Corporate Governance

Corporate Disclosure and the Role of Outside Directors: SEC v. Krantz (Part 1)

By J Robert Brown Jr.

When a company violates the law, outside directors are almost never liable for breach of their fiduciary duties, irrespective of the harm to the company.  This is because, under Caremark and its ilk (see Stone v. Ritter), there is, in Delaware, no meaningful duty to monitor.  Companies must have a system in place that provides information to the board but, as the cases repeatedly demonstrate, there need not be any specific content to the system.

The risk for outside directors for inattention is not, therefore, going to come from state law.  Instead, it is another matter of governance that will be resolved at the federal level, specifically through actions brought by the Securities and Exchange Commission.  Given that, it was of interest that the Commission  just brought a case against outside directors for inattention.  

The case arose out of disclosure violations alleged by the SEC against DHB Industries, Inc., a supplier of body armor to the U.S. military and law enforcement agencies.  As the Litigation Release described, the Company "through its senior executive officers, engaged in pervasive accounting and disclosure fraud, and misappropriation of company assets that resulted in the company filing materially false and misleading periodic reports with the SEC."  The Company (which is in bankruptcy), settled the case and agreed to a permanent injunction.  

So far just another fraud action, albeit one with some salacious facts (alledged payments for prostitutes, for example).  The Commission went further, however, and charged three outside directors with, among other things, aiding and abetting violations of Rule 10b-5.  In SEC v. Krantz, Litigation Release No. 21867 (SD Fla Feb. 28, 2011), the Commission alleged (and the case has not settled so these are very much allegations) that three outside directors were "willfully blind to numerous red flags signaling accounting fraud, reporting violations, and misappropriation at DHB."

The release does not provide much in the way of specifics about the precise behavior by the outside directors alleged to have violated the antifraud provisions.  The Complaint, however, has much more detail.  What makes the case interesting, is that this is not a circumstance where the outside directors knew about the misstatements and did nothing.  Instead, the allegations in the Complaint largely allege deficiencies in process. 

In one set of allegations, the outside directors were accused of not adequately responding to concerns raised by auditors and the Company's controller about the system for valuing inventory.  In another set of allegations, the outside directors agreed to internal investigations of certain alleged behavior involving the CEO but were accused of allowing the CEO to control the investigatory process.  In other words, the allegations in the Complaint essentially assert that the outside directors violated the antifraud provisions (at least as secondary actors) by not adequately doing their job. 

We'll discuss some of these allegations in the next few posts.  Because the case has not settled, the facts in the Complaint may ultimately be shown to be in error.  Nonetheless, the Complaint suggests the types of circumstances that could lead the Commission to charge outside directors, particularly those serving on the audit committee.  

Full post as published by The Race to the Bottom on March 10, 2011 (boomark / email).