Director and Officer Liability in SEC Enforcement Actions.

Director and Officer Liability in SEC Enforcement Actions SEC

investigations can target a company, its officers, directors, and other employees and consultants. The U.S. Department of Justice also targets companies, officers, directors, and other employees and consultants in its investigations. In company-led internal investigations and independent audits, companies’ officers and directors can face liability as well, along with other employees and outside consultants.

Do Outside Directors Enjoy Immunity from SEC Enforcement?

When a company is facing an SEC investigation, its board will often have one or more of its members involved in the investigation as well. However, these outside directors are by no means exempt from SEC enforcement, although the SEC has typically pursued charges against directors less frequently than against executives and owners. When directors facilitate a violation, the SEC can and will pursue civil charges against individual board members, and can refer the conduct to the Department of Justice for criminal prosecution. This is true whether the directors are on the board because they own a substantial percentage of the company or because they are “outside directors” with no ownership interest.

What Is the Role of Red Flags in Investigations?

Many board members have been targeted by the SEC when they ignored red flags pointing to violations within the company. In such cases, the red flags point to the director’s knowledge of a violation or, at the very least, to a level of recklessness that warrants liability. The more knowledge a director has, the more likely it is that the SEC will target the director as well. In this regard, board members on the company’s audit committee will face particular scrutiny in enforcement actions that stem from financial reporting violations.

While company-led investigations often end up exonerating the individuals involved, the board members, executives, and other employees who are subject to these investigations still need to have their own defense counsel to safeguard themselves against a broad range of consequences.

What Must the SEC Prove Against a Director or Officer?

To establish primary liability against a director or officer in an SEC enforcement action, the SEC must prove that the defendant’s conduct satisfied every element of the provision(s) charged. However, the SEC has the authority to seek “control liability” and “aiding and abetting liability” as well, which requires proof of liability under different standards.

Control Liability and Aiding and Abetting Liability - Control Liability: Under Exchange Act §20(a), the SEC

can establish liability if it can prove that the defendant had control over the person who committed a primary violation. The defendant can avoid liability by establishing that they acted in good faith and did not knowingly or recklessly induce the commission of the violation.

• Aiding and Abetting Liability: Under Exchange Act §20(e), the SEC can establish liability if it can prove that the defendant knowingly or recklessly provided substantial assistance to another person’s violation of the Securities Act, Exchange Act, or other related federal securities laws.

  Corporate Fiduciary Duties Company

  directors and officers have fiduciary duties to their companies. These duties are governed by state law, and they arise separately from liability under federal securities laws. A breach of a director’s or officer’s fiduciary duty, such as the duty of care or duty of loyalty, does not automatically establish liability under federal securities laws. However, the SEC often views such breaches as evidence that a securities violation has been committed.

  Rule 10b-5 and the Scienter Standard

  To establish liability under Rule 10b-5, the SEC must prove that the defendant acted with “scienter.” Mere ignorance or negligence is not sufficient. However, under Sections 17(a)(2) and 17(a)(3) of the Securities Act, the SEC can establish liability based on mere negligence.

  Company Liability Companies

  can also face liability under federal securities laws for violations committed by their directors, officers, and other employees. Under Rule 10b-5, for example, the SEC can establish liability for the acts of an entity’s employee or agent if the employee or agent was acting within the scope of their authority.

  How Do Certifications, Filings, and Questionnaires Create Personal Exposure?

  Board Minutes, Certifications, and Filed Reports In an SEC investigation, the SEC

  will look for evidence tying a particular director’s or officer’s knowledge and actions to the company’s alleged wrongdoing. Board minutes and signed filings can be key pieces of evidence. Also, under Exchange Act Rule 13a-14, a company’s principal executive officer and principal financial officer must certify that its quarterly and annual reports satisfy several key requirements. In certifying, the officer may be exposing himself or herself to liability. Under Sarbanes-Oxley §302, an executive officer who signs the corporate disclosures must certify that the company’s quarterly and annual reports and the company’s internal controls over financial reporting are adequate. If an officer certifies a report in the knowing or willful violation of these rules, the officer can face up to ten and twenty years of imprisonment, respectively, pursuant to 18 U.S.C. §1350. A false certification does not, of course, eliminate the government’s burden of proving every element of the provision(s) under which it is seeking to establish liability.

  Director, Executive, and Employee Questionnaires Directors

  and other insiders will routinely answer questionnaires and certify compliance with the company’s corporate policies and procedures. However, providing a false response to a questionnaire that is then incorporated into a filing that contains a materially misleading statement may implicate liability under the federal securities laws.

  Stock Exchange Rule Compliance To

  remain listed on the stock exchanges (i.e., New York Stock Exchange, NASDAQ, or OTC), public companies must satisfy various requirements imposed under the exchanges’ rules. At present, the stock exchanges generally require that public companies maintain majority-independent boards. “Independent” is a factual term with a factual meaning, and companies’ boards must be able to prove independence in their responses to inquiries from the SEC and other federal securities law regulators.

  Board and Stock Exchange Certifications Similar to Exchange Act

  filings and financial reports, these certifications can also have legal repercussions if they contain false or misleading statements that the SEC is in a position to prove based on company records and other forms of evidence. Therefore, you must ensure that all certifications are accurate. If, unfortunately, the SEC alleges that your certifications are materially misleading or not in compliance with the applicable rules and regulations, you must respond promptly and aggressively.

  What Happens During an SEC Investigation of Company Leadership?

  Does the SEC Conduct an Informal Investigation First?

  In most cases, the SEC will conduct an informal investigation prior to seeking a formal order of investigation from the Commission. However, a formal order is not required in all cases. The SEC staff conducts informal investigations under the Commission’s delegated authority.

  Does a Formal Order of Investigation Enable the SEC to Compel Testimony?

  A formal order of investigation authorizes designated SEC officers to subpoena witnesses’ testimony and documents. An attorney who represented the company in its legal matters may also be required to testify.

  Do Witnesses Compelled to Give Testimony Have the Right to Representation?

  Witnesses compelled to give testimony during an SEC investigation have the right to representation by counsel.

  Is the Attorney-Client Privilege Applicable in SEC Investigations?

  The attorney-client privilege applies during SEC investigations as it does in other types of civil and criminal proceedings. It may be waived at the client’s election or in order to comply with the government’s subpoena power.

  Can Compelled Witnesses Invoke Their Fifth Amendment Privilege?

  Compelled witnesses may invoke their Fifth Amendment privilege during investigative testimony. However, this privilege may be limited, and in civil SEC enforcement actions, the courts may draw adverse inferences based upon a witness’s invocation of his or her Fifth Amendment privilege.

  Does the SEC Have a Legal Obligation to Issue a Wells Notice?

  While SEC staff generally issue a Wells notice before recommending charges to the Commission, no statute guarantees the issuance of a Wells notice. As a result, individuals cannot challenge the SEC’s failure to issue a Wells notice on procedural grounds.

  What is a Wells Notice and What Should a Director or Executive Do if Charged?

  A Wells notice generally identifies the provision(s) under which the SEC staff is seeking to establish liability and allows the recipient of the Wells notice to write a response in an attempt to persuade the SEC not to initiate an enforcement action.

If you are targeted by the SEC, you should engage experienced defense counsel promptly. Once engaged, your defense counsel will work closely with you to help make informed decisions regarding how to deal with the SEC’s investigation.

At Spodek Law Group, we represent investigations involving directors, officers, and other executives and company owners. Our defense attorneys handle matters handling SEC investigations, and we have used this experience to successfully protect numerous individuals and companies against the imposition of fines, sanctions, and criminal penalties.

Our defense attorneys can also help your company establish an adequate compliance program, which can help protect your company as well as its executives and board members against liability. The sooner you engage experienced defense counsel, the better.

Can an SEC Investigation Also Lead to Criminal Charges?

What Other Authorities May File Charges Along with the SEC?

SEC matters can proceed administratively, through civil litigation, or in parallel with criminal investigations. Other authorities such as the DOJ, CFTC, FINRA, PCAOB, and state regulators can, and will, file charges in their own matters.

Does an SEC Settlement Preclude Charges from the DOJ?

No, an SEC settlement does not preclude the DOJ from seeking to establish criminal liability, unless the DOJ has separately and explicitly agreed not to file charges. As a result, individuals and companies will need to negotiate settlement with the DOJ if the DOJ pursues criminal charges.

What Does the SEC Seek in a Civil Enforcement Action?

The SEC is not able to seek imprisonment in a civil enforcement action, as it does not have a statutory right to seek criminal penalties. Instead, in SEC enforcement actions, it will typically seek fines and other penalties.

What are the Differences Between Criminal and Civil Enforcement Proceedings?

In criminal proceedings, the DOJ must prove criminal charges beyond a reasonable doubt. This is a higher burden than that of civil enforcement proceedings in which the SEC generally only needs to prove violations by a preponderance of the evidence. Criminal cases can also involve imprisonment, whereas civil cases cannot.

Who was Raj Rajaratnam?

Raj Rajaratnam founded and managed the Galleon Group hedge fund until 2009. Rajaratnam operated Galleon as an independent hedge fund manager with no affiliation to SAC Capital, managing it with a team of financial analysts and associates.

Why Were Charges Filed Against Raj Rajaratnam and Other Galleon Group Individuals?

Along with insider trading, other individuals and companies targeted by the SEC’s investigations of Rajaratnam and the Galleon Group included those who committed wire fraud, securities fraud, and conspiracy. In particular, the government alleged that Rajaratnam built up a vast insider-trading network, providing inside information to insiders within the corporate world and which could also have been obtained in return.

Along with Rajaratnam and other Galleon Group associates, six senior executives of publicly traded companies also became suspects in Rajaratnam’s insider-trading network. Among the targeted individuals were several board members and outside directors as well. The federal government’s prosecution of this insider-trading network involved both civil and criminal proceedings.

When Can the SEC Impose an Officer-and-Director Bar?

What is an Example of an Officer-and-Director Bar?

In an enforcement action in the Securities and Exchange Commission, James Craigie was fined $175,000. Craigie’s conduct also exposed him to a five-year public-company officer-and-director bar because he concealed his close executive friendship. He improperly declared himself “independent” on a director questionnaire, and the company’s proxy statements described him as “independent” as well. Craigie settled the SEC& #x27;s charges without admitting or denying the allegations, consenting to a court-ordered five-year prohibition on serving as an officer or director of a publicly traded company subject to SEC reporting requirements.

What is an Officer-and-Director Bar?

An officer-and-director bar is a prohibition on being an officer or director of any publicly traded company subject to reporting under the Securities and Exchange Act.

When Can a Court Order an Officer-and-Director Bar?

The SEC may seek to obtain an officer-and-director bar when it files an enforcement action with the court. If courts determine that an officer or director is unfit to serve, Securities Act §20(e) and Exchange Act §21(d)(2) allow them to impose such a bar. Courts will typically apply the framework set out in SEC v. Patel, and they will consider the defendant’s role, the degree of misconduct, the likelihood of future misconduct, and three other factors when deciding whether to impose such a bar.

When Can the SEC Impose an Officer-and-Director Bar Independently of the Courts?

The SEC also has the authority to impose officer-and-director bars independently of the courts. Securities Act §8A(f) and Exchange Act §21C(f) allow the Commission, acting on its own initiative, to bar anyone from serving as an officer or director. Such bars can be temporary or permanent.

SEC officer-and-director bars may be imposed in administrative proceedings, as well as in court cases in which the Commission is seeking a temporary bar or injunction. In SEC enforcement proceedings involving officer and director bars, the SEC has the burden of proving that a bar is warranted, and it must meet this burden by presenting sufficient evidence to support its conclusion.

What are the Legal Remedies and Defenses Available to Targets of Officer-and-Director Bars?

In cases in which the SEC improperly imposed an officer-and-director bar, federal courts can and will vacate the orders. Federal courts have also overturned administrative orders of the SEC, and they have reduced sanctions in civil SEC enforcement cases. We handle matters in this area, and we have a proven track record of successfully challenging SEC enforcement proceedings on behalf of our clients.

Will Indemnification or D&O Insurance Cover an SEC Case?

Side A Coverage Companies’ D&O

insurance policies typically provide coverage at three different levels (Side A, Side B, and Side C). Side B covers costs that the company indemnifies, and Side C covers the company’s own direct costs. Side A, on the other hand, covers losses paid by a director or officer personally, which is essential when the company is unable (or unwilling) to provide indemnification. In SEC enforcement cases, Side A coverage is often the only type of coverage available to target individuals.

Intentional-Conduct Exclusions One

of the most significant challenges to obtaining indemnification and insurance coverage is the presence of intentional-conduct exclusions in insurance policies. These exclusions prohibit coverage in cases in which the insured’s “intentional misconduct,” “fraudulent act,” or similar conduct is involved. However, in practice, these exclusions usually only restrict coverage to the extent the insured’s fraudulent or wrongful conduct is proved. As a result, intentional-conduct exclusions typically do not become operative until a final adjudication in the case at hand (or in a related proceeding) establishes that the insured’s conduct was fraudulent or other grounds for denial of coverage exist.

Advancement of Defense Costs Advancement

provisions provide for the payment of defense costs before an individual is entitled to indemnification. Under the Delaware General Corporation Law §145(e), companies are permitted to advance defense costs to their directors and officers in connection with SEC investigations and subsequent enforcement actions. However, to be entitled to advancement, the director or officer must provide a written undertaking to repay the advancement if the individual is eventually determined not to be entitled to indemnification.

Allocation Provisions In SEC

enforcement cases, which often involve multiple individuals and multiple claims, allocation provisions are crucial. An allocation provision governs how a director or officer’s losses are divided between covered and uncovered claims, or how the insurer divides losses among all insured parties. Generally, allocation provisions allow the insurer to deny coverage if only one of multiple insureds committed a fraud or other form of intentional misconduct.

Severability Provisions Another

key feature of D&O insurance policies is the severability provision. This provision ensures that the insurer cannot deny coverage to an insured based on another insured’s knowledge or action. Severability provisions are especially important for mitigating the impact of intentional-conduct exclusions, and they prevent the fraudulent acts of a single executive or director from triggering a denial of coverage for the rest of the company’s board members and executives. Final-Adjudication Language The final-adjudication language in D&O insurance policies is also important, as it determines when intentional-conduct exclusions become operative. The precise language used in the policy determines whether coverage can be denied before a court’s ruling or after appeals.

Indemnification of SEC Penalties

In most cases, the SEC imposes financial penalties and disgorgement requirements, and the question of indemnification will depend upon: (i) the applicable governing law, (ii) the language used in the company’s indemnification policies and bylaws, and (iii) applicable public policy considerations. Under the Delaware General Corporation Law and other similar state laws, a company generally cannot indemnify a director or officer for monetary penalties and disgorgement imposed by the SEC.

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& #x27;s attorneys defend federal criminal and white collar matters nationwide. Reach the firm at 212-300-5196.