On March 15, 2010, the SEC brought charges against the former audit committee chairman of a public company for securities fraud and other violations of the federal securities laws. In one of the first actions by the SEC against the chairman of an audit committee in order to hold him responsible for the failure to accurately disclose information in a company's periodic reports and proxy statements, the SEC alleged that the chairman knew or should have known that the company's SEC filings contained false or misleading statements about the CEO's transactions with the company. The charges also provided that the chairman failed to take appropriate action regarding red flags concerning the CEO's personal use of company funds, including information brought to his attention by others inside the company.

The chairman settled the charges with the SEC without admitting or denying any violation, agreed to pay a $50,000 penalty, and consented to an order barring him from serving as an officer or director of a public company for five years. He also consented to a final judgment enjoining him from future violations of the Securities Exchange Act and from aiding and abetting the company's violations.

The SEC's complaints alleged that the former CEO of the company fraudulently used corporate funds to pay almost $9.5 million in personal expenses to support his lavish lifestyle and caused the company to enter into $9.3 million of undisclosed business transactions between the company and other entities in which he had a personal stake. The SEC alleged that from 2003 to 2007 the CEO improperly used corporate funds for more than $3 million worth of personal jet travel for himself, family, and friends to such destinations as South Africa, Italy, and Cancun. He also used investor money to pay $2.8 million in expenses related to his yacht; $1.3 million in personal credit card expenses; and other costs associated with 28 club memberships, 20 automobiles, homes around the country, and three personal life insurance policies. The CEO was also charged, as were two former CFOs of the company who the SEC alleged aided the fraudulent conduct.

The SEC alleged that the chairman had a duty to take steps to ensure the accuracy and completeness of the statements contained in the company's SEC filings, yet failed to respond appropriately to various red flags concerning the CEO's expenses and the company's related-party transactions with the CEO's other entities. These red flags included concerns about the CEO's activities brought to the chairman's attention by two of the company's internal auditors. Moreover, when tasked by the board to oversee an investigation of these related-party transactions, the chairman received insufficient documentation and explanation from management concerning the CEO's expense reimbursements, and he then omitted these and other critical facts from his report to the board concerning the investigation.

According to the SEC, the fraud committed by the CEO could have been uncovered sooner had the chairman done any of the following:

  • Actually investigated the red flags himself
  • Hired outside counsel or others to investigate
  • Brought the information regarding the misappropriation to the attention of the company's board, auditors, or disclosure counsel to determine an appropriate course of action

This proceeding is significant because it is one of the first actions where the SEC has held the chairman of the audit committee responsible for the failure to accurately disclose information in a company's periodic reports and proxy statements. The SEC even alleged that the chairman had a duty to ensure the accuracy of the company's SEC filings, though that allegation was perhaps more a result of the egregious facts and his failure to adequately perform the investigation the board asked him to undertake rather than of his failure to perform any general duty. None of the other directors were charged in this matter.

The lessons for public company directors to take from this action are fairly straightforward:

  • When directors are tasked to undertake an internal investigation, it is prudent for them to involve outside legal and accounting advisors to ensure the thoroughness of the investigation and that the directors and the company are adequately protected. Information reported back to the board should be complete in all material respects.
  • When made aware of credible information indicating potential wrongdoing, a director should bring such information to the attention of the board or the appropriate committee, which should then review the matter and determine the appropriate course of action.
  • Related-party transactions can involve serious disclosure issues. Companies should use great care to ensure that all material related-party transactions are disclosed fully and accounted for properly, as the failure to do so may bring an SEC inquiry or enforcement action and the potential for substantial embarrassment or sanctions for the company.