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The Securities and Exchange Commission, crowned with new authority and emboldened by Congress, is seeking increasingly severe sanctions against the chief executive officers, chief financial officers, and outside directors allegedly responsible for their company’s financial imbroglios. The SEC’s enforcement actions increased from 484 in fiscal year 2001 to 598 in 2002 and 679 in 2003. All indications are that the increasing upward trend of enforcement actions will continue. Moreover, there is a definitively sharper edge to the SEC’s investigative activities, indicating that the SEC is moving away from an approach that emphasized cooperation to a more penalty- and enforcement-oriented approach. Directors and officers need to understand the dire consequences of ending up in the SEC’s crosshairs. In a September 28, 2004, speech, SEC chairman William Donaldson proclaimed that “over the past 18 months, the division of enforcement has … obtained orders for more than $3 billion in penalties and disgorgements.” While the bulk of such fines are exacted from companies, including the headline-grabbing $750 million penalty against WorldCom, Inc., the SEC is increasingly seeking to impose fines against individuals. In 2004 the SEC exacted a $300,000 penalty against the president/COO of Gemstar-TV Guide International Inc. for his involvement in allegedly overstating revenues to meet ambitious revenue growth projections, and a $249,000 penalty against the managing director of Canadian Imperial Bank of Commerce for what the SEC called aiding and abetting Enron Corp.’s manipulation of its reported financial results through a series of complex structured finance transactions. (In their settlements, none of these defendants admitted or denied wrongdoing.) Moreover, the SEC now frequently requires settling parties to forgo any rights they may have to indemnification by the company pursuant to company bylaws, to reimbursement by insurers, or to favorable tax treatment of penalties. The SEC justifies this newly aggressive position with §308 of the Sarbanes-Oxley Act of 2002, which allows the SEC to use certain civil penalties previously paid into the U.S. Treasury to compensate harmed investors. (The silver lining is that some companies may view early settlement with the SEC as strategically advantageous because payment to defrauded investors may take some wind out of the sails of securities class action plaintiffs.) As if these rising civil penalties were not enough to send shivers down the spine of any well-intended director or officer, the SEC has made clear that these penalties are imposed in addition to forced disgorgement of “ill-gotten gains.” In most cases, individuals may be forced to disgorge any monies obtained in the sale of company stock during a specified time period or to return part or all of their executive compensation or bonus. The disgorgement amounts obtained by the SEC in settlements and civil proceedings in the past year have been staggering, including $23 million against former Enron CFO Andrew Fastow and $4.7 million against the former executive vice president of American Commercial Financial Corporation, both of whom pleaded guilty to related criminal charges. Perhaps most disturbing for officers and directors is the SEC’s growing appetite for imposing D&O “bars” that temporarily or permanently prohibit individuals from serving as directors or officers of public companies. Section 1105 of Sarbanes-Oxley dramatically enhances the SEC’s power to impose D&O bars and lowers the legal standard for obtaining those bars. First, §1105 empowers the SEC to obtain D&O bars in administrative proceedings, without federal court approval. But perhaps more importantly, Sarbanes-Oxley lowered the required standard of proof to support a D&O bar from “substantial unfitness” to serve as a director or officer to simple “unfitness.” Before Sarbanes-Oxley, federal courts around the country adopted a six-factor test to determine whether a director or officer was “substantially unfit” such as to justify imposition of a D&O bar. However, this test and the accompanying case law are now of questionable use. The SEC has not provided any guidance on what constitutes “unfitness” under §1105, and to date no court has addressed the issue. Directors and officers are left with the unsettling prospect that virtually any misstep may render them “unfit” and possibly subject to a D&O bar. Indeed, D&O bars have risen exponentially in the past few years — 38 in 2000, 51 in 2001, 126 in 2002, and 170 in 2003 — and the end is not in sight. While it may not be surprising that the SEC has obtained D&O bars against high-profile individuals such as former WorldCom CFO Scott Sullivan and former Enron CFO Fastow, the SEC is more regularly seeking D&O bars against individuals in less well-known and, arguably, less significant cases where such bars would have been unheard of only a couple of years ago. For example, in 2003 the SEC obtained a five-year D&O bar against a former outside director of Candie’s Inc. for allegedly agreeing to permit the company to record certain fraudulent “sales credits” and assisting in obtaining falsified documentation of the credits. Last summer the SEC obtained a permanent bar against the former CEO and chairman of Wulf International Ltd. for his participation, according to the agency, in issuing fraudulent press releases about the company’s finances. (In both cases, the defendants consented to these penalties without admitting to or denying the allegations.) Finally, another newly minted Sarbanes-Oxley tool, §1103, allows the SEC to freeze “extraordinary payments” to corporate officers and directors. During an official investigation of the company or the individual recipient, the SEC can seek an extendable 45-day escrow of any extraordinary payments yet to be dispersed; and if any civil or criminal proceedings are instituted during the escrow period, the period is extended until their conclusion. In May 2003 the SEC won a district court order freezing the severance packages of Gemstar-TV Guide International’s CEO and CFO, payments totaling almost $38 million. In May 2004 the 9th U.S. Circuit Court of Appeals vacated Gemstar’s asset freeze because the district court judge failed to consider sufficient evidence of what a “usual” or “ordinary” severance package would be. A month later, however, Gemstar settled with the SEC, agreeing not to make certain extraordinary severance payments to its former CEO and CFO and agreeing to pay $10 million in penalties. So what constitutes an extraordinary payment under §1103? The 9th Circuit declined to define “extraordinary payment.” However, the SEC argued that the Gemstar severance payments were extraordinary because they (1) pertained to extraordinary corporate events and (2) were extraordinary in size. These arguments at least suggest that the SEC roughly interprets §1103 to encompass large severance packages paid to executives amidst financial scandal. At this point, however, there is no clear indication from the courts about whether they will adopt the SEC’s interpretation. The open question remains whether the SEC’s ever-increasing demand for stiff penalties, large disgorgements, and D&O bars might lead to a perception that the commission is abusing its newfound power. Such a perception could further deplete the already dwindling pool of qualified individuals willing to serve on corporate boards, for fear that the risks of such service far outweigh any benefits. Still, with competent legal counsel, board members and executives can navigate the new legal minefields created by the SEC’s enhanced powers. For officers and directors facing SEC investigations (formal or informal) in the post-Sarbanes-Oxley world, the key to limiting personal exposure is full cooperation. This means facilitating the SEC’s requests for documents and testimony and encouraging their company to do the same. In addition, the board should take an active role in internal investigations of any allegations of fraud or wrongdoing and immediately self-report such activity to the SEC. In this heated era of securities law enforcement, directors and officers must be vigilant and proactive. They can’t afford not to be. Ralph C. Ferrara is a partner in the Washington, D.C., office of New York’s Debevoise & Plimpton. Debevoise associate Ada Fernandez Johnson also contributed to this article.

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