Outside Director Liability: Recent SEC Enforcement Action
In a recent post (here), The D & O Diary examined the SEC’s decision not to pursue an enforcement action against the outside directors of the Hollinger International and examined what this move might suggest about the potential liability and enforcement action exposure for outside directors of companies caught up in the options backdating scandal. A recently settled SEC enforcement action filed against three outside directors of Spiegel suggests that, at least under certain circumstances, the SEC will pursue enforcement actions against outside directors. And even though it did not involve option timing allegations, the recent action against the Spiegel outside directors may also shed some light on outside directors’ enforcement exposures in connection with the options backdating investigations.
According to the settled enforcement action that the SEC filed on November 2, 2006 (here), in 1982, OTTO Gmbh & Co., a German mail-order company primarily owned by Michael Otto, acquired Spiegel. Spiegel went public in 1997 by listing a portion of its shares on NASDAQ. Otto served as Spiegel’s board Chair. Also serving on the Spiegel board were two other Germans, Michael Crusemann and Horst Hansen.
In early 2002, as a result of Spiegel’s deteriorating financial condition, Spiegel’s independent auditor advised that it would have to consider a “going concern” modification in its audit report that would accompany Spiegel’s financial statements in its 2001 10-K. Spiegel itself was working to line up new credit facilities that the company believed would address the auditor’s concerns and permit a clean audit report. Because the company did not want to face the market consequences that would result from the going concern opinion, it sought to withhold the 10-K filing while it tried to remedy its credit issues.
According to the SEC, between April 2002 and February 2003, Otto, Crusemann and Hanson, participated in a series of decisions to withhold the company’s SEC fillings. The directors actively participated in decisions to withhold the filings even though their inside and outside counsel specifically advised them that the failure to file violated American law and exposed the company and its officers to legal liability. The SEC also alleged that Cruseman and others received a document entitled “Pros/Cons to Filing Form 10-K” specifically stating that corporate officials could be personally liable for failure to file. The document also attached copies of securities laws indicating liability for the failure to file. Despite these warnings, the SEC alleged, the director actively decided that Spiegel should withhold its filings to avoid having to disclose the "going concern" opinion.
Spigel not only failed to file its 2001 10-K, but also failed to file its Form 10-Qs for the first three quarters of 2002. Spiegel ultimately filed the delinquent forms in February 2003, after the SEC threatened to file an enforcement action. Within weeks of the belated filings, Spiegel filed for Chapter 11 bankruptcy.
According to the SEC’s news release announcing the enforcement action settlement (here), Otto and Crusemann consented to the Court’s issuance of a permanent injunction against them enjoining them from future violations of the securities laws, and each consented to pay a civil penalty of $100,000. Hansen, the former head of Spiegel’s audit committee, consented to the SEC’s entry of an order ordering him to cease and desist from committing or causing future violations of the federal securities laws.
The SEC’s enforcement action clearly shows that at least under certain circumstances, the SEC will pursue outside directors. However, it is important to note that, at least according to the SEC’s allegations, the Spiegel directors did more than merely failing to supervise. They are alleged to have been actively and directly involved in the decision to withhold Spiegel’s filings, and to have done made those decisions with actual knowledge that the failure to file violated the securities laws. In effect, the directors were alleged to have knowingly pursued an illegal course of conduct.
In an interesting November 29, 2006 Law.com article (here), Christian Bartholomew of the Morgan, Lewis & Bockius law firm provides his views on what the Spiegel case might mean for possible outside director liability in the options backdating scandal. Bartholomew contends that the Spiegel enforcement action ought to set standard for what should be required before the SEC pursues options backdating-related enforcement proceedings against outside directors. Bartholomew argues that the enforcement action “should be limited to situations where the evidence is clear and compelling that a director actively and knowingly engaged in or materially assisted in an improper options dating scheme, fully understanding the legal, accounting and disclosure ramifications.” By the same token, “the SEC should not pursue backdating actions arising simply from a director’s failure to act or to intervene to halt management misconduct.”
Bartholomew’s observations about what might be described as the “Spiegel standard” are interesting, but it still remains to be seen exactly how the SEC will approach this issue. The SEC has already served three outside directors of Mercury Interactive with Wells Notices in connection with the company’s options backdating investigation (see the company's press release here). Time will tell whether the SEC limits its options backdating-related enforcement actions against outside directors to cases of knowing and active violations of the kind alleged in the Spiegel case.
Seven Contemptible Years: On November 27, 2006, the Second Circuit refused (here) to overturn a lower court’s denial of Martin Armstrong’s petition for a writ of habeas corpus. Armstrong has been in prison since January 14, 2000 for his refusal to turn over corporate records and $15 million in assets in connection with a securities fraud investigation involving his companies.
Armstrong was arrested in 1999 on charges that he defrauded Japanese investors out of $3 billion by falsely promising to invest in certain low risk assets, while he instead lost $1 billion in speculative trading that he attempted to cover up through a “Ponzi scheme.” In early 2000, in response to a civil contempt proceeding against him, Armstrong had produced $1.1 million in rare coins, one computer with the hard drive removed, three other computers (which later proved to have been tampered with), and various other assets. Armstrong failed to produce other subpoenaed items, including other specified computers, 102 gold bars, 699 bullion coins, and other rare coins worth $12.9 million. Armstrong testified that he kept some of the assets “hidden in a shed in the back yard” of his mother’s house and transferred others to business associates allegedly to pay off debts. The district court held Armstrong in contempt and “directed the marshals to confine Armstrong to the Metropolitan Correctional Center until he either complied with the turnover orders or demonstrated that it would be impossible to do so.” At periodic hearings since Armstrong’s incarceration on January 14, 2000, Armstrong has failed to comply or prove his inability to do so. Among other things, Armstrong has consistently contended that he has no obligation to do so, relying on his alleged constitutional rights against self-incrimination and his rights to due process.
Armstrong filed the habeas petition in August 2004 to raise constitutional objections to his confinement. The district court denied his petition in December 2004, which Armstrong appealed. On August 17, 2006, while his appeal was pending, he pled guilty to securities fraud.
In his appeal of the denial of the writ, Armstrong argued that, contrary to the district court’s statement that he “holds the keys to his prison cell,” the “key to his freedom comes at the cost of his Fifth Amendment right against compelled self-incrimination” and that his confinement also violates the Non-Detention Act, the Recalcitrant Witness Statue and due process. The Second Circuit affirmed the district court’s denial of the writ, based on the district court’s finding that Armstrong is capable of complying but is simply choosing not to do so. The Second Circuit held that the constitution did not protect him against producing the property and that Congress had “specifically authorized indefinite, coercive confinement.” The Second Circuit did conclude that Armstrong is entitled to a new hearing to assess whether he retains custody or control of the property. The court also noted that “on the seventh anniversary of Armstrong’s confinement, his case deserves a fresh look by a different set of eyes,” and directed the district court to reassign the case to a different judge.
"Indefinite, coercive confinement" certainly has a chilling sound to it. Perhaps it is time to retrieve those coins from Mom's back yard.
A November 30, 2006 New York Law Journal article about the Armstrong case can be found here.
Hat tip to the Courthouse News Service (here) for the link to the Second Circuit opinion.
While My Ukulele Gently Weeps: It has been a while since the D & O Diary has had any pretext to link to a YouTube video. We therefore choose to use the occasion of the release of new Beatles’ Love compilation CD to commend to its loyal readers the video linked below. The D & O Diary has never had a very high opinion of the ukulele (it is looks like a shrunken guitar, it has a plink-plink sound, and it is spelled weird) but this video (here) depicting an absolutely virtuoso ukulele performance of “While My Guitar Gently Weeps” requires a complete reassessment of the ukulele. The performance is, in a word, awesome. Enjoy.
The Wall Street Journal has a generally favorable November 29, 2006 review of the new Beatles’ Love compilation CD here (subscription required).
According to Wikipedia (here), the word "ukulele" roughly translates from Hawaiian as "jumping flea." Now you know.
According to the settled enforcement action that the SEC filed on November 2, 2006 (here), in 1982, OTTO Gmbh & Co., a German mail-order company primarily owned by Michael Otto, acquired Spiegel. Spiegel went public in 1997 by listing a portion of its shares on NASDAQ. Otto served as Spiegel’s board Chair. Also serving on the Spiegel board were two other Germans, Michael Crusemann and Horst Hansen.
In early 2002, as a result of Spiegel’s deteriorating financial condition, Spiegel’s independent auditor advised that it would have to consider a “going concern” modification in its audit report that would accompany Spiegel’s financial statements in its 2001 10-K. Spiegel itself was working to line up new credit facilities that the company believed would address the auditor’s concerns and permit a clean audit report. Because the company did not want to face the market consequences that would result from the going concern opinion, it sought to withhold the 10-K filing while it tried to remedy its credit issues.
According to the SEC, between April 2002 and February 2003, Otto, Crusemann and Hanson, participated in a series of decisions to withhold the company’s SEC fillings. The directors actively participated in decisions to withhold the filings even though their inside and outside counsel specifically advised them that the failure to file violated American law and exposed the company and its officers to legal liability. The SEC also alleged that Cruseman and others received a document entitled “Pros/Cons to Filing Form 10-K” specifically stating that corporate officials could be personally liable for failure to file. The document also attached copies of securities laws indicating liability for the failure to file. Despite these warnings, the SEC alleged, the director actively decided that Spiegel should withhold its filings to avoid having to disclose the "going concern" opinion.
Spigel not only failed to file its 2001 10-K, but also failed to file its Form 10-Qs for the first three quarters of 2002. Spiegel ultimately filed the delinquent forms in February 2003, after the SEC threatened to file an enforcement action. Within weeks of the belated filings, Spiegel filed for Chapter 11 bankruptcy.
According to the SEC’s news release announcing the enforcement action settlement (here), Otto and Crusemann consented to the Court’s issuance of a permanent injunction against them enjoining them from future violations of the securities laws, and each consented to pay a civil penalty of $100,000. Hansen, the former head of Spiegel’s audit committee, consented to the SEC’s entry of an order ordering him to cease and desist from committing or causing future violations of the federal securities laws.
The SEC’s enforcement action clearly shows that at least under certain circumstances, the SEC will pursue outside directors. However, it is important to note that, at least according to the SEC’s allegations, the Spiegel directors did more than merely failing to supervise. They are alleged to have been actively and directly involved in the decision to withhold Spiegel’s filings, and to have done made those decisions with actual knowledge that the failure to file violated the securities laws. In effect, the directors were alleged to have knowingly pursued an illegal course of conduct.
In an interesting November 29, 2006 Law.com article (here), Christian Bartholomew of the Morgan, Lewis & Bockius law firm provides his views on what the Spiegel case might mean for possible outside director liability in the options backdating scandal. Bartholomew contends that the Spiegel enforcement action ought to set standard for what should be required before the SEC pursues options backdating-related enforcement proceedings against outside directors. Bartholomew argues that the enforcement action “should be limited to situations where the evidence is clear and compelling that a director actively and knowingly engaged in or materially assisted in an improper options dating scheme, fully understanding the legal, accounting and disclosure ramifications.” By the same token, “the SEC should not pursue backdating actions arising simply from a director’s failure to act or to intervene to halt management misconduct.”
Bartholomew’s observations about what might be described as the “Spiegel standard” are interesting, but it still remains to be seen exactly how the SEC will approach this issue. The SEC has already served three outside directors of Mercury Interactive with Wells Notices in connection with the company’s options backdating investigation (see the company's press release here). Time will tell whether the SEC limits its options backdating-related enforcement actions against outside directors to cases of knowing and active violations of the kind alleged in the Spiegel case.
Seven Contemptible Years: On November 27, 2006, the Second Circuit refused (here) to overturn a lower court’s denial of Martin Armstrong’s petition for a writ of habeas corpus. Armstrong has been in prison since January 14, 2000 for his refusal to turn over corporate records and $15 million in assets in connection with a securities fraud investigation involving his companies.
Armstrong was arrested in 1999 on charges that he defrauded Japanese investors out of $3 billion by falsely promising to invest in certain low risk assets, while he instead lost $1 billion in speculative trading that he attempted to cover up through a “Ponzi scheme.” In early 2000, in response to a civil contempt proceeding against him, Armstrong had produced $1.1 million in rare coins, one computer with the hard drive removed, three other computers (which later proved to have been tampered with), and various other assets. Armstrong failed to produce other subpoenaed items, including other specified computers, 102 gold bars, 699 bullion coins, and other rare coins worth $12.9 million. Armstrong testified that he kept some of the assets “hidden in a shed in the back yard” of his mother’s house and transferred others to business associates allegedly to pay off debts. The district court held Armstrong in contempt and “directed the marshals to confine Armstrong to the Metropolitan Correctional Center until he either complied with the turnover orders or demonstrated that it would be impossible to do so.” At periodic hearings since Armstrong’s incarceration on January 14, 2000, Armstrong has failed to comply or prove his inability to do so. Among other things, Armstrong has consistently contended that he has no obligation to do so, relying on his alleged constitutional rights against self-incrimination and his rights to due process.
Armstrong filed the habeas petition in August 2004 to raise constitutional objections to his confinement. The district court denied his petition in December 2004, which Armstrong appealed. On August 17, 2006, while his appeal was pending, he pled guilty to securities fraud.
In his appeal of the denial of the writ, Armstrong argued that, contrary to the district court’s statement that he “holds the keys to his prison cell,” the “key to his freedom comes at the cost of his Fifth Amendment right against compelled self-incrimination” and that his confinement also violates the Non-Detention Act, the Recalcitrant Witness Statue and due process. The Second Circuit affirmed the district court’s denial of the writ, based on the district court’s finding that Armstrong is capable of complying but is simply choosing not to do so. The Second Circuit held that the constitution did not protect him against producing the property and that Congress had “specifically authorized indefinite, coercive confinement.” The Second Circuit did conclude that Armstrong is entitled to a new hearing to assess whether he retains custody or control of the property. The court also noted that “on the seventh anniversary of Armstrong’s confinement, his case deserves a fresh look by a different set of eyes,” and directed the district court to reassign the case to a different judge.
"Indefinite, coercive confinement" certainly has a chilling sound to it. Perhaps it is time to retrieve those coins from Mom's back yard.
A November 30, 2006 New York Law Journal article about the Armstrong case can be found here.
Hat tip to the Courthouse News Service (here) for the link to the Second Circuit opinion.
While My Ukulele Gently Weeps: It has been a while since the D & O Diary has had any pretext to link to a YouTube video. We therefore choose to use the occasion of the release of new Beatles’ Love compilation CD to commend to its loyal readers the video linked below. The D & O Diary has never had a very high opinion of the ukulele (it is looks like a shrunken guitar, it has a plink-plink sound, and it is spelled weird) but this video (here) depicting an absolutely virtuoso ukulele performance of “While My Guitar Gently Weeps” requires a complete reassessment of the ukulele. The performance is, in a word, awesome. Enjoy.
The Wall Street Journal has a generally favorable November 29, 2006 review of the new Beatles’ Love compilation CD here (subscription required).
According to Wikipedia (here), the word "ukulele" roughly translates from Hawaiian as "jumping flea." Now you know.
posted by Kevin LaCroix at 9:47 PM
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