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In many of the high-profile corporate scandals of recent years � including Enron Corp. and WorldCom, Inc. � company directors have been the target of public criticism and shareholder litigation. However, board members have escaped direct fire from the Securities and Exchange Commission when it came to enforcement actions. But that may be changing. In a fraud case now pending in federal court in Boston, the SEC has turned its sights on an outside director � not just the management � of a company that restated its results due to alleged fraud. Last year the agency sued Rudolph Peselman, a former director of Boston-based transportation equipment company Chancellor Corporation. The SEC also sued Chancellor itself, several executives, the company’s audit firm, and the audit firm’s engagement partner. Michael Marchese, another outside director, settled in a separate action filed by the SEC. He agreed not to violate the antifraud, periodic reporting, record-keeping, and internal controls provisions of U.S. securities laws. No trial date has been set in the SEC’s securities fraud suit against Peselman, which was filed in April 2003, and Peselman has denied the allegations. In an answer filed with the court, Peselman stated that he “denies any conduct in violation of the federal securities laws.” Peselman also asserts that he acted in good faith and relied on accountants and auditors. Whether the SEC will prevail in this litigation is an open question. But according to Stephen Cutler, the director of the SEC’s division of enforcement, the action against Peselman represents an effort to crack down on outside directors who do not fulfill their duty of care. In a press interview last summer, Cutler said, “This case signifies the Commission’s willingness to pursue cases against outside directors who were reckless in their oversight of management and asleep at the switch.” The SEC has long expressed a desire to enforce well-recognized principles of director responsibilities, such as the requirement that directors oversee the activities of the corporation with due care. It has emphasized the board’s responsibility to ensure the accuracy of public information and to prevent the continuation of securities violations. What is new is that the SEC is now putting some bite into its earlier pronouncements. In Peselman’s case, it is seeking a monetary penalty, an injunction against further violations of securities laws, and a bar that would permanently prohibit Peselman from serving as the director of a public company. The allegations in the Peselman suit stem from Chancellor’s 1998 acquisition of Conley, Georgia-based MRB, Inc. The SEC charges that Chancellor CEO Brian Adley inflated the company’s profits by, among other things, falsifying documents and prematurely consolidating its financial results with MRB’s to boost Chancellor’s revenues. Adley also allegedly caused the company to record $3.3 million in consulting fees for acquisition consulting services � never rendered � by entities that he controlled. The core of the SEC case against Peselman is the claim that the director, who was a member of Chancellor’s audit committee, ignored a number of red flags. For corporate secretaries, general counsel, and board members, especially audit committee members, it is useful to explore the particulars of the SEC’s case against Peselman to understand exactly what the agency considers reckless inattention on the part of a director. Peselman’s first alleged misstep involved Chancellor’s outside auditor, Bethesda, Maryland’s Reznick Fedder & Silverman. According to the SEC, Chancellor CEO Adley, sought to improperly consolidate the company’s 1998 financial results with MRB’s 1998 results, although Chancellor did not acquire MRB until January 1999. The SEC claims that management provided the auditors with backdated documents to support this claim, but Reznick Fedder questioned their authenticity. Adley and Chancellor’s chief operating officer then terminated Reznick Fedder and hired another auditor, Atlanta’s BKR Metcalf Davis. According to the complaint, Peselman consented to the dismissal of Reznick Fedder, although he knew that the dismissal was due to the accounting disagreement between the auditor and Adley. Peselman’s second alleged misstep was to sign the company’s annual report without first ensuring that the financial statement did not include materially misleading information. According to the SEC, Peselman failed to exercise due care in two respects: (1) Peselman knew that the initial auditor had disagreed with the accounting, but he failed to question the new auditor’s consent to the same accounting treatment; and (2) Peselman knew that on a previous occasion the company had written off more than $1 million in related � party transactions, but he still signed off on a statement that included the $3.3 million in fees owed to a venture capital firm owned by Adley. In discussing the case, Cutler has emphasized that it involves related party transactions. “I don’t think it’s any accident that the commission’s first salvo has come in a case involving related � party transactions,” he has said. “I don’t think there’s any area where the duty of outside directors is so acute.” Peselman’s final alleged misstep involved a failure to exercise care when the SEC required the company to restate its financial results. At the request of the SEC’s division of corporate finance, the company filed two restatements. Both restatements included misstatements concerning the related � party fees, the SEC says, but Peselman signed both restatements without questioning them. According to the SEC, Peselman “completely neglected” his duties as a director. The SEC contends that Peselman ignored the following red flags: (1) the resignation of an auditor over the accounting treatment insisted on by the CEO; and (2) the treatment of excessive fees in related � party transactions. Peselman also allegedly failed to ensure the accuracy of statements signed, despite these warning signals, and signed off on the restatements without inquiring into the accuracy of the disclosures. These alleged red flags are particularly interesting because they include behavior against which the SEC has repeatedly counseled. In a 1997 action against Boca Raton, Florida-based W.R. Grace & Co., the SEC discussed at length the failure of the Grace directors to ensure that disclosures concerning related-party transactions were complete. Although the directors were not charged, the SEC’s Report of Investigation emphasized the importance of abiding by the duty of care, especially involving related-party transactions. In its litigation release, the SEC commented that “serving as an officer or director of a public company is a privilege which carries with it substantial obligations. If an officer or director knows or should know that his or her company’s statements concerning particular issues are inadequate or incomplete, he or she has an obligation to correct that failure.” The SEC’s 1994 action against Fort Lee, New Jersey-based The Cooper Companies, Inc., was another occasion in which the agency stressed the responsibilities of the outside director. The SEC criticized the Cooper board for its failure to take action against two officers who were engaged in self-dealing schemes. The officers refused to cooperate with the company’s attorneys and refused to participate in the company’s internal investigation. The board allowed both officers to continue their duties despite these warning signs, and it permitted one of the officers to make a false press statement concerning an ongoing SEC investigation and a federal criminal action. In its report of investigation, the SEC noted that a director’s “obligations are particularly acute where potential violations of the federal securities laws involving self-dealing and fraud by management are called to the attention of the board of directors.” While the SEC’s report provided a scathing analysis of the Cooper directors’ lack of care, the SEC declined to charge them with violating the securities laws. The SEC’s pursuit of Peselman indicates a marked shift in the agency’s treatment of outside directors. While the principles of due care allegedly violated by Peselman are not new, the SEC’s response in this case provides some cause for concern. The SEC has essentially federalized the duty of care, which is traditionally the role of state corporate law. As Commissioner Paul Atkins stated in a March 2003 speech: “Sarbanes-Oxley contains many advances for corporate governance, although it also represents what formerly would have been an unimaginable incursion of the U.S. federal government into the corporate governance arena.” There is, however, some comfort for directors and officers in the action against Peselman. The charges against him involve Peselman’s alleged failure to heed obvious red flags of the sort that the SEC has long counseled against. Outside directors should be able to avoid liability by vigilantly exercising the traditional duties of care and loyalty in overseeing the management of the corporation. Ralph Ferrara is a partner in the Washington, D.C., office of New York’s Debevoise & Plimpton. Debevoise associate Winsome Gayle also contributed to this article.

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