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Corporate Disclosure and the Role of Outside Directors: SEC v. Krantz (The Board's Obligation to Supervise Internal Investigations) (Part 4) 

Another interesting aspect to the Complaint concerned the internal investigations authorized by the outside directors. 

The Complaint alleges (the outside directors have not settled or otherwise resolved the case so the allegations in the Complaint are unproven) that the outside directors became aware of possible disclosure issues.  One concerned business activity with a related entity (a company allegedly controlled by the CEO).

An  investigation was initiated to look into the matter.  The investigation was conducted by a prominent outside law firm (and eventually a second prominent outside law firm).  The fatal mistake in the eyes of teh Commission was that the outside directors allegedly allowed the CEO to supervise the investigation.  As the Complaint stated:

  • Instead of conducting an independent investigation into [the Company's] relationship with TAP [the controlled company], [the three outside directors] allowed [the CEO] to commission and control an investigation into the issue, which essentially allowed senior management to investigate itself. . .  [The CEO controlled]  inquiry, including the flow of documents and information and access to witnesses.  [The outside directors] were never involved in the investigation.

The CEO also "updated" the Audit Committee on the investigation. 

The report for the investigation ultimately recommended disclosure of the relationship with the controlled entity.  Nonetheless, the Commission viewed the investigative report as incomplete.  As the Complaint alleged:   

  • The report made no findings about the legitimacy or business purpose of the arrangement. It merely noted that [the Company's] "management believes that the prices TAP [the controlled entity] charged were fair prices established in good faith" and based on the information provided (which was provided by [the Company's] management) the firm found no evidence that [the Company's] relationship with TAP was designed to create artificial gains or losses. The report made no findings regarding Brooks' involvement with TAP, or [the Company's] failure to inform its auditors about the arrangement.  [The outside directors] received the law firm's report, but did not question any of the key issues.

Eventually, according to the Complaint, the outside directors learned that the initial law firm had resigned.  The resignation letter (sent to the outside directors) called the firm's report "into question."  The firm indicated that it had "discovered previously undisclosed information about the [Company's relationship with the controlled entity], which raised 'further questions bearing on issues of control and relatedness that warrant further review.'"

A second law firm and consulting firm was hired to look into the issue, with "coordination" left to the CEO.  The Commission also alleged that this process was deficient.  As the Complaint stated:

  • Given that [the CEO] controlled [Consultant's] investigation and the investigation relied upon information he provided, [Consultant's] investigation was not independent and its findings were not reliable. Despite [the first law firm's] resignation and revelation [the CEO] withheld information from [the first law firm], the Audit Committee still allowed [the CEO] to oversee and control [the Consultant's] inquiry into [the controlled entity].

The fact that it was a second firm, in the opinion of the Commission, heightened the duties of the board.  As the Complaint further stated:

  • Even though [the Consultant's] inquiry was conducted on the heels of [the first law firm's] resignation, [the outside directors] did not question or meet with [the Consultant] during its investigation. Nor did they ever question [the CEO] about the parameters of [the Consultant's] investigation, or about the information [the CEO] was providing to [the Consultant]. Moreover, they did not question the report's findings.

The Complaint, therefore, indicates that the antifraud provisions (under theories of secondary liability) may impose a duty on outside directors to adequately supervise internal investigations that could affect the disclosure process. 

For more detail, see the Litigation Release in SEC v. Krantz, Litigation Release No. 21867 (SD Fla Feb. 28, 2011) as well as the Complaint.

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