Airing a Board's Dirty Laundry

The fallout from Hewlett-Packard's ('HP') controversial boardroom leak investigation has led to a variety of actions ' including an investigation by the California Attorney General's office and Congressional hearings on the practice of 'pretexting' ' a tactic employed by Hewlett-Packard to gain the confidential phone records of board members. Despite the considerable press attention devoted to the incident, it is an otherwise under-the-radar action by the SEC that could have the greatest long-term impact on corporate governance and compliance.

On May 23, 2007, the SEC issued a cease-and-desist order (the 'SEC Order') stemming from HP's failure to report the reason for Thomas Perkins' resignation from the board in Item 5.02(a) of its Form 8-K filing (Form 8-K is used by public companies to report significant events to their shareholders as they happen, rather than doing so only on a quarterly basis in Form 10-Q). In the current case, Perkins' resignation was an event that triggered the obligation for HP to file an 8-K, and it did so in a timely manner. The SEC's action, however, focuses on what was not included in the filing.

The SEC's enforcement action is notable in two key respects: 1) It was brought even though HP relied on the advice of counsel in not reporting the reasons for Perkins' resignation; and 2) It was brought under cease-and-desist proceedings pursuant to Section 21C of the Securities Exchange Act of 1934 ('Exchange Act'), which lacks a 'public interest' standard that is normally needed for an SEC sanction. The impact these aspects of the enforcement will have on corporate governance and compliance bears close attention in the future.

The HP Boardroom Leak Investigation

The HP Board of Directors began an investigation of suspected boardroom leaks in early 2006 after seeing confidential information about board meetings disclosed to the press. The investigation used questionable tactics, including 'pretexting,' a practice that often involves private investigators posing as someone else to obtain that person's confidential information such as telephone or banking records. As details of this investigation began to emerge, there was understandably a considerable amount of public outrage over the tactics, and the fallout has included, among other things, an investigation by the California Attorney General's office, Congressional hearings, and the resignation of HP Chairman Patricia Dunn.

Interestingly, the SEC's action in this matter has nothing to do with the tactics employed by HP and their private investigators during the leak investigation. Rather, the SEC enforcement focuses on the lack of disclosure on a somewhat peripheral matter, but one that was nevertheless embarrassing to the company.

Following the leak investigation in early 2006, the board convened on May 18, 2006, to discuss the investigation's results. The investigation uncovered the identity of a director who had leaked information to the press, and at the May 18 meeting the name of that director was revealed. During the course of that meeting, board member Thomas Perkins expressed his displeasure that the identity of the director had been revealed, preferring instead that the director be approached privately for an explanation and a warning. According to the SEC Order, Perkins maintains that he and Dunn had an agreement to that effect, and that Dunn's failure to handle the matter confidentially violated that agreement. After the board voted to ask for the offending director's resignation, Perkins repeated his objections and resigned from the board.

On May 22, 2006, HP reported Perkins' resignation to the SEC on Form 8-K without giving a reason for his departure from the company. SEC Rule 13a-11 requires public companies to file periodic disclosures using Form 8-K to notify investors of significant events such as director departures. Under Item 5.02(a) of Form 8-K, public companies must disclose the reasons for a director's resignation if it is due to a disagreement with the company 'on any matter relating to [the company's] operations, policies or practices[.]' See Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, 69 Fed. Reg. 15625 (Mar. 25, 2004). The SEC brought cease and desist proceedings against HP pursuant to Section 21C of the Exchange Act and claimed that HP should have made such a disclosure.

The Item 5.02(a) Requirement

Item 5.02(a) is a relatively new requirement, promulgated in March 2004 and replacing the old Item 6 on Form 8-K. Under the previous requirement, disclosure of a disagreement between the company and a departing director was required only if that director provided a letter to the company describing the disagreement and requested that the matter be disclosed. Under the new rule, the duty to disclose is triggered by the existence of a disagreement and knowledge of that disagreement by an executive officer of the company.

Since the rule's adoption, the cease and desist order against HP is the first time that Item 5.02(a) has been enforced. Accordingly, it may be too soon to draw any definitive conclusions about the SEC's view of the requirement. It is nevertheless telling that the SEC brought the action despite it specifically taking note of the fact that HP relied upon the advice of both its General Counsel and its outside legal counsel in electing to not disclose the reasons for Perkins' resignation. According to the SEC Order, HP's legal counsel advised that the disclosure was unnecessary because Perkins 'merely had a disagreement with the company's Chairman, and not a disagreement with the company on a matter relating to its operations, policies, or practices.' See In the Matter of Hewlett-Packard Company, Administrative Proceeding File No. 3-12643, 2007 SEC LEXIS 1084, 7 (SEC 2007). The SEC, on the other hand, contended that Perkins' resignation was due to two specific disagreements with HP:

the decision to present (1) the leak investigation findings to the full Board; and (2) the decision by majority vote of the Board of Directors to ask the director identified in the leak investigation to resign. Id.

Because these disagreements 'related to important corporate governance matters and HP policies regarding handling of sensitive information,' the SEC held that the disagreement was over HP's operations, policies and/or practices. Id. at 8.

The SEC, relying on the D.C. Circuit Court's opinion in SEC v. Savoy, 587 F.2d 1149 (D.C. Cir. 1978) contends that no showing of scienter ' or fraudulent intent ' is required to prove a violation of Rule 13a-11 (the rule requiring companies to file Form 8-K). The SEC thus takes the view that it may impose sanctions on companies for deficient filings even when the deficiencies are based upon the advice of counsel. The lack of a scienter requirement for Rule 13a-11 stands in sharp contrast to the requirements for a Rule 10b-5 violation, which requires scienter in addition to material misrepresentations causing economic losses to shareholders. See generally Dura Pharmaceuticals Inc. v. Broudo, 544 U.S. 336 (2005). In 10b-5 actions, the presence of scienter is typically one of the most hotly contested issues ' with the entire action's outcome often hanging in the balance. In Savoy, however, the D.C. Circuit held that the legislative history of the Exchange Act indicates that section 13(d) 'is a reporting, and not an antifraud, provision.' Id. at 1167. The court notes that section 10(b)'s use of the words 'manipulative' and 'deceptive' 'manifested an 'intent to proscribe a type of conduct quite different from negligence[,]” (Id., quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 (1976)) and the lack of such terms in section 13(d) 'gives no hint that intentional conduct need be found[.]' Savoy, 587 F.2d at 1167. Although the holding in Savoy does not specifically cover section 13(a) (pursuant to which Rule 13a-11 is promulgated), the SEC is interpreting it as doing so, since the operative terms 'manipulative' and 'deceptive' do not appear in section 13(a) either.

Another issue for consideration in this matter is how the SEC interprets the phrase 'operations, policies or practices.' The adopting release is silent on the matter. See Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, 69 Fed. Reg. 15625 (Mar. 25, 2004). The interpretation of this phrase was central to the difference of opinion between the SEC and HP's counsel with respect to whether Perkins' disagreement should have been reported. If the SEC Order is used as a guide, the SEC will interpret this requirement broadly. While HP's contention that the disagreement was with the Chairman ' not the company ' is not an implausible conclusion, the SEC adopted a broader stance. Whether this is an indication of future interpretation decisions, or whether it was simply due to the SEC's desire to punish HP in some manner in the wake of the leak controversy, is a question that warrants close attention in the future. As indicated earlier, the SEC Order is the only enforcement action taken relating to Item 5.02(a) since its enactment, so it is difficult to draw definitive conclusions at this juncture.

The SEC may be wading into dangerous waters if it continues to interpret this requirement broadly. Public companies acting in good faith should be allowed to rely on legal counsel as to what constitutes 'operations, practices and policies.' Otherwise, the SEC risks involving itself too heavily in the internal workings of boardrooms ' an area that is more appropriately the province of state law, not federal securities regulation. Indeed, there is scant public policy interest in forcing companies to air all of their boards' internal disagreements.

Cease and Desist Proceedings

The other curious aspect of this enforcement is the fact that the SEC used cease and desist proceedings pursuant to Section 21C of the Exchange Act, rather than under the provisions relating to reporting requirements.

On its face, it seems odd that the SEC would use cease-and-desist proceedings to enforce a filing requirement. After all, the deficient filing had already been made, so what precisely was the SEC asking HP to cease and desist from? The possible answer to this oddity lies in the fact that cease-and-desist proceedings under section 21C ' unlike certain other enforcement provisions ' do not include the requirement that SEC action be in the public interest. Generally, the public interest standard requires there to be some public benefit for the action beyond serving as a merely a punitive measure.

While it is an open question as to whether the SEC's action in the HP matter would meet a public interest standard, it is nevertheless telling that the SEC chose the cease-and-desist route. It is no stretch of the imagination to conclude that, in light of the tremendous attention being given the HP leak controversy ' at the state level and in Congress, the SEC was simply looking for a way to 'get a seat at the table,' and the cease-and-desist avenue presented the path of least resistance to that goal.

Much like the enforcement of Item 5.02(a), it is entirely possible that the SEC's use of the cease-and-desist proceedings was more matter of finding creative ways to go after HP than it is any indication of future enforcement practices. In any event, it sets a bad precedent when federal regulators intrude into the area of state corporate governance laws simply because a case is highly publicized. In the age of The Sarbanes-Oxley Act of 2002, the SEC does not have any problem proving its relevance. Accordingly, it can and should exercise restraint in such areas, when states are perfectly capable of addressing corporate malfeasance.

Conclusions: Impact on Future 8-K Enforcement

The requirement that companies disclose disagreements with departing board members can lead to potentially embarrassing revelations. This is unquestionably true even under more innocent circumstances than those surrounding the HP matter. Under the old rule, it was up to the departing director to trigger any disclosure of the disagreement, but the new rule now makes it an affirmative duty of the company. With the SEC's enforcement action in the HP case, we see that the agency intends to enforce this provision, even if only on a stand-alone basis.

Time will tell just how closely the SEC will scrutinize Item 5.02(a) in the future. As a practical matter, however, its action in the HP case sets the wrong precedent ' one that could create nightmares for corporate compliance officers. After all, do we really want the federal government to force public companies to air all of their board's dirty laundry?

Ralph C. Ferrara is a partner with Dewey & LeBoeuf and former General Counsel of the United States Securities and Exchange Commission. Paul Howard is a student at Georgetown Law School and worked with Mr. Ferrara during the summer of 2007.

The fallout from Hewlett-Packard's ('HP') controversial boardroom leak investigation has led to a variety of actions ' including an investigation by the California Attorney General's office and Congressional hearings on the practice of 'pretexting' ' a tactic employed by Hewlett-Packard to gain the confidential phone records of board members. Despite the considerable press attention devoted to the incident, it is an otherwise under-the-radar action by the SEC that could have the greatest long-term impact on corporate governance and compliance.

On May 23, 2007, the SEC issued a cease-and-desist order (the 'SEC Order') stemming from HP's failure to report the reason for Thomas Perkins' resignation from the board in Item 5.02(a) of its Form 8-K filing (Form 8-K is used by public companies to report significant events to their shareholders as they happen, rather than doing so only on a quarterly basis in Form 10-Q). In the current case, Perkins' resignation was an event that triggered the obligation for HP to file an 8-K, and it did so in a timely manner. The SEC's action, however, focuses on what was not included in the filing.

The SEC's enforcement action is notable in two key respects: 1) It was brought even though HP relied on the advice of counsel in not reporting the reasons for Perkins' resignation; and 2) It was brought under cease-and-desist proceedings pursuant to Section 21C of the Securities Exchange Act of 1934 ('Exchange Act'), which lacks a 'public interest' standard that is normally needed for an SEC sanction. The impact these aspects of the enforcement will have on corporate governance and compliance bears close attention in the future.

The HP Boardroom Leak Investigation

The HP Board of Directors began an investigation of suspected boardroom leaks in early 2006 after seeing confidential information about board meetings disclosed to the press. The investigation used questionable tactics, including 'pretexting,' a practice that often involves private investigators posing as someone else to obtain that person's confidential information such as telephone or banking records. As details of this investigation began to emerge, there was understandably a considerable amount of public outrage over the tactics, and the fallout has included, among other things, an investigation by the California Attorney General's office, Congressional hearings, and the resignation of HP Chairman Patricia Dunn.

Interestingly, the SEC's action in this matter has nothing to do with the tactics employed by HP and their private investigators during the leak investigation. Rather, the SEC enforcement focuses on the lack of disclosure on a somewhat peripheral matter, but one that was nevertheless embarrassing to the company.

Following the leak investigation in early 2006, the board convened on May 18, 2006, to discuss the investigation's results. The investigation uncovered the identity of a director who had leaked information to the press, and at the May 18 meeting the name of that director was revealed. During the course of that meeting, board member Thomas Perkins expressed his displeasure that the identity of the director had been revealed, preferring instead that the director be approached privately for an explanation and a warning. According to the SEC Order, Perkins maintains that he and Dunn had an agreement to that effect, and that Dunn's failure to handle the matter confidentially violated that agreement. After the board voted to ask for the offending director's resignation, Perkins repeated his objections and resigned from the board.

On May 22, 2006, HP reported Perkins' resignation to the SEC on Form 8-K without giving a reason for his departure from the company. SEC Rule 13a-11 requires public companies to file periodic disclosures using Form 8-K to notify investors of significant events such as director departures. Under Item 5.02(a) of Form 8-K, public companies must disclose the reasons for a director's resignation if it is due to a disagreement with the company 'on any matter relating to [the company's] operations, policies or practices[.]' See Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, 69 Fed. Reg. 15625 (Mar. 25, 2004). The SEC brought cease and desist proceedings against HP pursuant to Section 21C of the Exchange Act and claimed that HP should have made such a disclosure.

The Item 5.02(a) Requirement

Item 5.02(a) is a relatively new requirement, promulgated in March 2004 and replacing the old Item 6 on Form 8-K. Under the previous requirement, disclosure of a disagreement between the company and a departing director was required only if that director provided a letter to the company describing the disagreement and requested that the matter be disclosed. Under the new rule, the duty to disclose is triggered by the existence of a disagreement and knowledge of that disagreement by an executive officer of the company.

Since the rule's adoption, the cease and desist order against HP is the first time that Item 5.02(a) has been enforced. Accordingly, it may be too soon to draw any definitive conclusions about the SEC's view of the requirement. It is nevertheless telling that the SEC brought the action despite it specifically taking note of the fact that HP relied upon the advice of both its General Counsel and its outside legal counsel in electing to not disclose the reasons for Perkins' resignation. According to the SEC Order, HP's legal counsel advised that the disclosure was unnecessary because Perkins 'merely had a disagreement with the company's Chairman, and not a disagreement with the company on a matter relating to its operations, policies, or practices.' See In the Matter of Hewlett-Packard Company, Administrative Proceeding File No. 3-12643, 2007 SEC LEXIS 1084, 7 (SEC 2007). The SEC, on the other hand, contended that Perkins' resignation was due to two specific disagreements with HP:

the decision to present (1) the leak investigation findings to the full Board; and (2) the decision by majority vote of the Board of Directors to ask the director identified in the leak investigation to resign. Id.

Because these disagreements 'related to important corporate governance matters and HP policies regarding handling of sensitive information,' the SEC held that the disagreement was over HP's operations, policies and/or practices. Id. at 8.

The SEC, relying on the D.C. Circuit Court's opinion in SEC v. Savoy, 587 F.2d 1149 (D.C. Cir. 1978) contends that no showing of scienter ' or fraudulent intent ' is required to prove a violation of Rule 13a-11 (the rule requiring companies to file Form 8-K). The SEC thus takes the view that it may impose sanctions on companies for deficient filings even when the deficiencies are based upon the advice of counsel. The lack of a scienter requirement for Rule 13a-11 stands in sharp contrast to the requirements for a Rule 10b-5 violation, which requires scienter in addition to material misrepresentations causing economic losses to shareholders. See generally Dura Pharmaceuticals Inc. v. Broudo , 544 U.S. 336 (2005). In 10b-5 actions, the presence of scienter is typically one of the most hotly contested issues ' with the entire action's outcome often hanging in the balance. In Savoy, however, the D.C. Circuit held that the legislative history of the Exchange Act indicates that section 13(d) 'is a reporting, and not an antifraud, provision.' Id. at 1167. The court notes that section 10(b)'s use of the words 'manipulative' and 'deceptive' 'manifested an 'intent to proscribe a type of conduct quite different from negligence[,]” ( Id., quoting Ernst & Ernst v. Hochfelder , 425 U.S. 185, 199 (1976)) and the lack of such terms in section 13(d) 'gives no hint that intentional conduct need be found[.]' Savoy , 587 F.2d at 1167. Although the holding in Savoy does not specifically cover section 13(a) (pursuant to which Rule 13a-11 is promulgated), the SEC is interpreting it as doing so, since the operative terms 'manipulative' and 'deceptive' do not appear in section 13(a) either.

Another issue for consideration in this matter is how the SEC interprets the phrase 'operations, policies or practices.' The adopting release is silent on the matter. See Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, 69 Fed. Reg. 15625 (Mar. 25, 2004). The interpretation of this phrase was central to the difference of opinion between the SEC and HP's counsel with respect to whether Perkins' disagreement should have been reported. If the SEC Order is used as a guide, the SEC will interpret this requirement broadly. While HP's contention that the disagreement was with the Chairman ' not the company ' is not an implausible conclusion, the SEC adopted a broader stance. Whether this is an indication of future interpretation decisions, or whether it was simply due to the SEC's desire to punish HP in some manner in the wake of the leak controversy, is a question that warrants close attention in the future. As indicated earlier, the SEC Order is the only enforcement action taken relating to Item 5.02(a) since its enactment, so it is difficult to draw definitive conclusions at this juncture.

The SEC may be wading into dangerous waters if it continues to interpret this requirement broadly. Public companies acting in good faith should be allowed to rely on legal counsel as to what constitutes 'operations, practices and policies.' Otherwise, the SEC risks involving itself too heavily in the internal workings of boardrooms ' an area that is more appropriately the province of state law, not federal securities regulation. Indeed, there is scant public policy interest in forcing companies to air all of their boards' internal disagreements.

Cease and Desist Proceedings

The other curious aspect of this enforcement is the fact that the SEC used cease and desist proceedings pursuant to Section 21C of the Exchange Act, rather than under the provisions relating to reporting requirements.

On its face, it seems odd that the SEC would use cease-and-desist proceedings to enforce a filing requirement. After all, the deficient filing had already been made, so what precisely was the SEC asking HP to cease and desist from? The possible answer to this oddity lies in the fact that cease-and-desist proceedings under section 21C ' unlike certain other enforcement provisions ' do not include the requirement that SEC action be in the public interest. Generally, the public interest standard requires there to be some public benefit for the action beyond serving as a merely a punitive measure.

While it is an open question as to whether the SEC's action in the HP matter would meet a public interest standard, it is nevertheless telling that the SEC chose the cease-and-desist route. It is no stretch of the imagination to conclude that, in light of the tremendous attention being given the HP leak controversy ' at the state level and in Congress, the SEC was simply looking for a way to 'get a seat at the table,' and the cease-and-desist avenue presented the path of least resistance to that goal.

Much like the enforcement of Item 5.02(a), it is entirely possible that the SEC's use of the cease-and-desist proceedings was more matter of finding creative ways to go after HP than it is any indication of future enforcement practices. In any event, it sets a bad precedent when federal regulators intrude into the area of state corporate governance laws simply because a case is highly publicized. In the age of The Sarbanes-Oxley Act of 2002, the SEC does not have any problem proving its relevance. Accordingly, it can and should exercise restraint in such areas, when states are perfectly capable of addressing corporate malfeasance.

Conclusions: Impact on Future 8-K Enforcement

The requirement that companies disclose disagreements with departing board members can lead to potentially embarrassing revelations. This is unquestionably true even under more innocent circumstances than those surrounding the HP matter. Under the old rule, it was up to the departing director to trigger any disclosure of the disagreement, but the new rule now makes it an affirmative duty of the company. With the SEC's enforcement action in the HP case, we see that the agency intends to enforce this provision, even if only on a stand-alone basis.

Time will tell just how closely the SEC will scrutinize Item 5.02(a) in the future. As a practical matter, however, its action in the HP case sets the wrong precedent ' one that could create nightmares for corporate compliance officers. After all, do we really want the federal government to force public companies to air all of their board's dirty laundry?

Ralph C. Ferrara is a partner with Dewey & LeBoeuf and former General Counsel of the United States Securities and Exchange Commission. Paul Howard is a student at Georgetown Law School and worked with Mr. Ferrara during the summer of 2007.