The SEC has opened a new front in the war on corporate irresponsibility by pursuing outside directors who fiddle while Rome burns. Directors of public companies are now vulnerable to SEC enforcement actions for breaching their responsibilities to shareholders.
Traditionally, the SEC has left claims involving breaches of fiduciary duties to shareholders under state law. Recently, however, SEC Enforcement Chief Stephen Cutler told Bloomberg News that the SEC's civil action in April against Boston-based Chancellor Corporation ("Chancellor") and its directors is the agency's new enforcement model and the "first salvo in this area." The SEC is, in effect, seeking to establish a federal anti-fraud remedy for failing to meet state law duties of care, attention and good faith.
According to the SEC, Chancellor improperly booked revenue in 1998 from a subsidiary it didn't control until January 1999. When Chancellor's auditors protested, they were fired with the board's approval. The subsequent auditor approved the offending entry which yielded Chancellor a 177 percent increase in revenue for 1998. Also in 1998, Chancellor's auditors forced it to write down dubious interested-party transactions. In 1999, with these auditors gone, Chancellor's new auditors allegedly allowed similar interested-party transactions in violation of generally accepted accounting principles. The SEC claims that Chancellor's board knew of the 1998 write-downs, the controversy over the timing of the subsidiary acquisition, the subsequent firing of the original auditors, and the sudden end to discord between the officers and auditors upon hiring the new audit firm - all "red flags" possibly indicating management or financial impropriety.
Not surprisingly, the SEC filed a civil claim for securities fraud against Chancellor's CEO, President, CFO, controller, auditing firm, and the audit team leader. But the SEC also brought claims against two outside directors, both of whom were audit committee members. One director was named in the SEC's civil action along with Chancellor's key officers and audit firm. The other director has consented to an administrative settlement for violations of the anti-fraud provisions of the Securities Exchange Act of 1934, as well as for causing reporting violations by Chancellor - namely, that he signed a Form 10-K annual report the SEC claims "contained materially misleading financial statements." There is no allegation that these directors participated in the fraud. Rather, the allegations are that that they neglected to investigate despite "red flags" indicating possible management fraud, and that they were "reckless" in their lack of due care when they signed SEC annual report filings.
Cutler expressed the SEC's new willingness to go after outside directors who do not profit, buy or sell, but simply fail to exercise the level of care required by their positions. Cases that involve related-party transactions are especially likely for attention since, in Cutler's words, "I don't think there's any area where the duty of outside directors is so acute."
Harvey Pitt, the recently departed SEC chairman, told Bloomberg, "This is definitely a sign of things to come. The commission has made it clear it wants outside directors to uphold the highest standards. This case definitely shows the agency's determination to go after them."
The two SEC releases below, both issued in April of this year, detail the Chancellor case: http://www.sec.gov/litigation/litreleases/lr18104.htm; http://www.sec.gov/litigation/admin/34-47732.htm.