SOX Lowers the Bar for Barring Directors and Officers

The Commission began to seek D&O bars in the early 1970s, usually in the context of negotiated consent decrees. At that time, however, there was debate (even within the Commission) about whether a D&O bar was an inappropriate intrusion into corporate governance. For example, former SEC Commissioner Cox suggested that shareholders should be permitted to decide whether to allow a person who has violated the securities laws to serve as an officer or director.

In 1987, to address this uncertainty, the SEC submitted proposed legislation that would have given the Commission the authority to seek bars against persons who violated any provision of the federal securities laws. The SEC also asked for the authority to impose D&O bars in administrative proceedings. This proposal was criticized as overbroad, because it would have permitted bars based on technical violations of the securites laws, and because it did not require a link between the alleged violation and fitness to serve as a director or officer.

To address these concerns, the SEC proposed new legislation that ultimately was codified as part of the Remedies Act of 1990. Section 20(e) of the Securites Act of 1933 and Section 21(d)(2) of the Securities Exchange Act of 1934 were amended to permit federal courts to impose D&O bars against defendants who violated Section 17(a)(1) of the Securities Act or Section 10(b) of the Exchange Act (which prohibit fraud in the offer and sale, and in connection with the purchase and sale of securities, respectively), and whose conduct demonstrated “substantial unfitness” to so serve. While the Remedies Act did not define “substantial unfitness,” the SEC assured Congress that it would seek D&O bars infrequently and selectively, in cases involving recidivist violators or egregious conduct.

Consistent with these principles, most courts eventually adopted a six-factor test to decide whether to impose a D&O bar: 1) the egregiousness of the underlying securities law violation; 2) the defendant's repeat offender status; 3) the defendant's role or position when he or she engaged in the fraud; 4) the defendant's degree of scienter; 5) the defendant's economic stake in the violation; and (6) the likelihood that misconduct will recur. SEC v. Patel, 61 F.3d 137, 141 (2d Cir. 1995). When the Remedies Act first went into effect, practitioners' experience was that the SEC sought D&O bars on a case-by-case basis, without attempting to develop uniform guidelines. Eventually, however, the SEC appeared to apply the same six-factor test in both litigation and in negotiated settlements.

Post-SOX: Lower Standards and More Bars

Not surprisingly, SOX and corporate scandals changed the environment. SOX amended Sections 20(e) and 21(d)(2) to provide that a court may impose a D&O bar if it finds the defendant is merely unfit. SOX also amended Section 8A of the Securities Act and Section 21C of the Exchange Act to give the SEC authority to impose D&O bars in administrative proceedings.

While SOX does not define “unfit,” legislative history makes it clear that Congress wished to make it easier to impose D&O bars. Courts are imposing bars with newfound zeal. From Jan. 2001 until July 1, 2002, courts imposed only 49 bars. Before SOX, courts were known to reject the SEC's request for D&O bars, even in cases involving what the SEC termed egregious conduct. See, e.g., SEC v. Shah, 1993 WL 288285 (S.D.N.Y. 1993) (declining to impose bar against defendant who traded on inside information and bribed a federal official). Since SOX was enacted, courts have imposed 161 D&O bars. While courts have continued to use the same six-factor test, there do not appear to be any reported cases in which a court, after litigation, declined to impose a bar. Likewise, while time-limited bars used to be common, bars today are much more likely to be permanent. In 2001, courts imposed 14 permanent and seven time-limited bars. In 2003, courts imposed 52 permanent bars, but only 12 time-limited bars. It is still the case that the vast majority of bars are imposed as part of consented-to final judgments.

What Does A D&O Bar Prohibit?

What does a D&O bar mean for a barred person who wishes to work in a non-executive capacity? The bar orders themselves — which are drafted by the SEC and presented to defendants and judges for execution — do not answer this question. They state only that the defendant is “prohibit[ed] from acting as an officer or director” of a publicly held company.

The securities statutes defining officer and director focus on duties, not titles. Section 3(a)(7) of the Exchange Act defines director to include “any director of a corporation or any person performing similar functions with respect to any organization, whether incorporated or unincorporated.” Exchange Act Rule 3b-2 defines the term “officer to mean the president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer, and any person routinely performing corresponding functions … ”

Courts have taken a flexible, fact sensitive approach, focusing on whether the defendant controls the company at issue. For example, in SEC v. Solucorp Industries Ltd., 274 F. Supp.2d 379 (S.D.N.Y. 2003), the SEC argued that the defendant, who held the title of consultant, was a de facto officer because he occupied a corner office, had a substantial ownership position in the company, introduced himself as CEO and COO, and third parties testified that he controlled the company. The defendant argued that he had no authority to sign contracts, to issue any press releases or to make financial disclosures for the company, reported to the president, and had no involvement in the company's accounting decisions. The court rejected this defense, holding that because he “performed duties analogous to those of an officer and had access to insider information, in that he performed a policy-making function for an issuer akin to that of a president, principal financial officer, or any vice president in charge of a business unit, division or function,” the defendant could be liable as an officer. Based on misconduct detailed in the complaint, the court permanently barred the defendant from serving as an officer or director.

Enforcing a D&O Bar

Because D&O bars are imposed via final judgments entered by the district court, violators risk civil or criminal contempt. As an additional remedy, the SEC may also seek to impose a voting trust on the shares of the individual and company. See http://www.sec.gov/news/press/2004-155.htm (Hollinger International and its former CEO Conrad Black); SEC. V. Drexel Burnham Lambert, Inc., 837 F.Supp. 587 (S.D.N.Y. 1993).

Tips for Defense Counsel

First, reject the SEC mindset that a D&O bar is an automatic punishment for any violation of the securities laws. Rather, a bar should be imposed only if a defendant/ respondent is unfit to so serve, based on the six-factor Patel test.

Second, focus on what it means to be unfit to serve as a director or officer. An executive's securities law violations may have nothing to do with the company where he works, and thus do not demonstrate unfitness to serve under the Patel test.

Third, evaluate whether to inform the government of post-bar employment plans. In In the Matter of Powell, Initial Decision Release No. 255 (Aug. 17, 2004), the two defendants consented to suspensions from association with a broker dealer, but informed the SEC of their plans to remain involved with their former company. The ALJ found that the SEC could not sanction respondents when it was fully informed of the plan and did not object. But following this example has a downside. It carries the risk that the SEC might reject the proposal, even if proper, or attempt to limit the employee's prospects to an arrangement that may prove unsatisfactory.

Banishment from the public company world — through the enforcement of a D&O bar – used to be an extreme remedy for management misconduct. Now, the trend has turned, with Sarbanes-Oxley (SOX) and the current enforcement climate leading to a flood of requests for bars. In 2000, the SEC asked federal courts to impose 38 D&O bars, 7.5% of the cases initiated that year. In 2001, the SEC asked for 51 D&O bars, or 10.5%. In 2002, in the wake of corporate scandals that gave rise to Sarbanes-Oxley, the SEC requested 126 D&O bars, in 21% of initiated actions. In 2003, that number shot up to 170, in 25% of cases. As Stephen Cutler, the head of the SEC's Enforcement Division, recently explained, the SEC is “aggressively” seeking D&O bars “in expanded ways.” http://www.sec.gov/news/ speech/spch092004smc.htm. Practitioners are now finding D&O bars to be a routine component of settling an SEC action.

While the SEC's zeal is undeniable, the agency's emphasis on D&O bars has raised questions about this sanction. What standards apply in deciding whether to impose a D&O bar? What does a D&O bar actually prohibit? What happens if a D&O bar is violated?

Pre-SOX: The 'Substantial Unfitness' Test

The Commission began to seek D&O bars in the early 1970s, usually in the context of negotiated consent decrees. At that time, however, there was debate (even within the Commission) about whether a D&O bar was an inappropriate intrusion into corporate governance. For example, former SEC Commissioner Cox suggested that shareholders should be permitted to decide whether to allow a person who has violated the securities laws to serve as an officer or director.

In 1987, to address this uncertainty, the SEC submitted proposed legislation that would have given the Commission the authority to seek bars against persons who violated any provision of the federal securities laws. The SEC also asked for the authority to impose D&O bars in administrative proceedings. This proposal was criticized as overbroad, because it would have permitted bars based on technical violations of the securites laws, and because it did not require a link between the alleged violation and fitness to serve as a director or officer.

To address these concerns, the SEC proposed new legislation that ultimately was codified as part of the Remedies Act of 1990. Section 20(e) of the Securites Act of 1933 and Section 21(d)(2) of the Securities Exchange Act of 1934 were amended to permit federal courts to impose D&O bars against defendants who violated Section 17(a)(1) of the Securities Act or Section 10(b) of the Exchange Act (which prohibit fraud in the offer and sale, and in connection with the purchase and sale of securities, respectively), and whose conduct demonstrated “substantial unfitness” to so serve. While the Remedies Act did not define “substantial unfitness,” the SEC assured Congress that it would seek D&O bars infrequently and selectively, in cases involving recidivist violators or egregious conduct.

Consistent with these principles, most courts eventually adopted a six-factor test to decide whether to impose a D&O bar: 1) the egregiousness of the underlying securities law violation; 2) the defendant's repeat offender status; 3) the defendant's role or position when he or she engaged in the fraud; 4) the defendant's degree of scienter; 5) the defendant's economic stake in the violation; and (6) the likelihood that misconduct will recur. SEC v. Patel , 61 F.3d 137, 141 (2d Cir. 1995). When the Remedies Act first went into effect, practitioners' experience was that the SEC sought D&O bars on a case-by-case basis, without attempting to develop uniform guidelines. Eventually, however, the SEC appeared to apply the same six-factor test in both litigation and in negotiated settlements.

Post-SOX: Lower Standards and More Bars

Not surprisingly, SOX and corporate scandals changed the environment. SOX amended Sections 20(e) and 21(d)(2) to provide that a court may impose a D&O bar if it finds the defendant is merely unfit. SOX also amended Section 8A of the Securities Act and Section 21C of the Exchange Act to give the SEC authority to impose D&O bars in administrative proceedings.

While SOX does not define “unfit,” legislative history makes it clear that Congress wished to make it easier to impose D&O bars. Courts are imposing bars with newfound zeal. From Jan. 2001 until July 1, 2002, courts imposed only 49 bars. Before SOX, courts were known to reject the SEC's request for D&O bars, even in cases involving what the SEC termed egregious conduct. See, e.g., SEC v. Shah, 1993 WL 288285 (S.D.N.Y. 1993) (declining to impose bar against defendant who traded on inside information and bribed a federal official). Since SOX was enacted, courts have imposed 161 D&O bars. While courts have continued to use the same six-factor test, there do not appear to be any reported cases in which a court, after litigation, declined to impose a bar. Likewise, while time-limited bars used to be common, bars today are much more likely to be permanent. In 2001, courts imposed 14 permanent and seven time-limited bars. In 2003, courts imposed 52 permanent bars, but only 12 time-limited bars. It is still the case that the vast majority of bars are imposed as part of consented-to final judgments.

What Does A D&O Bar Prohibit?

What does a D&O bar mean for a barred person who wishes to work in a non-executive capacity? The bar orders themselves — which are drafted by the SEC and presented to defendants and judges for execution — do not answer this question. They state only that the defendant is “prohibit[ed] from acting as an officer or director” of a publicly held company.

The securities statutes defining officer and director focus on duties, not titles. Section 3(a)(7) of the Exchange Act defines director to include “any director of a corporation or any person performing similar functions with respect to any organization, whether incorporated or unincorporated.” Exchange Act Rule 3b-2 defines the term “officer to mean the president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer, and any person routinely performing corresponding functions … ”

Courts have taken a flexible, fact sensitive approach, focusing on whether the defendant controls the company at issue. For example, in SEC v. Solucorp Industries Ltd. , 274 F. Supp.2d 379 (S.D.N.Y. 2003), the SEC argued that the defendant, who held the title of consultant, was a de facto officer because he occupied a corner office, had a substantial ownership position in the company, introduced himself as CEO and COO, and third parties testified that he controlled the company. The defendant argued that he had no authority to sign contracts, to issue any press releases or to make financial disclosures for the company, reported to the president, and had no involvement in the company's accounting decisions. The court rejected this defense, holding that because he “performed duties analogous to those of an officer and had access to insider information, in that he performed a policy-making function for an issuer akin to that of a president, principal financial officer, or any vice president in charge of a business unit, division or function,” the defendant could be liable as an officer. Based on misconduct detailed in the complaint, the court permanently barred the defendant from serving as an officer or director.

Enforcing a D&O Bar

Because D&O bars are imposed via final judgments entered by the district court, violators risk civil or criminal contempt. As an additional remedy, the SEC may also seek to impose a voting trust on the shares of the individual and company. See http://www.sec.gov/news/press/2004-155.htm (Hollinger International and its former CEO Conrad Black); SEC. V. Drexel Burnham Lambert, Inc. , 837 F.Supp. 587 (S.D.N.Y. 1993).

Tips for Defense Counsel

First, reject the SEC mindset that a D&O bar is an automatic punishment for any violation of the securities laws. Rather, a bar should be imposed only if a defendant/ respondent is unfit to so serve, based on the six-factor Patel test.

Second, focus on what it means to be unfit to serve as a director or officer. An executive's securities law violations may have nothing to do with the company where he works, and thus do not demonstrate unfitness to serve under the Patel test.

Third, evaluate whether to inform the government of post-bar employment plans. In In the Matter of Powell, Initial Decision Release No. 255 (Aug. 17, 2004), the two defendants consented to suspensions from association with a broker dealer, but informed the SEC of their plans to remain involved with their former company. The ALJ found that the SEC could not sanction respondents when it was fully informed of the plan and did not object. But following this example has a downside. It carries the risk that the SEC might reject the proposal, even if proper, or attempt to limit the employee's prospects to an arrangement that may prove unsatisfactory.