Originally published in Portsmouth Herald
In February, the Securities and Exchange Commission brought enforcement action (SEC v. Krantz, Chasin & Nadelman) against three outside directors of DHB Industries, Inc., a publicly traded manufacturer of military and law enforcement body armor. The SEC's complaint alleges that the directors failed to maintain their independence from the company's management and turned a blind eye to warning signs of fraud and other misconduct by corporate officers.
The DHB directors' alleged misconduct and failures were egregious and the SEC has brought few other cases against outside directors. Nonetheless, the SEC's action should remind corporate directors that their appointments come with real and important responsibilities, which can form the basis for personal liability if not properly discharged.
The DHB complaint alleges that DHB executives manipulated earnings by overstating inventory values, failing to appropriately charge for obsolete inventory, and falsifying journal entries. Further, DHB's CEO fraudulently diverted $10 million out of the company through transactions with a related entity that he controlled; used company funds to pay for excessive personal expenses, and engaged in insider trading to earn $185 million through sales of DHB stock. The SEC charged DHB's three outside directors with facilitating the fraud because they failed to carry out their fiduciary responsibilities. The SEC said the directors turned a blind eye to numerous red flags signaling accounting fraud, reporting violations, and misappropriation. The directors were also charged with selling DHB stock at a substantial profit after learning of the CEO's misconduct, which was not disclosed to investors.
The misconduct by the DHB executives and outside directors' dereliction of responsibilities is extraordinary. Nonetheless, the DHB case gives directors of both public and private companies reason to remind themselves of their duties.
Directors have two fundamental fiduciary duties, the duties of care and loyalty. Care requires that directors discharge their duties in good faith and with the care that an ordinarily prudent person in a like position would exercise under similar circumstances and in a manner the director reasonably believes to be in the best interests of the corporation. Loyalty requires that directors act on the corporation's and shareholders' behalf and refrain from self-dealing, usurpation of corporate opportunity, and other acts from which they would receive improper personal benefit or that would injure the corporation or its shareholders.
Decisions directors make on an informed basis, in good faith, and in the honest belief that the action is in the best interest of the corporation will be protected by the business judgment rule. To invoke this protection, directors have a duty to inform themselves of all material information reasonably available to them. Accordingly, the business judgment rule does not protect a director who has a personal financial interest in the transaction, lacks independence, does not inform himself of all reasonably available information, or fails to exercise due care. Instead, the director must show that his conduct meets the stricter standard of "entire fairness" to the corporation.
Directors, especially outside directors, must maintain both actual and perceived independence. Most directors maintain independent business judgment in performing their duties, but the true test is whether shareholders and, in the case of public companies, regulators will perceive the director's actions to be truly impartial. Conflicts of interest quickly undermine a director's perceived independence. A director's personal relationship with an executive, perks and compensation, or financial relationship with the company, can all undermine actual and perceived independence.
Only an informed director can properly discharge his duties. Directors must ensure that they devote the proper amount of attention to their positions and investigate and respond to all potential red flags. Rubber-stamping management decisions or failing to conduct reasonable investigations when confronted with red flags or respond to concerns that outside consultants, legal counsel, and auditors raise can lead to serious problems for directors.
In DHB, the SEC alleged that the outside directors lacked the required independence because of prior business relationships with the CEO and the lavish perks and compensation received allegedly in exchange for acquiescence to the fraud. The SEC also claimed that the directors approved management decisions without adequate review and ignored numerous red flags, including reports of improper payment of CEO expenses, the termination of consultants hired to investigate, and the resignation of multiple auditors who highlighted the lack of proper accounting and disclosure. Finally, the SEC alleged that the outside directors wrongfully allowed management to control investigations into those issues and failed to question the termination of individuals who uncovered and reported them.
While it is unlikely that outside directors will confront mismanagement and fraud like that in DHB, the case should serve to remind outside directors of their duties of loyalty and care, that they owe those duties to shareholders, not to management, and that they must be vigilant in exercising those duties.
Julie Richardson is an attorney in the Corporate Department of McLane, Graf, Raulerson & Middleton, Professional Association.
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