Since passage of the Sarbanes-Oxley Act in 2002 ushered in new fears over director liability, finding qualified board members who are willing to take the job has been a more challenging task. Now two recent enforcement actions by the Securities and Exchange Commission against directors might be giving potential board members even more pause.
Breath easier. A closer look into the details of each case reveals little cause for alarm; there is no indication that the SEC is launching a broad-scale effort to investigate directors—although it's certainly demonstrating a willingness to take errant directors to task.
Earlier this month, the SEC's Enforcement Division brought insider-trading charges against Rajat Gupta, a board member for Goldman Sachs and Procter & Gamble. The SEC says Gupta used his position to leak insider information about the companies to Raj Rajaratnam, CEO of the Galleon Group hedge fund, who is at the center of one of the biggest insider-trading investigations in 20 years.
The SEC alleges that Gupta tipped Rajaratnam about Berkshire Hathaway's $5 billion investment in Goldman in 2008, at the height of the financial crisis, as well as Goldman's upcoming public equity offering. According to the SEC, the insider trading by Rajaratnam and others generated more than $18 million in illicit profits and helped the Galleon funds avoid more than $3 million in losses.
“Gupta was honored with the highest trust of leading public companies, and he betrayed that trust by disclosing their most sensitive and valuable secrets,” Robert Khuzami, director of the SEC's Enforcement Division said in a statement announcing the charges. “Directors who violate the sanctity of boardroom confidences for private gain will be held to account for their illegal actions.”
Despite Khuzami's strong words, no other directors are involved in the case nor has the SEC targeted board members in general as part of its look at so called “expert networks.” And securities experts are quick to say that the case may not be as strong as it appears to be. Especially unusual about the SEC's actions is that, of the 26 Galleon-related cases brought by the Commission, Gupta is the first to be brought as an administrative proceeding, rather than before a federal court.
“Almost never does the SEC bring a really significant case like this as an administrative proceeding,” says Tom Gorman, former senior counsel for SEC enforcement and now a partner with Dorsey & Whitney. “They bring them in federal district court, because the remedies are stronger. That's considered to be the form of choice for the SEC Enforcement Division, so it's very unusual for them to have done it this way.”
The Dodd-Frank Act passed last year expands the administrative powers of the SEC by allowing the agency to seek a full range of penalties—both monetary and disgorgement of illicit profits—against executives of financial firms through a streamlined process before an SEC administrative law judge. Prior to Dodd-Frank, the SEC had to bring such claims to federal court, where defendants have full discovery rights.
The case may signal a change in tactic by the SEC, that perhaps the agency plans to bring more actions as administrative proceedings.
“Directors who violate the sanctity of boardroom confidences for private gain will be held to account for their illegal actions.”
—Robert Khuzami,
Director,
SEC's Enforcement Division
Yet some corporate attorneys question the move to use more administrative proceedings. “I think it seriously calls into question the SEC's claims over the last two years that they are rejuvenating the enforcement program, because I don't think you make it a really effective enforcement program by just trying to find a more favorable and easier way for you to win your cases. You do that by bringing them in federal court and litigating them on the merits,” Gorman says.
Gorman says the case against Gupta is more an investigation of one director who may have stepped over the line than a concerted effort to rein in the behavior of board members more broadly. Gupta was a rogue example that probably could not have been avoided, he says. “The problem for every company, is that if someone wants to evade the programs, they can do so,” Gorman says. “The best of the best of procedures can be overwritten.”
In the wake of the allegations, Gupta resigned March 1 from P&G's board. He has also recently resigned from the boards of American Airlines, Genpact, and Harmon International.
Rajaratnam, meanwhile, went on trial in district court in New York on March 9. His trial is expected to last about 10 weeks.
Point Blank
The other significant insider-trading action came two days earlier on Feb. 28, when the SEC filed two separate complaints in U.S. District Court for the Southern District of Florida against military body-armor supplier DHB Industries (now known as Point Blank Solutions) and three of its former independent directors for their “willful blindness” to accounting fraud.
SEC MAKES ITS CASE
The following excerpt is from the SEC release, "SEC Charges Military Body Armor Supplier and Former Outside Directors With Accounting Fraud."
The SEC alleges that Pompano Beach, Fla.-based DHB Industries (now known as Point Blank Solutions) engaged in pervasive accounting and disclosure fraud through its senior officers and misappropriated company assets to personally benefit the former CEO. This resulted in the filing of materially false and misleading periodic reports to investors. The SEC further alleges that outside directors Jerome Krantz, Cary Chasin, and Gary Nadelman were willfully blind to numerous red flags signaling the accounting fraud, reporting violations, and misappropriation at DHB.
The SEC previously charged former DHB CEO David Brooks as well as two other former DHB senior officers for their roles in the fraud.
"We will not second-guess the good-faith efforts of directors. But in stark contrast, Krantz, Chasin and Nadelman were directors and audit committee members who repeatedly turned a blind eye to warning signs of fraud and other misconduct by company officers," said Robert Khuzami, Director of the SEC's Division of Enforcement.
Eric I. Bustillo, Director of the SEC's Miami Regional Office, added, “This massive accounting fraud permeated throughout an entire company and was facilitated by the egregious, wholesale failure of the company's board to act in the face of mounting red flags. As the fraud swirled around them, Krantz, Chasin, and Nadelman ignored the obvious and submitted to the directives and decisions of DHB's senior management while themselves profiting from sales of the company's securities.”
The SEC filed two separate complaints in U.S. District Court for the Southern District of Florida against DHB and the former outside directors. According to the SEC's complaint against Krantz, Chasin, and Nadelman, their willful blindness to red flags allowed senior management to manipulate the company's reported gross profit, net income, and other key figures in its earnings releases and public filings between 2003 and 2005. The company overstated inventory values, failed to include appropriate charges for obsolete inventory, and falsified journal entries. By ignoring red flags, the three outside directors also facilitated the misconduct by Brooks, who diverted at least $10 million out of the company through fraudulent transactions with a related entity that he controlled. Their willful blindness to red flags additionally facilitated DHB's improper payment of millions of dollars in personal expenses for Brooks, including luxury cars, jewelry, art, real estate, extravagant vacations, and prostitution services. Despite being confronted with the red flags indicating fraud, Krantz, Chasin, and Nadelman approved or signed DHB's false and misleading filings.
The SEC's complaints against DHB, Krantz, Chasin, and Nadelman charge them with violating or aiding and abetting the antifraud, reporting, books and records, and other provisions of the federal securities laws. DHB has agreed to settle with the SEC and agreed to a permanent injunction from future violations. The proposed settlement took into account the remedial measures already taken by the company. The company is currently in bankruptcy and its settlement with the SEC is pending the approval of the bankruptcy court. The SEC seeks injunctive relief, disgorgement of ill-gotten gains, monetary penalties, and officer and director bars against Krantz, Chasin, and Nadelman.
The U.S. Attorney's Office for the Eastern District of New York previously filed criminal charges against Brooks, Hatfield, and Schlegel based on the same misconduct. On Sept. 14, 2010, a jury convicted Brooks and Hatfield of, among other things, multiple counts of securities fraud, insider trading, and obstruction of justice, including obstructing the SEC's investigation. Brooks and Hatfield are awaiting sentencing. Schlegel previously pled guilty to criminal charges pursuant to a plea agreement. The SEC's civil actions against Brooks, Hatfield, and Schlegel are stayed pending the full resolution of the criminal actions.
Source: SEC Release on Point Blank.
The SEC alleges that Jerome Krantz, Cary Chasin, and Gary Nadelman ignored numerous red flags signaling accounting fraud, reporting violations, and misappropriation at DHB. As a result, senior management was able to manipulate the company's reported gross profit, net income, and other key figures in its earnings releases and public filings from 2003 through 2005, and in 2007 the company ended up restating financials for all of those years. The SEC is seeking disgorgement of ill-gotten gains, monetary penalties, and to bar the directors from serving on any other boards.
Eric Bustillo, director of the SEC's Miami Regional Office, said in a statement: “This massive accounting fraud permeated throughout an entire company and was facilitated by the egregious, wholesale failure of the company's board to act in the face of mounting red flags. As the fraud swirled around them, Krantz, Chasin, and Nadelman ignored the obvious and submitted to the directives and decisions of DHB's senior management while themselves profiting from sales of the company's securities.”
The Point Blank case is somewhat unusual in that the SEC doesn't generally bring enforcement actions against directors. Khuzami stressed that the SEC “will not second-guess the good-faith efforts of directors,” but he also described Krantz, Chasin, and Nadelman as “directors and audit committee members who repeatedly turned a blind eye to warning signs of fraud and other misconduct by company officers.”
The SEC's regional Miami office declined to offer further comment.
Also unusual about this case is that the SEC alleges that Krantz, Chasin, and Nadelman didn't meet the spirit of being independent directors, because they were “long-time friends and neighbors with personal relationships with former CEO David Brooks that spanned decades,” according to the complaint.
The Point Blank case demonstrates the importance of the board selection process and ensuring that the directors who are selected are, in fact, truly independent. Gorman says that rotating board members or staggering their terms may also help prevent something like what happened at Point Blank.
Point Blank has agreed to settle with the SEC and agreed to a permanent injunction from future violations. The proposed settlement took into account the remedial measures already taken by the company. The company is currently in bankruptcy, and its settlement with the SEC is pending the approval of the bankruptcy court. Its other claim to notoriety is that when the SEC also pursued Brooks to give back improperly received compensation under Section 304 of the Sarbanes-Oxley Act, he argued that DHB had agreed to indemnify him for any clawback losses. A federal appeals court ultimately struck down that arrangement last year.
A jury convicted Brooks and Sandra Hatfield, the firm's former chief operating officer, last September on multiple counts of securities fraud, insider trading, and obstruction of justice. Brooks and Hatfield are awaiting sentencing.
A spokesman in the SEC's Washington D.C. office had no comment on whether the SEC plans to bring other charges against directors.
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