Part III: How Corporate Officials Can Get A Good Night’s Sleep Despite Current SEC Enforcement Trends

This is the third in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Directors and officers (cont)

While enforcement officials are focusing on the duties and obligations of directors in cases such as Krantz, they are also concentrating on ways to expand their reach. Negligent fraud, as in the Dell case, is one way. Another is through the use of Exchange Act Section 20(a), control person liability. This provision, which permits liability to be imposed on certain executives for failing to properly oversee operations, has been sporadically used over the years. Now, however, enforcement officials are using the provision to broaden the reach of SEC enforcement while avoiding the complexities of proving primary or aiding and abetting liability.

The cases brought the against executives of Nature’s Sunshine Products, Inc are illustrative of this new trend. There the first FCPA case imposing Section 20(a) liability was brought against company CEO, Douglas Faggioli and CFO, Craig D. Huff. SEC v. Nature’s Sunshine Products, Inc., Case No. 09CV672 (D. Utah Filed Jul. 31, 2009). The claims are based on payments made in 2000 and 2001 by the Brazilian subsidiary of the company to local regulators to circumvent new import restrictions. The company was charged with FCPA violations. The two officers were charged under Section 20(a) as “control persons.”

To resolve the case, the three defendants consented to the entry of permanent injunctions prohibiting future violations of the antifraud and books and records and internal control provisions of the federal securities laws. The company agreed to pay a civil penalty of $600,000. Messrs Faggioli and Huff each agreed to pay a civil penalty of $25,000. See also SEC v. SinoTechEnergy Ltd., Civil Action No. 2:12-cv-00960 (W.D. LA. Filed April 23, 2012)(Chairman and controlling shareholder alleged to have control person liability); SEC v. Harbert Management Corp., Civil Action No. 12 Civ. 5092 (S.D.N.Y. Filed June 27, 2012)(Funds charged with control person liability for failing to prevent controlled entities from engaging in manipulation).

Finally, the Commission is using a strict liability approach in clawback actions to recoup certain incentive based compensation of CEOs and CFOs. The cases here are being brought despite the fact the executive was not involved in any wrong doing.

Sarbanes-Oxley or SOX Section 304 and Dodd-Frank Section 954 each provide for the clawback of certain executive incentive based compensation when there is a restatement. Section 304 requires the repayment of certain CEO and CFO incentive-based compensation and stock trading profits when the company must restate its financial statements because of misconduct. The Section does not specify that the misconduct be that of the CEO or CFO.

Dodd-Frank Section 954, now Exchange Act Section 10D, is similar. It expands the class of those at risk using the undefined term “executive officers.” It also expands the time period from the one year in SOX to three while dropping the requirement that wrongful conduct cause the restatement. The remedy is more limited however, apparently being restricted to disgorgement. The requirement will be implemented through exchange listing standards under a yet to be written Commission rule.

The SEC has adopted a strict liability approach in SOX 304 cases. See, e.g., SEC v. Jenkins, Case No. CV 09-01510 (D. Ariz. Filed July 22, 2009); SEC v. O’Del, Civil Action No 1:10-CV-00909 (D.D.C. Filed June 2, 2010). Indeed, the complaints typically state that the defendant was not involved in the underlying wrongful conduct which may be the subject of a separate SEC and/or DOJ action. While the wisdom of the SEC’s view might be debatable, its position has been upheld by the Second Circuit. Cohen v. Viray, Case No. 3860-cv (2nd Cir. Sept. 30, 2010).

Collectively, these cases represent not just an aggressive approach to executive liability but one which is expanding and in some instances easing the SEC’s burden of proof. To be sure, cases such as Kravitz are based extreme sets of facts. Yet when viewed in the context of the expanding reach of SEC enforcement in this area there should be little doubt that in the future directors and officers need to be particularly cognizant of their monitoring obligations as good corporate stewards.

Next:Employees, the company and insider trading