The Securities and Exchange Commission (“SEC”) recently brought a case in which it charged an outside director as a primary violator for committing and causing a public company’s securities law violations relating to the company’s disclosures in its Forms 10-K and proxy statements. Although the SEC has long argued that it could bring cases against outside directors based on a public company’s SEC disclosures, in practice those cases have been very rare.
On March 15, 2010, the SEC filed four actions in federal district court charging securities fraud and other securities law violations against the former CEO of InfoGroup Inc. (“InfoGroup”), two of the company’s former CFOs, and its Audit Committee Chair. The Audit Committee Chair, outside director Vasant Raval, settled his matter without admitting or denying the SEC’s allegations; the CEO also reached a settlement.
Raval agreed to a bar from serving as an officer or director of a public company for five years, and agreed to pay a $50,000 civil penalty. He also consented to a final judgment enjoining him from violations of Securities Exchange Act of 1934 (“Exchange Act”) Sections 10(b) and 14(a); and Rules 10b-5, 14a-3 and 14a-9, and from aiding and abetting InfoGroup’s violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B); and Rules 12b-20 and 13a-1. The case against the two CFOs is ongoing. The company settled a related administrative proceeding.
The SEC has long emphasized the responsibilities of outside corporate directors. For example, in the Report of Investigation in the Matter of the Cooper Companies, Inc. as it Relates to the Conduct of Cooper’s Board of Directors, the SEC stated that “corporate directors have a significant responsibility and play a critical role in safeguarding the integrity of [a] company’s public statements and the interests of investors when evidence of fraudulent conduct by corporate management comes to their attention.” Exch. Act Rel. No. 35082 (Dec. 12, 1994).1 The SEC regularly sues outside directors for conduct such as insider trading, or for involvement in fraudulent securities offerings. But it appears that the SEC has not, until now, brought a case charging an outside director as a primary violator for a company’s securities law violations for failing to take affirmative steps to ensure the accuracy of SEC filings.
The action against Raval focused on his failure to adequately perform his duties as audit committee chair. The SEC stated that the board of directors received information in January 2005 that raised questions about whether InfoGroup had reimbursed the CEO for personal expenses, and whether related party transactions with companies owned by the CEO were proper.
The SEC alleged that InfoGroup’s CEO received about $9.5 million in undisclosed, unauthorized compensation between 2003-2007. The complaint alleged that the CEO, InfoGroup’s largest shareholder, charged personal expenses to the company, including $3.1 million for personal jet travel for himself, family and friends to places such as South Africa, Italy and Cancun; $2.8 million in expenses related to his yacht; over $1 million in credit card expenses; costs associated with 28 club memberships, 20 automobiles and upkeep for several of his homes; and three personal life insurance policies. The SEC further alleged that InfoGroup also engaged in undisclosed related party transactions totaling $9.3 million with two companies controlled by the CEO.
The board tasked Raval, as the audit committee chair, to investigate the matter and report back before InfoGroup filed its 2004 Form 10-K and proxy statement in March 2005. Raval then conducted his own internal investigation, without the assistance of independent counsel, which revealed insufficient documentation or explanations for expense reimbursements to the CEO and for related party transactions with companies controlled by the CEO. In addition, during his investigation, Raval received unsolicited information from InfoGroup’s director of internal audit that questioned the business purpose of certain of the CEO’s expense reimbursements. Raval assured the director of internal audit that he would address her concerns with the CEO, but he did not.
Just 12 days after being tasked to investigate these matters, Raval presented a report to InfoGroup’s board that Raval characterized as the result of “in-depth investigation.” The report, the SEC alleged, omitted critical facts, including that Raval was aware of insufficient documentation for CEO expense reimbursements. Raval later received in June and July 2005 information from a second director of internal audit and from InfoGroup’s outside disclosure counsel questioning certain of the CEO’s expense reimbursement requests and other transactions. Raval failed to inform the board of these matters. The SEC stated that Raval failed to take meaningful action to further investigate the matter and omitted critical facts in a report to the board regarding the CEO’s expense reimbursements.
The SEC alleged that Raval knew, or was reckless in not knowing, that InfoGroup was making false and misleading statements in SEC filings concerning expense reimbursement payments to and transactions with the CEO, and that Raval nonetheless signed the SEC filings as a director. The SEC contended in its complaint that the fraud committed by the CEO and others could have been discovered sooner had Raval further investigated the red flags himself, hired outside counsel or others to do so, or brought relevant facts to the attention of InfoGroup’s board, auditor or disclosure counsel for further action.
Although the Raval matter involves particularly egregious allegations, nevertheless the case is an important precedent. The SEC complaint alleges that Raval had a broad duty “to ensure the accuracy and completeness of the statements contained in the company’s Commission filings” and that he “failed to take appropriate action with respect to significant red flags concerning [the CEO’s] expenses and Info’s related party transactions with [the CEO’s] entities.” We do not believe that this case means that an outside director has a duty to investigate and verify all facts contained in SEC filings he or she signs or that it is unreasonable for a director to rely on a company’s disclosure certification process. However, the case certainly indicates that where a director is aware of “red flags” concerning potential improper conduct, the director must conduct a thorough investigation, consider using outside counsel or other experts to conduct that investigation, and fully inform the board about the results of that investigation.2 The SEC alleged not only that Raval was liable as audit committee chair for violations in the company’s financial statements, but also for the company’s violations concerning compensation disclosure in its proxy statement, despite the fact that Raval apparently did not sit on the company’s compensation committee, which was responsible for overseeing those disclosures.
In recent years, the SEC has aggressively investigated the conduct of outside directors in a variety of contexts, including stock option backdating, FCPA and financial misstatement cases. However, despite the broad language in the Cooper Companies Section 21(a) report more than 15 years ago, the SEC has brought few if any cases alleging that an outside director was liable for a company’s disclosure violations. The Raval case and its harsh sanctions — a five-year bar on serving as an officer and director, and a $50,000 penalty, in a case where Raval obtained no personal benefit of any kind — may indicate a new aggressiveness by the SEC in its enforcement program against outside directors. The case underscores the importance, when outside directors receive what the SEC might later characterize as a “red flag” concerning potential misconduct, of hiring independent counsel to conduct a thorough and credible investigation of that potential misconduct.
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This article was originally published by Bingham McCutchen LLP.