Liability for Persons Signing SEC Disclosure Documents

There is considerable debate over the extent to which corporate officers and directors can be held liable under § 10(b) of the Securities Exchange Act of 1934 (the Exchange Act) for signing materially false and misleading documents that are publicly filed under the federal securities laws and rules of the Securities and Exchange Commission (SEC or Commission).

In general, courts have held that the fact that an officer or director has signed a disclosure document is not dispositive of that person's liability. In particular, courts have drawn distinctions between "inside" directors who participate in and have knowledge of the day-to-day operations of the corporation and could thus arguably be held responsible for alleged misrepresentations, and "outside" directors, who do not have the same level of involvement or scope of knowledge concerning corporate affairs.

The SEC, however, appears to advocate the view that all officers and directors must take a proactive role with respect to the process by which a corporation issues its publicly-filed disclosures, requiring even outside directors to take affirmative steps to oversee the disclosure process and ensure that all public statements are both accurate and complete.

Amicus Curiae

In that regard, the Commission recently filed an amicus curiae brief in support of plaintiff's appeal to the United States Court of Appeals for the Ninth Circuit of a judgment awarded in favor of a corporate officer/director in Howard V. Hui. ¹ In its brief, the Commission criticizes the district court's finding that the defendant was not subject to liability because he had not assisted in drafting the challenged document. Instead the Commission advocates the view that an officer or director who signs a false public filing "with scienter" is a primary violator of § 10(b), even if he or she played no role in the company's day-to-day management and did not participate in the preparation or drafting of the challenged documents.

Group-Pleading Doctrine

Although Federal Rule of Civil Procedure 9(b) requires allegations of fraud to be pled with particularity, courts have permitted plaintiffs asserting claims under § 10(b) to take advantage of the group-pleading doctrine, which allows general averments of the role each individual defendant played in the alleged fraudulent activities. The doctrine,² first established by the U. S. Court of Appeals for the Ninth Circuit in Wool v. Tandem Computers Inc.,³ creates the presumption, for pleading purposes, that statements made in public documents, such as registration statements, prospectuses, and periodic SEC filings, "constitute the collective actions" of the officers and directors who signed the documents, and thus allow securities fraud to be pled without allegations of individualized conduct.

The group-pleading doctrine applies, however, only to officers or directors whom plaintiffs allege "participated in the day-to-day corporate activities, or had a special relationship with the corporation, such as participation in preparing or communicating group information at particular times."⁴ The rationale for this limitation, as the court explained in In re Interactive Network, Inc. Securities Litigation,⁵ is that the application of group-pleading to directors who do not satisfy these prerequisites would "extend[. . .] the group of possible defendants liable in 10b-5 cases beyond those who might be responsible for making the decision.⁶

When the Private Securities Litigation Reform Act of 1995 (the PSLRA) was enacted, questions were raised as to the continued vitality of the group-pleading doctrine because that statute not only requires that fraud be pled with particularity, but also requires plaintiffs to specifically assert that each defendant had acted with culpable scienter. Courts have reached divergent results in resolving this issue.

In In re Stratosphere Corp. Securities Litigation,⁷ the court held that group-pleading existed to the same extent as it had before the PSLRA: it was applicable to those high level executives who were "directly involved in day-to-day operations and were privy to confidential information."

In Marra v. TelSave Holdings Inc.,⁸ however, the court concluded that the group pleading presumption "did not survive the PSLRA's enactment," and in Coates v. Heartland Wireless Communications Inc.,⁹ the court observed that the PSLRA "codifie[d] a ban against group-pleading," as it would be "nonsensical to require that a plaintiff specifically allege facts regarding scienter as to each defendant, but . . . allow him to rely on group pleading in asserting that the defendant made the statement or omission."

Outside Directors

A majority of courts have determined that, absent involvement in day-to-day corporate management, outside directors who have not otherwise made material misstatements cannot be held liable for § 10(b) disclosure violations as a matter of law. Most courts have rejected group-pleading when it was based on nothing more than plaintiffs' allegations that an outside director held a position on a corporate oversight committee, had access to corporate documents or was privy to confidential information.¹⁰

For example, in In re Glenfed, Inc. Securities Litigation,¹¹ the Ninth Circuit dismissed plaintiff's § 10(b) claims against the outside directors because of their lack of "operational involvement" in the corporation, and held that the fact that the outside directors held positions on audit, executive and other oversight committees alone was insufficient to establish § 10(b) liability.

In Gupta Corp. Securities Litigation,¹² allegations that outside directors had access to corporate documents such as financial statements, press releases and presentations to securities analysts also were held insufficient to state a claim. In In re Interactive Network Inc. Securities Litigation,¹³ the court deemed insufficient allegations that an outside director had been privy to "confidential proprietary information concerning [the corporation], its operations, finances, financial condition and product development."

Some courts, on the other hand, have made exceptions and have permitted group-pleading in cases where outside directors had extensive knowledge of the corporation or the specific area of deficient disclosure. For example, in In re Biosciences Securities Litigation,¹⁴ the court allowed group-pleading with respect to the outside directors of a small pharmaceutical company because the directors allegedly had broad experience in the pharmaceutical industry and had "used their expertise and inside status to closely monitor Biosciences' dealings."¹⁵

One court attempted to "stratify" directors based upon their varying levels of corporate and industry knowledge. Thus, in Tischler v. Baltimore Bancorp,¹⁶ the court declined to dismiss § 10(b) claims against outside directors who had been members of the defendant bank's audit committee or who had "special knowledge of the investment, banking, real estate, and/or insurance business," because the court believed that those directors had had access to information about the bank's financial status, or the state of the banking industry in general, which should have put them on alert to the alleged disclosure violations.

The court dismissed claims against outside directors with no particular knowledge of the bank's financial position, or the banking industry in general, because these directors "did not have a basis" to question the information which had been given to them by the management directors.

The judicial application of group pleading to outside directors could be viewed as leading to an ironic result. Outside directors who have little or no knowledge about the corporation, its industry, or the content of the disclosure documents which they are signing have § 10(b) claims against them dismissed by the court. At the same time, outside directors who make an effort to educate themselves in these matters and act as responsible outside directors, but are not alleged to have specific knowledge or the supposedly fraudulent statements, are then treated by the courts as members of the "collective" group deemed to have "made" these material misrepresentations. Indeed, these outside directors are held accountable to the same extent as inside directors who are alleged to be the actual wrongdoers. Apparently, then, for outside directors, a little knowledge is a dangerous thing and no good deed goes unpunished.

Apart from the group-pleading doctrine, a few courts have held outside directors primarily liable for misrepresentations made in publicly-filed documents which they had signed despite the fact that they had played no role in the preparation of the challenged documents. In In re JWP Inc Securities Litigation,¹⁷ officers and directors were sued for § 10(b) disclosure violations when JWP was forced to restate its audited consolidated financial statements due to numerous accounting irregularities which were discovered by JWP's new president.

The writeoffs reflected on the restated financial statements were extensive and wiped out JWP's entire net worth, forcing the company into bankruptcy. The court determined that outside directors who had served on JWP's audit committee, and who had signed the corporation's Annual Form 10-Ks, had "actually made" the misrepresentations contained in those filings. Although these outside directors had not played a role in the day-to-day operations of the company, they nevertheless had been repeatedly informed by the company's auditors that the internal auditing procedures were an "area of concern which needed to be improved." This was ample evidence, the court held, for a reasonable jury to conclude that the defendants had "acted with sufficient recklessness . . . [to] infer fraudulent intent."¹⁸

'Howard v. Hui'

In Howard v. Hui,¹⁹ plaintiff alleged that defendant, Steven Hui, the chairman and chief executive officer of Everex Systems Inc., had violated § 10(b) by making false and misleading statements in Everex's publicly filed documents. Plaintiff predicated her claim on the fact that Mr. Hui 1) reviewed draft quarterly unaudited Everex financial statements, Form 10-Qs, and press releases; 2) met with Everex's president and chief financial officer to "orally formulate text for the quarterly announcement of financial results"; 3) was present at meetings where the board reviewed draft unaudited financial statements; and 4) signed final Form 10-Qs.

Defendant Hui claimed that Everex's financial statements were not materially false and misleading and that, in any case, he had not participated in the preparation of the challenged documents and could not be held liable for their content. Mr. Hui asserted that the only contact he had with the Form 10-Q was when he signed the document as chief executive officer. The district court, in awarding a directed verdict in favor of Mr. Hui, agreed that he had not "made" the alleged misstatements and that, even if he had, he had not acted with the requisite scienter.

According to the court, "[w]hile Hui did sign the financial statements . . . he was certainly not the person who supervised the preparation of those financial statements, and he did not do anything about what went into them."²⁰ In addition, with respect to Mr. Hui's scienter, the court stated that there was "no evidence that . . . Hui knew or thought that any of the numbers were wrong."

In June 1999, the Commission filed an amicus curiae brief with the U. S. Court of Appeals for the Ninth Circuit in support of plaintiff's appeal of the directed verdict awarded to Mr. Hui. The SEC's brief criticizes the court's finding that an officer or director must have participated in the preparation of the challenged statement in order to be accountable for a materially false and misleading disclosure within that document.

Instead, the Commission asserts that the mere act of signing a false public statement "with scienter" is itself a "deceptive act" as contemplated by § 10(b), and that an officer or director who does so is a primary violator," regardless of whether the signer also played a role in the preparation of the document.

To hold otherwise, the SEC argued, would be to allow the signers of public documents to "disclaim legal responsibility" in private actions on the ground that they were not involved in preparing the document.

"Such a result," the SEC stated, "is inconsistent with the responsibility of corporate officials to assure that documents filed with the Commission are true and accurate."

The Commission further asserts that the court had "misinterpret[ed] the distinction between primary violators and aiders and abettors," noting that the U.S. Supreme Court in Central Bank, N.A. v. First Interstate Bank of Denver, N.A.²¹ eliminated private rights of action under § 10(b) based on a theory of aiding and abetting. The Commission thus argues that a strong public policy favoring private securities actions dictates a reversal of the judgment in Hui.

The SEC's argument is somewhat unclear, however, as the court nowhere makes reference to any distinction between primary and secondary liability, and the defendant did not argue that plaintiff had established no more than aiding and abetting violations. The Commission does make clear, however, that it advocates heightened liability for corporate officers and directors and deprecates the court's view that an officer or director can rely on management or professional advisers to address issues of corporate disclosure.

Reports of Investigation

The Commission's position in Hui appears to be a further extension of the views it has articulated in other contexts. Although the Commission does not appear to have obtained injunctive relief or issued administrative cease and desist orders sanctioning outside directors for failure to take affirmative steps to assure the accuracy of SEC filings, the Commission has nonetheless expressed its views on these matters in several Reports of Investigation issued pursuant to § 21(a) of the Exchange Act. For example, in the Report Regarding the Investigation of Gould Inc.,²² the SEC investigated the alleged failure by Gould Inc.'s senior management to adequately disclose to the corporation's board of directors what could be viewed as a self-dealing transaction, whereby senior management had formed a partnership to purchase a tract of real estate adjacent to a tract owned by the corporation.

The SEC reported that the information which management revealed to the board about the transaction was deficient and did not allow the board to make an informed judgment about the equity of the partnership's transaction. Notwithstanding its conclusions concerning management's failure to adequately inform the board, the SEC criticized the directors for ineffectual due diligence efforts, which the Commission characterized as being perfunctory at best. The Commission concluded that the directors had conducted no "additional investigation beyond inquiry of financially-interested management," when they should have known to seek information from "independent non-interested sources."

In the Report of Investigation Concerning the Conduct of Certain Former Officers and Directors of W.R. Grace & Co.,²³ the Commission investigated alleged material omissions in W.R. Grace & Co's (Grace's) annual reports and proxy statements. These omissions related to the nondisclosure of a $3.6 million retirement compensation agreement Grace had entered into with the company's Chief Executive Officer, J. Peter Grace, Jr., as well as a related party agreement-in-principle to sell a portion of Grace's businesses to Grace Jr's son, J. Peter Grace III.

According to the Report, certain officers and directors of Grace were aware of both agreements, but did not question why neither agreement was disclosed in Grace's periodic SEC filings. The SEC reported that the directors, which included an outside director, "should have inquired" about the nondisclosure and "[i]f the answers they received from these inquiries were not fully satisfactory to them . . . they should have insisted that the documents be corrected before they were filed with the Commission."

In the SEC's view, it was not enough for the directors to assume, without confirming, that other corporate officers and legal counsel had conducted a complete and informed analysis and made a determination with respect to the requisite disclosure. In order to rely on the company's internal procedures, the SEC said, directors must have "a reasonable basis for believing that those procedures have resulted in full consideration" of the specific issues at hand.

Then-Commissioner Wallman, in dissent, stated that, he "fail[ed] to see where the red flag exist[ed] that would require non-lawyers to question the explicit determinations of their disclosure counsel as to the level of disclosure detail." Commissioner Wallman expressed the belief that the onus should be placed on corporate counsel to "ask the appropriate questions" in order to fully inform themselves of facts and circumstances relevant to disclosure. While Commissioner Wallman recognized that the Commission was "understandably wary about pursuing lawyers for their legal judgments," he asserted that holding directors and officers responsible for not questioning the judgment of counsel was also inappropriate. He observed that the Commission needed to recognize that under some circumstances "there simply may be no person that will be individually liable" for inadequate corporate disclosure. Commission Chairman Levitt has denied that the Grace Report represented a change in officers' and directors' ability to reasonably rely on their company's internal procedures.²⁴ Rather, he said, the report stood for the proposition that when corporate directors had reason to know that important information was not being disclosed, they had an affirmative duty to seek an answer as to why disclosure was not being made (or, presumably, whether disclosure was adequate).²⁵

Aircraft Carrier's Rule

In November 1998, the Commission published proposed rules -- colloquially referred to as the Aircraft Carrier -- intended to implement comprehensive changes in the registration of securities offerings.²⁶ One proposed rule in the Aircraft Carrier release would require all signers of Exchange Act documents to certify, in writing, that they had read the documents in their entirety and that they were unaware of any material misrepresentations or omissions contained therein.²⁷

Commenters have raised many areas of concern with this proposed rule. From a logistics standpoint, it was observed, certification is impractical, as drafting changes are usually made on a continual basis up until a disclosure document's filing deadline, and would, thus, be difficult, if not impossible, to afford all board Members the opportunity to read and investigate for accuracy a document's final version and still meet the filing deadline.²⁸

In addition, it was noted that there is no practical "forum" that would allow board members to question, contribute and change the content and wording of disclosure documents. Short of organizing a group "drafting session," it is unclear just how this "pre-certification" process could be accomplished to everyone's satisfaction.

The effect that the certification rule would have on officer and director liability is uncertain. Commenters have suggested that requiring board members to personally guarantee the accuracy and completeness of all information contained in periodic filings would further limit the board's ability to reasonably rely on internal disclosure procedures, and would necessarily change the board's focus from ensuring that corporate disclosure procedures were efficient and accurate to concentrating on issues of personal liability.

Many have asserted that certification would serve only as fodder for federal securities claims against officers and directors without improving the quality of corporate disclosure.²⁹

The SEC claims that the certification proposal merely codifies an assumption also noted in its amicus brief in Hui that when the public sees a corporate official's signature on a document, "it understands that the official is thereby stating that he believes that the statements in the document are true." This assumption does not necessarily recognize, however, that there is a difference between expressing confidence in the proficiency of an internal corporate process specially designed to allow those with knowledge and ability to produce an accurate document, and attesting to one's personal knowledge as to a document's complete accuracy.

Implications

Traditional rules of corporate governance allow officers and directors to reasonably rely on management and experts to produce publicly-filed disclosure documents which are accurate and complete. As the Delaware Chancery Court held in In re Caremark International Inc. Derivative Litigation,³⁰ adequate compliance under federal securities laws requires a board of directors "to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists." In its amicus brief in Hui, as well as its proposed certification rule, the Commission is seeking to heighten officers' and directors' responsibilities for corporate disclosures.

Its apparent goal is to require officers and directors to take "steps" to "ensure" a document's accuracy, thus constraining their ability to rely on a corporation's internal disclosure processes, despite the fact that such reliance is fully sanctioned by judicial precedent. The potential effects of this view would be far-reaching, as it might even create an implicit shift in the burden of proof in securities cases, requiring officers and directors to prove that they took appropriate steps to ensure a document's accuracy.

Indeed, in many ways, it could be argued that the Commission is attempting to engraft into § 10(b) the standard of § 11 of the Securities Act of 1933, which provides that a person who signs a registration statement is liable for any material misrepresentation contained in the registration statement. Under § 11(b), such a signer can only avoid liability if he sustains the burden of proving that, after reasonable investigation, he had reasonable grounds to believe and did believe that the statements were true and complete.

The SEC has stated that an officer or director who signs a false disclosure document "with scienter" is a primary violator ³¹ of § 10(b). This argument does not seem unreasonable if faced with an officer or director who had actual knowledge of falsity. But many courts have held that "scienter" contemplates recklessness, which has been defined as "conduct which is highly unreasonable and which represents an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it."³²

The SEC has given no indication as to what "reckless" means in the context of outside director responsibility for corporate disclosures and has provided no guidelines as to what is "enough" due diligence to satisfy the Commission's standard.

In many ways, it could be argued that the Commission is attempting to engraft into § 10(b) the strict liability standard of § 11 of the Securities Act of 1933. But while § 11 provides for a good faith defense with respect to those portions of the registration statement which were prepared by an expert, here, such reliance could be misplaced and could subject officers and directors to liability for federal securities laws violation.

1. 1998 WL 795186 (N.D. Cal.)
2. The doctrine is also referred to as the "group-published" doctrine.
3. 818 F.2d 1433 (9^th Cir. 1987).
4. In re Aetna Inc. Securities Litig., 34 FSupp.2d 935, 949 (E.D. Pa. 1999) (quoting In re GlenFed Inc. Securities Litig., 60 F.3d 591, 593 (9^th Cir. 1995).
5. 948 FSupp. 917, 921 (N.D. Cal. 1996).
6. Officer liability has sometimes been established in the absence of a signature when that officer was shown to have particular knowledge of the area that was the subject of the inadequate disclosure. See In re Apple Computer Securities Litig., 886 F.2d 1109 (9th Cir. 1989) (non-signing officers who made optimistic public statements about the anticipated success of a new computer, despite knowing that the product was experiencing serious technical difficulties, created a jury question as to their liability for material misrepresentations); Hurley v. Federal Deposit Insurance Corp., 719 FSupp. 27 (D. Mass. 1989) (holding that a bank's senior vice-president in charge of lending was liable for material omissions made in SEC filings with respect to the bank's lending practices, despite the fact that the senior vice-president had not actually signed the filings).
7. 1 FSupp. 2d 1096, 1107 (D. Nev. 1998).
8. 1999 WL 317103 (E.D. Pa.)
9. 26 FSupp.2d 910 (N.D. Tx. 1998).
10. See In re Valence Technology Sec. Litig., 1995 WL 798927, *7 (N.D. Cal.); Picard Chemical Inc. Profit Sharing Plan v. Perrigo Co., 940 FSupp. 1101, 1135 (W.D. Mich. 1996); Stack v. Lobo, 903 FSupp. 1361, 1377 (N.D. Cal. 1995); In re Oak Technology Sec. Litig., 1997 WL 448168, *11 (N.D. Cal.); Strassman v. Fresh Choice Inc., 1995 WL 743728 (N.D. Cal.).
11. 60 F.3d 591 (9^th Cir. 1995).
12. 900 FSupp. 1217, 1241-42 (N.D. Cal. 1994).
13. 948 FSupp. 917, 921 (N.D. Cal. 1996).
14. 806 FSupp. 1197 (E.D. Pa. 1992).
15. The court also suggested that officers and directors of smaller companies like Biosciences, Inc. (only 40 employees), should be "Expected to hear more responsibility and have created knowledge of the venture than an officer, or especially, director in a large, well-established corporation."
16. 801 FSupp. 1493 (D. Md. 1992).
17. 928 FSupp. 1239, 1255-56 (S.D.N.Y. 1996).
18. See also F.N. Wolf & Co., Inc. v. Estate of James W. Neal, 1991 WL 34186 (S.D.N.Y.) ("[D[irector signing a document filed with the SEC . . . 'make[s] or causes to be made' the statements contained therein").
19. 1998 WL 795186 (N.D. Cal.).
20. Transcript of Judge Charles A. Legge's Oral Ruling on Motion for Directed Verdict at Volume 13, pages 2528-2530, 8/24/98.
21. 511 U.S. 164 (1994).
22. 1977 WL 21237, Release No. 34-13612.
23. 1977 WL 597984, Release No. 34-39157.
24. Alan L. Dye & Suzanne A. Bar, Securities Law Compliance Programs, SD11 ALI-ABA 1239, *1243 (1998).
25. See also In a Report of Investigation in the matter of National Telephone Co., Inc., 1978 WL 15409, Release No. 34-14380 (SEC admonished the officers and directors of a failing company for allowing the company to issue optimistic public disclosures in the face of the company's impending bankruptcy).
26. Regulation of Securities Offerings, Securities Act Release No. 33-7607A [Current Binder] Fed. Sec. L. Rep. (CCH) paragraph 86, 108 (November 13, 1998).
27. Id. at *118.
28. Comment to Aircraft Carrier Release by Business Roundtable. The Comment also noted that difficulty in meeting the filing deadline would particularly be true in light of the Aircraft Carrier's proposal to shorten the filing deadline for Form 10-Qs from 45 to 30 days.
29. Comment on Aircraft Carrier Release from Association of the Bar of the City of New York.
30. 698 A2d 959 (Del. Ch. 1996).
31. The Commission's general counsel, Harvey Goldschmid, has rhetorically asked "what could be more primary than signing a disclosure document?" -- a statement which succinctly expresses the SEC's view that officer or director liability should be based solely on a false document. Ellen L. Rosen, National Law Journal, July 19, 1999.
32. Chill v. General Electric Co., 101 F3d 263, 268 (2d Cir. 1996).

Dennis J. Block and Jonathan M. Hoff are partners at Cadwalader, Wickersham & Taft. Cindy D. Salvo, assisted in the preparation of this article.

This article is reprinted with permission from the August 26th issue of the New York Law Journal © 1999 NLP LP Company.