A public company and its management face litigation risks as a result of issuing public securities. Securities holders may bring claims under the federal securities laws for alleged disclosure violations. Shareholders may bring corporate governance claims, such as derivative claims for breaches of fiduciary duty by management or the board of directors. The SEC or the company’s securities exchange may conduct investigations and bring enforcement proceedings against the company or management for disclosure violations. Criminal prosecutors may investigate and prosecute criminal violations of the securities laws.

Although these risks are real, there are ways to mitigate them and provide increased protection to directors and officers. This chapter summarizes some of the most common litigation risks facing public companies and their officers and directors and provides practical tips for managing these risks.

Liability Under the 1934 Act – Section 10(b) and Rule 10b-5

The most common cases brought by public company securities holders are private securities actions under the 1934 Act, the federal law governing the securities markets. Section 10(b) of the 1934 Act and Rule 10b-5 make it unlawful for a company or a person, in connection with the purchase or sale of a security, to:

  • Make any untrue statement of a material fact; or
  • Omit to state a material fact necessary in order to make a statement made, in light of the circumstances under which it was made, not misleading.

In practical terms, a company or a person violates Rule 10b-5 by making an intentional or reckless misrepresentation or omission of fact that influences the price of a public company’s stock. Rule 10b-5 applies to virtually any type of statement by a public company, officer or director, including statements in periodic reports, press releases and analyst calls. Purchasers or sellers of stock can sue even if they did not see, hear or rely on the alleged misstatement in deciding to trade in a company’s stock. These purchasers and sellers rely on the fraud on the market presumption, which allows them to allege that they relied on the integrity of the market price for the stock to reflect all publicly available material information. Rule 10b-5 imposes liability even when a person or company was not a party to a securities transaction, such as when an investor buys stock via a transaction on a stock exchange.

A company, its officers and directors, and any other person who makes a false or misleading statement may be directly liable for damages under Rule 10b-5. Those who control the company may also be liable – even if they did not personally make any false or misleading statements.

Although liability under Rule 10b-5 is broad, there are some important limitations. A company or person is not liable for mere negligence. Instead, Rule 10b-5 imposes liability only on a defendant who acts with scienter, which means with knowledge of or reckless disregard for the falsity of a statement or the materiality of an omission. In addition, a defendant is liable only for economic losses actually caused by the alleged misrepresentation or omission. In light of these limitations, defendants often assert a multi pronged defense to claims under Rule 10b-5, arguing the following:

  • The statement was not false or misleading or the omission was not material;
  • The defendants did not know or recklessly disregard the fact that the statement was false; and
  • The alleged misrepresentations or omissions did not cause the economic losses allegedly suffered by the plaintiffs.

Practical Tip:
If You Speak, Speak the Whole Truth!

Rule 10b-5 does not impose an affirmative duty to disclose all material information about your company’s business. But when you do speak, you must do so truthfully. For example, while your company may have no obligation to disclose the development of a new product, if you choose to announce the new development, your statements must be accurate and complete.

Liability Under the 1933 Act – Sections 11 and 12(a)(2)

In some circumstances, public company shareholders may also bring claims under a second federal law, the 1933 Act, which governs securities offerings. Claims under the 1933 Act are limited to false or misleading statements made in connection with a registered offering of securities. Claims under the 1933 Act, however, can be even more threatening than a Rule 10b-5 claim because plaintiffs asserting 1933 Act claims need to allege little in the way of actual misconduct in order to defeat a motion to dismiss those claims and proceed to take discovery. The risk of legal claims under the 1933 Act provides a powerful incentive to issuers and their agents to ensure the accuracy of registration statements and prospectuses.

Two sections of the 1933 Act, Sections 11 and 12(a)(2), impose liability for misstatements in registration statements and prospectuses. Those sections often overlap, but they are not identical. They have different elements and provide for recovery of different types of damages.

Section 11 – Liability for Misrepresentations in a Registration Statement

Section 11 of the 1933 Act permits shareholders to recover damages for misstatements or omissions of material fact in a registration statement – including the prospectus. With limited exceptions, Section 11 does not require a plaintiff to prove that he or she relied on the alleged misstatement, nor that the defendant acted with scienter (the requirement of knowledge or reckless disregard that a statement was false or misleading for claims under the 1934 Act). To state a claim under Section 11, a plaintiff generally must prove only the following:

  • The registration statement or prospectus misrepresented or omitted a material fact at the time it became effective;
  • The plaintiff bought securities traceable to that registration statement; and
  • The plaintiff suffered damages (typically a loss due to a decline in the price of a security).

A shareholder may bring a Section 11 claim against, among others:

  • The company issuing the securities;
  • Any director of the company at the time of the offering; or
  • Any person who signed the registration statement.

Other potential Section 11 targets include any person who controls these primary defendants, as well as underwriters and accountants.

Directors and officers of the company (but not the company itself) and some other defendants may assert an affirmative defense of reasonable care. In addition, all defendants may have available the following affirmative defenses:

  • The misstatement or omission, if it occurred, did not cause the plaintiff’s damages; and
  • The plaintiff knew the truth when he or she purchased the securities.

Section 12(a)(2) – Seller’s Liability

Section 12(a)(2) of the 1933 Act provides shareholders with a right to sue for a misstatement or omission of material fact in a prospectus or oral communication used to offer or sell securities to the public. Any investor who purchases a security in a public offering can assert a Section 12(a)(2) claim against any person who offers or sells the security. Section 12(a)(2) applies only to sales of securities in public offerings, not to trading in the secondary market or to private sales of securities. It also applies only against those considered to be sellers of the securities at issue. Within those parameters, Section 12(a)(2) imposes relatively few requirements on a plaintiff. A plaintiff need not prove reliance, scienter or that the misstatement or omission caused the purchase. In order to recover, a plaintiff must prove only that:

  • The defendant offered or sold securities;
  • By the use of any means of interstate commerce (e.g., an interstate mailing or telephone call);
  • Through a prospectus or oral communication;
  • Which included a misstatement or omission of material fact; and
  • The plaintiff was ignorant of the truth.

A defendant may assert an affirmative defense of reasonable care, i.e., the defendant did not know, and in the exercise of reasonable care could not have known, of the misstatement or omission.

A successful plaintiff who still holds the security is entitled to rescission and may recover the consideration paid for the security, minus any income. Where the plaintiff has sold the security, he or she may recover rescissory damages, generally the difference between the purchase price and the resale price, plus interest, and minus any income or return of capital on the security.

Special Situations Under the 1933 and 1934 Acts

Forward-Looking Statements

Forward-looking statements, such as forecasts of earnings or revenues, have historically served as the basis for private claims under the 1933 and 1934 Acts. In order to encourage companies to make forward-looking statements, Congress created, in the Private Securities Litigation Reform Act of 1995, a safe harbor defense against federal securities law claims for forward-looking statements. Under this safe harbor, a forward-looking statement cannot be the basis for liability if the company:

  • Properly identifies the statement as a forward-looking statement; and
  • Accompanies the statement with meaningful cautionary statements that identify important factors that could cause actual results to differ materially from those forecast in the forward-looking statement.

A company does not need to identify all important factors, or even the factor that ultimately causes actual results to differ from those forecast in the forward-looking statement, as long as it issues the most complete cautionary statements possible in the circumstances. (We provide practical guidance on this safe harbor in Chapter 3.)

Liability for Endorsing Third-Party Statements

A company or person may be liable for false or misleading statements made by stock analysts or other third parties if that company or person:

  • Gives false or misleading information to the analyst or third party;
  • Expressly or implicitly adopts a third-party statement as its own; or
  • Endorses or adopts a third-party statement after publication, such as by distributing the statement to the public.

Practical Tip:
How to Avoid Liability for Endorsing an Analyst’s Report

Your company can take three basic steps to minimize the risk of liability for statements in a stock analyst’s report:

  • Enforce your company’s policy of neither endorsing nor adopting statements made by analysts;
  • Do not provide links to analysts’ reports on the company’s website or otherwise distribute analysts’ reports to shareholders or other members of the public; and
  • Comply with Regulation FD. (We explain how in Chapter 3.)

Duty to Correct and Duty to Update

A company has a duty to correct a material statement of historical fact that the company discovers to have been untrue when made. The company must correct the prior statement within a reasonable time after learning that the original statement of historical fact was not true when a failure to correct would affect the total mix of information available for investors to use to make informed investment decisions. In contrast, there is no general duty to update statements that were true when made.

Frequently, the passage of time causes a forward-looking statement, although reasonable when made, to become outdated or, if viewed as a current statement, to be materially misleading. Because it may be difficult to determine when an earlier statement has become materially misleading in light of developments, the best practice is to:

  • identify statements as accurate only on and as of the date they are made, and
  • explicitly disclaim any intention or obligation to update them.

Shareholder Class Actions

Plaintiffs often bring claims under the 1933 and 1934 Acts as shareholder class actions. A shareholder class action is a lawsuit brought by a purchaser or seller, or a relatively small group of purchasers or sellers, on behalf of all investors who purchased or sold securities during a specified time, known as the class period. Plaintiffs and their lawyers often file shareholder class actions when a negative public announcement by a company triggers a drop in the company’s stock price.

A shareholder class action typically begins with several plaintiffs filing complaints, which are then consolidated into a single class action complaint. Defendants often move to dismiss the complaint on the ground that it fails to allege facts that satisfy the relevant legal standards. If the court grants that motion, the court dismisses the case either:

  • With prejudice, meaning that plaintiffs are not entitled to amend and refile a complaint making the same legal claims based on the same alleged misconduct (such a decision may be subject to appeal); or
  • Without prejudice, meaning that plaintiffs have an opportunity to correct any defects in the complaint and refile a complaint making legal claims based on the same alleged misconduct.

If the court denies the motion to dismiss, the case proceeds to the discovery phase. Because most securities lawsuits allege misconduct implicating an extended time period and multiple aspects of a company’s operations and financial condition, discovery is often broad, costly and time-consuming. Once the plaintiffs obtain access to extensive internal records of the company, the plaintiffs’ theory of what was not properly disclosed often changes and expands.

Practical Tip:
Named in a Shareholder Class Action? Take These Four Steps

As soon as a plaintiff names you or your company in a shareholder class action, you should promptly take these four basic steps:

  •  Consult your insurance broker and give timely notice of the lawsuit, including a copy of the complaint, to the company’s D&O insurance carriers.
  •  Research and retain outside legal counsel experienced in securities litigation. Choose qualified counsel with good practical judgment. You may be working closely with these lawyers for an extended period of time, and you should feel comfortable with them and confident in their abilities.
  • Work with legal counsel to preserve documents relating broadly to the subject matter of the lawsuit. Counsel will identify which documents should be retained and by whom. Preserve both paper documents and electronic documents and data.
  • Develop strategies and goals for handling the lawsuit. The first step in nearly all securities lawsuits is to move to dismiss the complaint. But plan beyond the motion to dismiss because the case may begin to move quickly if the court denies the motion.

Changes in Securities Litigation and Related Issues After Sarbanes-Oxley and the Dodd-Frank Act

Sarbanes-Oxley and the Dodd-Frank Act have had only a modest impact on private securities class actions. However, the statutes have contributed to an increase in enforcement activity by the SEC and other governmental agencies and have had a significant effect on how companies are expected to respond to reports of wrongdoing.

The Dodd-Frank Act gives more enforcement powers to the SEC in three ways.

  • It loosens the “state of mind” requirements to prosecute charges of aiding and abetting violations of the federal securities laws. This makes it easier for the SEC to establish liability on these types of claims. The prior standard required that an aider or abettor knowingly provide substantial assistance in connection with another person’s violations. The Dodd-Frank Act creates liability for someone who aids or abets another’s violations knowingly or recklessly.
  • It creates financial incentives for whistleblowers who provide information leading to an SEC enforcement action resulting in a financial recovery of more than $1 million. The SEC will pay whistleblowers from 10% to 30% of collected funds.
  • It allows the SEC to compel a witness to attend a trial any place in the United States. Before the Dodd-Frank Act, the SEC could compel witnesses to travel only 100 miles to give testimony at trial.

CEO/CFO Certifications

Sarbanes-Oxley generally requires the CEO and CFO to certify their company’s periodic reports. The certification requirement itself does not appreciably increase the potential liability of a CEO or CFO in securities class actions. However, plaintiffs have used the certifications to allege that, based on the CEO’s and CFO’s required review of a periodic report, they knew, or were reckless in not knowing, that the periodic report contained material misrepresentations or omissions. The SEC uses certifications in enforcement proceedings and related litigation. (We discuss practical tips for compliance with the certification requirements in Chapter 2.)

Extension of Statute of Limitations

Sarbanes-Oxley extends the statute of limitations for private securities lawsuits that assert fraud, deceit, manipulation or a contrivance in contravention of a regulatory requirement. Claims subject to the statute of limitations must be brought not later than the earlier of:

  • Two years after discovery of the violation or
  • Five years after the occurrence of the violation. Because the extended statute of limitations applies only to claims involving fraud, deceit, manipulation and similar misconduct, courts have held that it applies to claims pursuant to Rule 10b-5 under the 1934 Act but not to claims under Section 11 of the 1933 Act.

Retention and Destruction of Documents

Accountants are required to retain a broad range of documents relating to audits or reviews of a company’s financial statements, including audit and review work papers, for seven years from the end of the fiscal period in which the audit or review was conducted. In addition, Sarbanes-Oxley imposes criminal liability on any person – not only an auditor – who “corruptly” alters, destroys, mutilates or conceals a document or other record with the intent to impair its integrity or availability for use in an official proceeding.

These changes, along with court decisions regarding spoliation of evidence, changes in procedural rules and evolving standards of practice have all elevated the importance of companies’ document management practices.

Practical Tip:
Creating a Document Management Policy

To protect your company and your employees, your company’s document management and retention policy should include four elements:

  • A document creation policy: Encourage professionalism in written communications, prohibit the use of profane language and unfounded gossip or speculation and encourage face-to-face discussion to resolve issues. You do not have to manage a misleading or unduly embarrassing document that was never created.
  • A document retention policy: Identify which documents to retain, the retention period for different classes of documents, and the procedures to follow. Consult with tax, regulatory affairs, legal and other personnel to determine the appropriate retention period for each category of documents. Retained documents should include both important business records and documents necessary to satisfy governmental requirements.
  • A document destruction policy: Set out procedures for destroying documents that do not need to be retained, such as personal correspondence, nonessential emails, drafts of documents and records that have passed their retention dates.
  • Clear standards for suspending document destruction practices and preserving records, along with clear responsibilities for compliance: When litigation (or an investigation or other official proceeding) commences, or is reasonably foreseeable, preserve all relevant documents. Destroying relevant documents under those circumstances – or under any other circumstance that might suggest an intent to make the documents unavailable in the lawsuit, investigation or other official proceeding – may subject the company and its employees to sanctions for destroying evidence or even criminal charges for obstruction of justice. There is no bright-line test, so err on the side of caution.

Standards of Professional Conduct for Attorneys

The SEC’s up-the-ladder reporting rules require attorneys to report evidence of material violations of state or federal law to a company’s senior management. If senior management does not respond appropriately, the reporting attorney is required to report the violation to a committee of independent directors or to the full Board. The SEC proposed but never adopted a “noisy withdrawal” rule to require an attorney to withdraw from representation and to notify the SEC if senior management or the Board does not respond appropriately to the reported violation.

Whistleblower Incentives and Protection

Sarbanes-Oxley and the Dodd-Frank Act created new incentives and protection from retaliation for employees, agents and contractors who lawfully provide information or help investigations conducted by the SEC, other federal regulatory or law enforcement agencies, Congress or any supervisor of the employee. The Dodd-Frank Act created an SEC whistleblower program to help the Division of Enforcement discover and prosecute securities law violations. The SEC whistleblower program’s three key elements are (1) providing financial awards to a successful whistleblower, (2) protecting the whistleblower against retaliation, and (3) maintaining the anonymity of the whistleblower. The SEC makes financial awards to individuals who voluntarily provide the SEC with original information that leads to successful enforcement actions resulting in monetary sanctions exceeding $1 million. These awards range from 10% to 30% of the sanctions the SEC collects.

The Dodd-Frank Act shields from retaliation any employee who participates in proceedings alleging violations of selected federal securities laws, if he or she has a reasonable belief that a securities violation has occurred, is in progress or is about to occur.

Employee Retirement Income Security Act of 1974 (ERISA) Claims

ERISA is a federal law that governs employee benefit plans. Because many public companies have plans that allow employees to invest in the company’s stock, a decline in the company’s stock price can trigger claims under ERISA similar to claims under the federal securities laws. ERISA plaintiffs are company employees who invested in company stock under the company benefit plan. Plaintiffs typically allege that company executives, who had a fiduciary duty to employees under the plan, concealed some fraud or misrepresentation from employees and that the discovery of this fraud or misrepresentation caused the decline in the company’s stock price. Plaintiffs also typically allege that they would not have invested in the company’s stock as part of their benefit plan if they had known about the fraud or misrepresentation. Employees often assert ERISA claims in addition to federal securities law claims (or separately assert both types of claims at the same time).

Most ERISA litigation focuses on whether the defendants in fact breached fiduciary duties owed to the employees. A person is considered a fiduciary for purposes of ERISA if he or she:

  • Exercises any discretionary authority or control with respect to management of an ERISA plan;
  • Provides investment advice for a fee or other compensation or has discretionary authority or responsibility to do so; or
  • Has any discretionary authority or responsibility in the administration of an ERISA plan.

A court can find fiduciary status either based on explicit references to the defendant as a fiduciary in plan documents or because the defendant engaged in conduct that is fiduciary in nature. A fiduciary who is found to have breached his or her fiduciary duties to the ERISA plan may be held personally liable to plan participants for the plan’s losses resulting from the fiduciary’s breach.

Corporate Governance Litigation

In addition to claims under the federal securities laws, directors and officers of a public company may also face claims in connection with the corporate governance issues that we discuss in Chapters 7, 8 and 9. Corporate governance litigation often involves alleged conflicts of interest. (We discuss ways to manage conflict-of-interest situations in Chapter 7.)

Change-of-Control Transactions

Change-of-control transactions are especially fraught with potential conflicts of interest for directors and are a common source of litigation, whether brought by frustrated potential acquirers or by shareholders dissatisfied with the terms or outcome of a transaction. For example, shareholder plaintiffs often allege that directors have approved a merger or other change-of-control transaction in order to entrench themselves or to obtain benefits for themselves or a favored shareholder. The duty of the Board in a change-of control transaction is fairly clear, at least in theory:

  • The Board must act in the best interests of the company and all of its shareholders; and
  • If the Board decides to sell the company, it generally must take reasonable steps to obtain the best available price and cannot unduly favor a lower-valued transaction.

Breaking News:
Litigation Accompanies (Almost) Every Public M&A Deal

Shareholder litigation challenging merger and acquisition transactions has become routine:

  • Investors have come to litigate virtually every public company merger and acquisition transaction of $1 billion or more. Approximately four out of five settlements of this type of merger and acquisition litigation provide for additional disclosures about the transaction to shareholders and nothing else. It is extremely rare for a settlement to provide additional merger consideration to shareholders.
  • These merger and acquisition lawsuits usually take the form of a class action on behalf of the target company’s shareholders. The typical suit alleges that the target company’s board of directors violated its fiduciary duties by conducting a flawed sale process, not maximizing shareholder value, and failing to disclose to shareholders all material information about the transaction.

In order for directors’ decisions in a change-of-control transaction to be protected under the deferential business judgment rule, directors must agree to the transaction offering the best value reasonably available for the company’s shareholders. Use the three methods that we describe in Chapter 7 for dealing with conflicts of interest in a change-of-control transaction to help protect the directors from liability. If the business judgment rule does not apply, courts will apply an enhanced level of scrutiny when reviewing directors’ behavior in the face of a takeover threat.

The sale of a company will generally trigger dissenters’ rights pursuant to provisions in the governing corporate statute that allow for judicial review of price. The company must carefully comply with the statute’s provisions. Doing so can protect against claims for money damages in favor of a litigated statutory appraisal process. (The statutory dissent process will not preempt claims for injunctive relief or claims for fraud, misrepresentation or other serious impropriety.)

Derivative Lawsuits

Plaintiffs frequently pursue corporate governance claims through derivative lawsuits. In a derivative lawsuit, a shareholder sues on behalf of the company, seeking relief for alleged claims that belong to the company but that the company has not asserted for itself. A derivative plaintiff cannot recover damages personally; instead, any damages or injunctive relief are solely for the benefit of the company. A company’s officers and directors are the most common targets of derivative claims, although plaintiffs may also target major shareholders and third parties.

A derivative plaintiff must comply with strict procedural requirements:

  • The plaintiff must be a shareholder at the time of the alleged wrong and remain a shareholder throughout the litigation;
  • The plaintiff must be an adequate representative of the company’s other shareholders;
  • The company usually must be made a party to the litigation, generally as a nominal defendant; and
  • Before bringing suit, the plaintiff must make a demand on the Board that the company take steps to assert the claim.

Some states (but not all) permit a plaintiff to proceed without first making a demand on the Board if the plaintiff can demonstrate that such a demand would be futile by establishing a reasonable doubt that:

  • The directors acted disinterestedly and independently; and
  • The directors exercised valid business judgment in authorizing the challenged transaction.

A company may assume control of derivative litigation by appointing a Special Litigation Committee of the Board to investigate the claims asserted by a derivative plaintiff and to determine whether pursuing the claims is in the company’s best interests. A Special Litigation Committee will have the power to terminate, settle or pursue the litigation, and may decide to permit the existing plaintiff to continue the suit. The Board should appoint disinterested independent directors to the Special Litigation Committee and give the Special Litigation Committee full authority to accomplish its investigation and to implement its decisions. Courts will often grant motions to stay derivative suits, including burdensome discovery, pending the outcome of Special Litigation Committee investigations. Any decision by a Special Litigation Committee to terminate the litigation will be subject to judicial review, and a party challenging the termination decision may pursue limited discovery into the independence and good faith of the Special Litigation Committee’s investigation.

Alternatively, the Board may ask an advisory committee of independent directors to conduct an investigation and report the results to the full Board. The full Board will then determine how best to respond to the derivative litigation based on the independent committee’s recommendations. The risk of this approach is that, to the extent a derivative plaintiff has alleged that the full Board has some interest or involvement in the alleged misconduct or lacks independence, courts are less likely to defer to the independent committee’s recommendations and the full Board’s review than to a Special Litigation Committee composed of independent directors authorized to act independently on the results of an investigation.

Practical Tip:
The Lonely Life of the One-Member Special Litigation Committee

A Special Litigation Committee (or any other special Board committee) must be composed of directors who are disinterested and independent. In many Model Business Corporation Act states, a minimum of two directors may be required, but in Delaware and some other states, a committee may be composed of only one director. In the words of one court, “[i]f a single member committee is to be used, the member should, like Caesar’s wife, be above reproach.” As a practical matter, the independence of a single-member committee may come under more rigorous scrutiny than would otherwise be applied to individual members of a larger committee.

Once a plaintiff has initiated a derivative action, the parties will need court approval to settle or dismiss it. In most derivative cases, notice of a settlement must be provided to the shareholders, and the court will convene a hearing to determine whether the settlement is fair and adequate. Attorneys’ fees may be awarded to plaintiff’s counsel – either out of the proceeds of the settlement or from the company itself – if the court determines that counsel’s efforts conferred a substantial monetary or nonmonetary benefit upon the company.

Shareholder Access to Corporate Books and Records

Statutes in numerous states, including Delaware, permit shareholders of public corporations to inspect some of a company’s books and records upon request to the company with sufficient advance notice. The statutes of the state in which the company is incorporated govern these inspections. In most cases, a shareholder must express a proper purpose for a books and records inspection request. Courts have generally upheld as proper purposes a shareholder’s desire to:

  • Investigate possible wrongdoing or mismanagement by the company’s executive officers;
  • Appropriately value shares of the company’s stock; and
  • Communicate with other shareholders regarding proposals for shareholders’ meetings.

States vary in the type of corporate books and records that they permit shareholders to access, but they usually include at least the company’s certificate or articles of incorporation, bylaws and minutes of shareholders’ meetings. Shareholder inspection demands are often simply the prologue to a later event, such as shareholder derivative litigation, a request for a meeting with directors for the purpose of discussing proposed reform, preparation of shareholder resolutions or a proxy fight.

Foreign Corrupt Practices Act

A key subset of federal securities laws is the Foreign Corrupt Practices Act of 1997 (FCPA). The FCPA has two key components. First, anti-bribery provisions prohibit public and private companies from paying bribes or giving anything of value in order to influence a foreign official. Second, books and records provisions mandate that public companies maintain books and records in sufficient detail to be “reasonable” to a prudent manager of the business. Promising, offering or authorizing someone to pay a bribe or to give something of value to a foreign official may all violate the FCPA. The FCPA goes beyond cash, to include goods, services, rights, contracts and benefits. A foreign official may include any foreign governmental party or public international organization representative, a candidate for public office or an employee of a government-owned business. Violation of the FCPA can result in criminal penalties, including prison terms for individuals, as well as monetary fines. The Department of Justice and the SEC, who jointly enforce the FCPA, have made the FCPA a top enforcement priority.

Practical Tip:
Help Your Employees to Steer Clear – and Record It!

Follow these four key practices to keep your company FCPA compliant:

  • Maintain a robust compliance program designed to scrutinize requests for reimbursement for gifts by employees or consultants who engage in foreign business for your company.
  •  Include appropriate third-party reviews in your record. Check in on suppliers, resellers, distributors and agents.
  •  Have a rigorous due diligence process for any acquisition that involves doing business abroad.
  •  Enhance and test a robust whistleblower system. Tie it to internal training!

Regulatory Investigations and Enforcement


Each year the SEC brings hundreds of civil enforcement actions against companies and individuals that are alleged to have violated the federal securities laws for:

  • Insider trading;
  • Accounting fraud;
  • Disclosure violations; and
  • Aiding and abetting violations.

The SEC will often first seek an immediate injunction against defendants to prohibit unlawful acts and practices. It may then seek disgorgement, monetary penalties and other sanctions against the alleged wrongdoers. While the SEC does not have the authority to pursue criminal actions, it may refer criminal matters to the Department of Justice.

The SEC initially pursues investigations through an informal inquiry, interviewing potential witnesses and examining brokerage records, trading data or company documents, in order to determine whether further investigation is warranted. Following the preliminary investigation, if the SEC issues a formal order of investigation, the SEC Staff may issue subpoenas compelling witnesses to testify and produce books, records and other relevant documents to assist the SEC in its investigation. The SEC can authorize its staff to file a case in federal court or to bring an administrative action against individuals and companies.

FINRA Regulation of Nasdaq and Other Exchanges

In addition to the SEC’s civil enforcement authority, securities markets have established self-regulatory organizations to govern the conduct of their members. The Financial Industry Regulatory Authority, Inc. (FINRA) is the largest independent regulator for U.S. securities firms. FINRA was created in July 2007 as a result of the consolidation of the National Association of Securities Dealers and the member regulation, enforcement and arbitration functions of the NYSE. FINRA is involved in virtually all aspects of the securities business, including registering and educating industry participants, examining securities firms, rulemaking, enforcing its own rules as well as the federal securities laws, and administering a dispute resolution forum for investors and registered firms. FINRA performs market regulation under contract for Nasdaq, the NYSE, the International Securities Exchange Holdings, Inc. and the Chicago Climate Exchange. (Note that in 2016, the NYSE will bring market surveillance, investigation and enforcement back in house, under the purview of NYSE Regulation.)

FINRA investigates trading in public company stock through its Office of Fraud Detection and Market Intelligence. Most often, FINRA initiates these investigations to look into suspicious trading in connection with a significant public announcement by a company, such as the announcement of a merger agreement. The Office routinely collects information concerning company personnel who knew relevant inside information before a public announcement, as well as a chronology of the events within the company relevant to the subject matter reflected in the public announcement. FINRA investigations are serious and may merit the assistance of qualified counsel to ensure compliance.

SEC, Department of Justice and State Securities Regulators

Regulators have enforced the securities laws vigorously in recent years. The SEC has brought more enforcement actions and has sought more serious sanctions, including prohibiting directors and officers from serving for public companies and other more severe penalties (such as fines and disgorgement). The SEC has also turned a keen eye to gatekeepers (including chief legal officers) and third parties who aid and abet alleged violations of the securities laws. The Department of Justice has also been more active, bringing hundreds of criminal cases for alleged corporate fraud.

Sarbanes-Oxley and the Dodd-Frank Act give the SEC more resources and powers. Sarbanes-Oxley, for instance, gives the SEC greater authority to bar individuals from serving as officers or directors of public companies, to recover profits earned by insiders before an accounting restatement, and to obtain a freeze order barring an issuer from making certain extraordinary payments during an SEC investigation.

Since 2008, the Madoff fraud and the financial crisis failures have enhanced the SEC’s ability and efforts to investigate, prosecute and vigorously enforce the securities laws.

Create and Monitor an Effective Compliance Program

Companies can be criminally liable for crimes that employees commit in connection with their employment. In determining whether to charge a company for an employee’s wrongdoing, prosecutors and regulators often ask: Did the company have an effective compliance program to detect and prevent violations of law?

Protect your company with a compliance program that:

  •  Includes clear written standards and procedures;
  •  Names a single person or small team responsible for overseeing the compliance program;
  •  Expects the CEO and senior management to set the appropriate tone at the top;
  •  Provides appropriate training at all levels, including the Board and senior management;
  •  Monitors, audits, evaluates and promotes the reporting of potential and actual violations, including a confidential or anonymous reporting mechanism;
  •  Protects attorney-client privileged communications; and
  •  Holds employees accountable for violations of policy or law.

When a possible violation occurs, take prompt and reasonable steps to investigate, remedy or, as appropriate, report the violation.

The Important Role of D&O Insurance

Companies often purchase D&O insurance to protect directors and executive officers (as well as the company itself) from the types of claims and investigations described above. D&O insurance helps provide companies, directors and officers with the resources to defend and resolve such cases. D&O insurance also protects directors and officers from the risk that the company will be unable or unwilling to pay for a defense, settlement or judgment, such as where the company is insolvent or the claims are not subject to indemnification. For these reasons, D&O insurance is an essential element of any strategy to mitigate the litigation and investigation risks confronted by public companies and their directors and officers. There are three common types of D&O insurance. We provide a simple graphic of D&O insurance in Appendix 3.

  • Side A coverage typically covers claims against officers and directors that are not indemnified by the company. Directors and officers can think of this as “worst case” coverage, which will be available to protect them if the company is unwilling or unable to make good on its indemnification obligations.
  • Side B coverage typically reimburses the company for indemnified costs incurred in connection with claims against directors and officers. Because most solvent companies indemnify their directors and officers from such claims, policy payouts often involve this type of coverage.
  • Side C coverage typically applies to claims against the company itself and is limited to securities claims.

D&O insurance policies also routinely cover defense costs, and because D&O insurance policies are wasting policies, the amounts paid for ongoing defense costs in connection with litigation or investigations will reduce the total insurance proceeds remaining for settlement or for payment of a judgment or related expenses. D&O insurance policies are almost always claims-made policies, meaning that coverage is provided for claims made during the policy period, rather than for conduct occurring during that period. As a result, it is essential that the company and the insured directors and officers provide their D&O insurance carriers with prompt notice of any claims that might be covered. Any delay in providing notice could result in a loss of coverage.

Practical Tip:
Be Vigilant – Manage Your Company’s D&O Insurance Program

Ensure that your company’s D&O insurance program provides protection, not only for the company, but for the company’s directors and officers. Then:

  • Review your company’s D&O insurance program annually with your broker and counsel to ensure that the program provides appropriate types and amounts of coverage.
  • Ask how the policies will cover gaps in D&O insurance coverage layers that follow one insurer’s insolvency. Ask how the policy will apply in unusual situations, such as where the company becomes bankrupt or during a governmental investigation.
  • Ask for pricing on a Side A–only D&O insurance program. An insurer offering Side A–only D&O insurance will often be willing to allow its policy to “drop down” to fill a gap caused by the insolvency of an insurer providing a lower layer of insurance.
  • Consider purchasing smaller insurance layers so that your company can fill any small gaps in coverage caused by the insolvency of an insurer.
  • Ask counsel to brief you on the order-of-payment language in any D&O insurance policy. Does it provide that if directors, officers and the company all have simultaneous claims on the policy that exceed the liability limits, the directors and officers are entitled to payment before the company? This can ensure that the policy will not be seen as a company asset in the event that the company enters bankruptcy.
  • Ensure that claims by the company’s bankruptcy trustee are not excluded from D&O insurance coverage under the policy’s likely “insured vs. insured” exception. (This bars coverage claims by one insured party against another.)
  • Ask for confirmation that the policy has appropriate severability language that protects innocent directors and officers in the event one executive officer engages in wrongdoing. Be sure that the policy cannot be rescinded simply based on fraud or misconduct of the CEO or CFO.