The SEC's New Target: Independent Directors

In the past year, the SEC has brought two enforcement actions against independent directors at two publicly traded companies. Historically, the SEC has not targeted public company directors, but  will do so only when the directors "knowingly permit or facilitate" securities violations.

The message from the SEC to independent directors is clear -- take your position seriously, closely monitor and manage the company's activities, or face serious enforcement exposure.

Independent directors play a unique role in corporate governance.  They are viewed as important guardians of the board's critical role in steering a company, and guarding against actions by board members who may be less objective.

The SEC enforcement actions involved four independent directors at two publicly traded companies -- one of the actions was filed in federal court and the other was an administrative proceeding (authorized by recent Dodd-Frank changes). 

The SEC filed a complaint in federal court against three former “independent” directors of DHB Industries, Inc. (“DHB”, now known as Point Blank Solutions, Inc.), who were  members of the audit committee. The  SEC alleged that the three former board members facilitated DHB’s securities violations by "willful blindness" to red flags signaling fraud.  They allegedly allowed senior management to file materially false and misleading filings with the SEC and use corporate funds to pay for personal expenses.  The complaint alleged that the three audit committee members repeatedly failed to investigate red flags, failed to address specific concerns, and allowed fraudulent activity by the CEO and other members of the senior management to continue unabated.

In the second action, the SEC brought an administrative cease-and-desist proceeding against Rajat K. Gupta, an independent director of The Goldman Sachs Group, Inc., until March 2010, and of Proctor & Gamble Co. until his resignation on March 1, 2011 following these charges.  The commission’s order  alleged the facts surrounding Gupta's involvement in the notorious Raj Rajaratnam insider trading case.  Specifically, Gupta tipped Rajaratnam of an impending $5 billion investment by Warren Buffett’s Berkshire Hathaway in Goldman Sachs before the public announcement of the transaction and that Gupta disclosed nonpublic financial results of Goldman Sachs and Proctor & Gamble to Rajaratnam.

The SEC's enforcement actions make it cleat that it will act against independent directors who violate securities laws or egregiously disregard their duties. The SEC is trying to draw a clear line -- it will not second guess good faith business decisions made by directors but it will act against directors who repeatedly ignore warning signs of fraud or other misconduct. 

Board members need to be vigilant, especially in today's risky environment.  There are numerous risks toa  company, each of which cannot be ignored.  There are several steps that directors can take to mitigate the risk of government enforcement action.

--- Due Diligence:   A board member should conduct thorough due diligence before joining a board of directors to make sure that he/she has sufficient time to fulfill his/her board responsibilities.  Board duties have grown in this new regulated environment.  

-- Indemnification, Exculpation and Insurance Protection:   A potential board member also should consider the available indemnification, exculpation and insurance protections.  And, once serving on the board, directors should be monitor these protections and policies. 

-- Independence:  A board member should monitor the board's committees to ensure that they are sufficiently independent and capable of carrying out assigned duties.   Federal and state laws, listing exchanges and other statutes and rules govern board and committee composition and independence requirements. 

-- Disinterestedness:  Board committees assigned certain matters, such as a special investigations committee, should avoid any potential claims of friendship or outside business relationships with the subject of an internal investigation or senior management. 

-- Experience and Skill Levels: A potential director needs to examine the experience and skills of board members.

-- Prompt and Reasonable Actions:  Board members should respond appropriately to possible management misconduct by initiating internal investigations to examine potential evidence.  Red flags should not be ignored or given only cursory attention.