from the company in the event of SEC enforcement action(s) or other litigation. For example, under the Delaware General Corporation Law (DGCL) Section 145(e), Delaware companies and Delaware limited liability companies can advance defense costs that are indemnifiable “upon the request of the party who has been accused of wrongdoing and such party’s execution of an undertaking to repay such amount if it is ultimately determined that advance payment of the amount is not indemnifiable.”

Even when a director or officer is entitled to indemnification, practical and legal considerations can make this indemnification difficult to obtain. For example, if the company files for bankruptcy, a promised indemnification can quickly become practically unavailable.

Under the DGCL, Delaware companies and Delaware limited liability companies are required to indemnify a director, officer, or employee if (i) the director, officer, or employee succeeds on the merits of the action, or (ii) the director, officer, or employee otherwise becomes entitled to indemnification under state law, the Delaware charter or bylaws, or a relevant contract.

Like in all other types of SEC and federal litigation matters, determining entitlement to indemnification requires careful analysis of all applicable governing laws, charters, bylaws, contracts, and other pertinent documents, in light of all relevant public policy considerations.

D&O Insurance: Side A, Side B, and Side C

All D&O insurance policies have three components: “Side A,” “Side B,” and “Side C.”

• Side A: This covers directors’ and officers’ personal liability (i.e., liability not covered by the company’s indemnification provision).
• Side B: This covers the company’s liability for indemnification obligations it owes to directors and officers.
• Side C: This covers the company’s direct liability.

What penalties and collateral consequences can directors face?

Officer-and-Director Bars

In Exchange Act Section 21(d)(2) enforcement actions, if the SEC proves that a board member has committed a violation that “demonstrates unfitness to serve as an officer or director in the future,” the court can impose an officer-and-director bar upon the SEC’s request. Officer-and-director bars impose liability with respect to “issuers subject to section 12(b) or section 15(d) of this Title, or those that are subject to such sections as a result of a proposed registration statement filed under section 13(a).”

Unlike many other SEC enforcement penalties, such as the disgorgement of net profits or the civil penalties imposed under Exchange Act Section 21(d)(3), officer-and-director bars are not subject to fines. Instead, they are designed to prevent fraud-perpetrating individuals from serving as directors in order to prevent similar violations in the future.

While bars imposed in SEC administrative proceedings can be terminated or modified upon a showing of rehabilitation, a court-imposed officer-and-director bar can only be modified through judicial relief. As a result, these bars can pose significant, and often permanent, career risks.

In the absence of an officer-and-director bar, the penalties that the SEC can pursue in SEC enforcement proceedings include:

Disgorgement

Exchange Act Section 21(d)(7) expressly authorizes the SEC to seek disgorgement in enforcement actions. According to the U.S. Supreme Court in Liu v. SEC, disgorgement is only authorized where the SEC is acting in a quasi-remedial fashion and can only include disgorgements “of the defendant’s net profits from the violation, and not that are above the ‘net profits’ from the unlawful act.”

Civil Penalties

The SEC can impose the following types of civil penalties in SEC enforcement proceedings. The amount of penalty depends on the type of violation that the SEC is seeking to establish. Third-tier penalties are generally reserved for cases that involve fraud or a similar scienter-based violation.

• First-Tier Penalties: “The SEC can impose first-tier penalties for any violation of the federal securities laws. A first-tier penalty requires either an injunction or a cease-and-desist order.”
• Second-Tier Penalties: “A second-tier penalty requires the SEC to prove ‘fraud, deceit, manipulation, or deliberate or gross negligence’ in connection with the violation.”
• Third-Tier Penalties: “A third-tier penalty requires the SEC to prove ‘fraud, deceit, manipulation, or deliberate or gross negligence’ in connection with the violation, in addition to a substantial loss to investors or a substantial risk of substantial loss.”
• Other Penalties: “Other penalties include disgorgement, debarment from acting as an issuer’s promoter or director, and bars from appearing before the SEC (under Rule 102(e)).”

Recurrent Injunctions and Civil Penalties

If a director is found liable in an SEC enforcement proceeding, this can lead to recurrent injunctions and civil penalties in addition to statutory penalties. Recurrent injunctions will prevent a director from repeating fraudulent, deceptive, or manipulative conduct.

Other Collateral Consequences

Other potential consequences of an SEC enforcement action include:

• Bad Actor Status: As explained above, certain enforcement proceedings can also result in “bad actor” status under Rule 506(d) of Regulation D, meaning that a director is ineligible to conduct certain types of private offerings or provide fundraise services for a private company.
• Asset Freezes and Receiverships: Under Exchange Act Section 21(d), the SEC can obtain asset freeze orders in federal district court to freeze assets during the pendency of an investigation and receivership orders to place a receiver in charge of an issuer’s or other entity’s assets.

Talk to Spodek Law Group

Every case turns on its own facts, and general information is no substitute for advice about yours. Todd Spodek, managing partner of Spodek Law Group, and the firm's attorneys defend federal criminal and white collar matters nationwide. Reach the firm at 212-300-5196.