Board Members Must Be Alert to 'Red Flags' of Potential Fraud Charges

It can be enticing to receive an invitation to serve on a board of directors of a public company.

Accepting a directorship, however, can put one at risk of fraud accusations by the Securities and Exchange Commission because of missteps in seemingly innocuous circumstances.

The SEC’s approach to enforcement actions against directors has the effect of deputizing directors as agents of the SEC’s Division of Enforcement. Perhaps the approach will curb corporate dishonesty, but directors who fail to follow clues that in the glare of hindsight may appear to have been significant warnings of malfeasance may well find themselves the pursued rather than the pursuer.

However, directors can significantly lessen their chances of getting in the SEC’s crosshairs if they understand what the SEC now considers to be fraud.

In 2003, in response to corporate scandals, the then head of the SEC’s Division of Enforcement announced that the agency would bring civil fraud charges against corporate directors who failed to respond appropriately to clear warnings, or “red flags,” of fraudulent activities, even if they were neither directly involved in their corporation’s fraudulent activities nor had actual knowledge of the fraud.

It is not remarkable that the SEC has determined to make disengaged directors the objects of enforcement proceedings. That the charge selected is fraud, however, is remarkable.

Red and Yellow Flags

In common parlance we think of fraud as intentional deception. But fraud in the securities context can be established by a showing of recklessness, variously defined as carelessness approaching indifference or an extreme departure from ordinary care.

The concepts of “red flags” and recklessness are elastic enough to leave directors uncertain as to when they might face fraud allegations, and the SEC is prepared to take an expansive view of both concepts.

A director’s signature on a document filed with the SEC is the most likely way to put the director in jeopardy. For example, if the director signed an annual report on Form 10-K that contains statements later proven to be false, and the SEC concludes that information available to the director should have caused heightened scrutiny, fraud charges are likely to be brought.

This model for holding directors accountable for fraud offers little guidance as to what a director must do to avoid a charge. What will constitute a “red flag” will depend on the facts or circumstances of a given case, and with the benefits of hindsight, flags that did not seem even pale pink in real time will take on a darker hue once the fraud has been unveiled.

A Hypothetical Situation

A hypothetical scenario may serve to illustrate how unsuspecting directors may find themselves in the SEC’s sights. A business associate of the president of Acme Widgets is asked to serve as an outside director of Acme’s board. She accepts, then learns shortly after joining the board that Acme’s management has been dissatisfied with its outside auditors for billing and performance issues, criticisms that seem to have a factual basis.

The existing auditors complete the ongoing audit and in the course of doing so insist that revenue has been improperly recognized and that income must be reduced by significant amounts. Management objects, and asserts that the auditors are applying revenue recognition criteria too rigidly. But ultimately the audit committee accepts the adjustments.

Halfway through the following year, Acme’s management advocates the removal of the auditors because of billing and performance issues. The board and the audit committee accept management’s recommendation and new auditors, recommended by management, with apparently appropriate credentials, are hired.

They perform the subsequent year’s audit and issue an unqualified opinion letter that the financial statements fairly present Acme’s financial condition. Those financial statements reflect a significant increase in revenues over the prior year. The director, who signed the Form 10-K, is told that the new accountants have adopted some of management’s positions with respect to the recognition of revenue that the prior accountants had rejected.

The outside director, who is not trained in accounting, accepts the disagreement between the two sets of accountants as a difference of professional judgment. Relying on the new auditors’ “clean opinion,” the director signs the Form 10-K, which includes Acme’s financial statements.

Some months after the Form 10-K is filed, a whistleblower reports to the SEC that Acme’s management directed the recognition of revenue on a substantial number of transactions that did not qualify, and thereby substantially inflated Acme’s revenue.

According to the whistleblower, false documents were created to foster the impression that the transactions in question warranted revenue recognition, many documents were concealed from the auditors, and management pressed the new accountants to accept management’s views on revenue recognition.

An SEC investigation confirms the whistleblower’s report, but finds no evidence that the director knew of management’s scheme to inflate revenue.

Is the director home free? Not necessarily. The SEC has seen “red flags” in circumstances not terribly different from this example and it has not regarded the existence of a “clean opinion” as a defense.

Devastating Consequences

The consequences of an SEC fraud charge are devastating. The SEC may seek monetary penalties up to $100,000 per violation (or the gross amount of any benefit derived from the violation); bars precluding future participation as an officer or director of a public company; and various other forms of relief.

The commencement of a proceeding will generally be followed by an SEC press release announcing the proceedings, and the director, if named in the proceeding, will wake up one morning to a newspaper account that he or she has been “Sued by the SEC for Fraud.”

In this age of Google, that stain will be long lasting and easily found.

Most parties settle the case at some stage of the litigation. A settling party in an SEC case, unlike such parties in general civil litigation, may not maintain innocence post-settlement because the SEC’s standard settlement includes an agreement that the defendant will not deny the validity of the SEC’s allegations.

Moreover, if fines are imposed, the settlement agreement will require that the settling party pay with his or her own funds, not with insurance proceeds or corporate indemnification funds. Ordinarily, the SEC will issue a press release announcing the settlement, again publicizing the allegations of fraud, but there will be little that a defendant can say in response.

Prevention

The cost of a director’s inattention is enormous. How do directors become more vigilant? What action is required will depend on the circumstances, but below are basic principles for all directors to follow.

• Do not be a passive director. A director who accepts the position thinking he or she can satisfy duties by simply showing up for meetings risks being caught in the fraud trap.

• Know what you don’t know. When matters that come before the board extend beyond your knowledge and experience, get clear explanations from qualified professionals before you sign a document.

• Look into conflicting information. If the company’s professional advisors give contradicting advice, the board may have to retain its own professionals to advise on the conflicting opinions.

• Be mindful of hot button issues. High levels of related-party transactions, or transactions with apparent conflicts of interest, for example, may warrant further inquiry.

• Pay strict attention to all company public pronouncements. A director will not be able to claim he or she was unaware of “red flags” that were contained in such filings or announcements.

• Read and understand fully any document before signing, particularly one that will be filed with the SEC. Every director who signs a document will be held accountable for its contents.

• Be wary of management that is overly controlling of the board’s processes or the flow of information to the board. Management views are to be considered, but the board must exercise its own discretion in performing its oversight functions.

Gary S. Matsko is a shareholder at Davis, Malm & D’Agostine, P.C. where he concentrates his practice in civil litigation. Mr. Matsko has litigated cases involving business sales and acquisition, securities claims, employment disputes, shareholder disputes, environmental matters and other business litigation. He can be reached at (617) 367-2500 or [email protected].