The Securities and Exchange Commission (SEC) rarely takes judicial or even administrative action against boards of directors. However, on December 10, 2012, the SEC instituted public administrative and cease-and-desist proceedings under the Investment Company Act of 1940 (1940 Act) against eight outside directors of mutual funds sponsored by Morgan Keegan & Company, Inc. (Morgan Keegan). On June 13, 2013, the eight directors settled the proceedings by consenting to the cease-and-desist order.
The SEC’s allegations were that the eight directors delegated to a committee composed of the funds’ officers and accounting employees the directors’ responsibility for assuring that the funds’ investments were valued at fair value as required by the 1940 Act without:
- providing any meaningful substantive guidance on how those determinations should be made;
- learning how fair values were actually being determined;
- receiving more than limited information on the factors considered in making fair value determinations and almost no information explaining why fair values were assigned to specific portfolio securities;
- providing any other guidance – either written or oral – on how to determine fair value; and
- knowing or inquiring what methodology was used by the committee.
Under most states’ corporation laws, including Ohio’s, a director may rely — and may be protected when relying — upon committees, but the standard of care required of a director is greater if the committee is not composed solely of directors. For example, under both Ohio’s for-profit and non-profit corporation laws, a director may rely upon a committee composed solely of directors as to matters within the committee’s designated authority as long as the director reasonably believes the committee merits confidence. This is not a difficult standard to meet because it requires the director (i) to know the committee’s authority, which the director can know by reviewing the committee’s charter, and (ii) to reasonably believe the committee merits confidence, about which the director can have some confidence because each member of the committee has the director’s fiduciary duties of care and loyalty when serving on the committee. Those duties are to act in good faith, in a manner the director reasonably believes to be in or not opposed to the best interests of the corporation, and with the care that an ordinarily prudent person in a like position would use under similar circumstances.
On the other hand, if the committee is composed of non-directors, a director may only rely upon the committee for matters about which the director reasonably believes the committee members are reliable and competent. Because non-directors do not have the same fiduciary duties of care and loyalty as a director, courts have held that a director must ask questions of a non-director committee in order to have such a reasonable belief. Reliability requires inquiring about the truth and veracity, and freedom from conflicts of interest, of each committee member. Competence requires inquiring about the care the members of the committee have taken in discharging their responsibilities, including the key question, “What happens if things don’t go as planned?”
Even though the SEC allowed the eight outside directors of the Morgan Keegan funds to consent to the cease-and-desist order without admitting or denying the SEC’s findings, they have suffered both economic loss in terms of legal fees and expenses, and reputational loss because of publicity. Although the cease-and-desist order does not by itself result in a Morgan Keegan director being subject to the new “bad actor” disqualification of section 506(d) of SEC Regulation D, it is a disclosure item in the “management” section of registration statements, prospectuses and proxies subject to Regulation S-K.