Securities fraud actions are among the most vexatious forms of litigation for directors and officers, both as to the frequency of the cases and the enormity of defense and settlement costs. Data compiled by Joseph Grundfest for a Rock Center for Corporate Governance working paper show that the private securities class action bar filed more than 3,050 actions between 1997 and 2012, reaping settlements in excess of $73 billion, and filed approximately 47% of all class actions pending in federal courts between 2002 and 2004.
In sharp relief, in fiscal year 2012 the Securities and Exchange Commission obtained orders requiring the payment of more than $3 billion in penalties and disgorgement for the benefit of harmed investors — far less than the private bar's results. However, this year the SEC has made it clear that it will seek to become more aggressive with a substantially strengthened enforcement program.
The challenge for corporate executives is that the SEC enforcement initiatives pose significantly heightened personal risks to directors and officers, unlike private securities fraud class actions.
Private securities fraud class actions are usually filed under the federal securities laws, and typically settle without any finding that executives acted dishonestly or fraudulently. As such, corporate indemnification is often not in question, state laws regarding the insurability of intentional wrongful acts are not applicable, and directors' and officers' liability policy exclusions for dishonesty, fraud and illicit personal profit are usually not brought to bear. That may change with recent SEC enforcement initiatives.
Individuals will be the primary targets of the SEC. In a speech before the Council of Institutional Investors fall conference in September 2013, SEC Chair Mary Jo White said that the Commission will be “looking first at the individual conduct and working out to the entity, rather than starting with the entity as a whole and working in.” She added that it will pursue individuals wherever possible because “when people fear for their own reputations, careers or pocketbooks, they tend to stay in line.” Moreover, the SEC has recognized that while the investing public may not take note when the SEC carefully reviews offering documents, Americans do take note when the agency charges a chief executive officer or freezes an individual's personal assets. Hence directors and officers are at significant risk as targets under the new SEC enforcement approach.
An actual admission of specific wrongdoing by an executive may be required by the SEC in cases involving a large number of investors or particularly egregious misconduct. According to SEC Chair White, the admission is sought to hold the individuals to a level of “public accountability,” and will “create an unambiguous record of the conduct” which “demonstrates unequivocally the defendant's responsibility for his or her acts.”
The issue becomes whether the admission also unequivocally raises questions about the company's ability to indemnify the executive, whether the acts are insurable under applicable state law, and whether the admitted acts trigger directors' and officers' liability insurance policy fraud or profit exclusions.
Penalties are promised to be more frequent and more severe than in prior cases. In her speech, White revealed that the SEC intends to “make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties — whether against companies or individuals — play a very important role” in enforcement. As in the case of admissions of misconduct, penalties may also give rise to questions regarding indemnification, insurability, and policy coverage.
Other less recent initiatives are no more encouraging for corporate executives. For example, under Section 304 of the Sarbanes-Oxley Act of 2002 (SOX), the SEC has begun to recover, or claw back, compensation of chief executive officers and chief financial officers of companies making financial restatements due to misconduct. Compounding consternation is the SEC's position that corporate indemnification for SOX 304 is against public policy, a position supported by the Second Circuit decision in Cohen v. Viray.
The increasingly strident enforcement tone against corporate executives is a harbinger of times of high risk ahead in the boardroom. Corporate governance coupled with corporate indemnification and directors' and officers' liability insurance coverage are more important today than ever before. â–
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