Number 1161
March 10, 2011
Client Alert
Latham & Watkins
Litigation Department
SEC v. Krantz: Liability of Outside Directors
in SEC Enforcement Actions
“The case against
the DHB directors
provides a useful
primer on what
the SEC believes
outside directors
should and should
not do when
confronted with
red flags.”
Outside directors are rarely charged in
corporate fraud actions brought by the
Securities and Exchange Commission
(SEC, or the Commission). Recently,
however, in SEC v. Krantz, Chasin,
and Nadelman, the SEC charged three
outside directors with fraud for failing to
take reasonable steps in response to red
flags signaling management misconduct
relating to an accounting fraud by
a public company.1 The SEC further
alleged that the directors enabled the
company’s former CEO to divert at
least $10 million from the company for
personal gain. While the facts of Krantz
are extreme, the case nevertheless
provides important insight into the
SEC’s views on how independent
directors should respond to evidence of
management misconduct.
The Evolving Views of
the SEC on the Oversight
Responsibilities of
Independent Directors
For more than 35 years, the SEC
has made clear its view that outside
directors must make themselves familiar
with the corporation’s public disclosures
and accounting practices and must
investigate “red flags” that come to
their attention indicating that the
corporation’s public disclosures may be
false or misleading. In many corporate
fraud cases over the years, however,
particularly before the frauds at Enron
and WorldCom, the Commission chose
not to charge outside directors for failing
to take reasonable steps, as opposed
to committing affirmative bad acts,
but instead chose to admonish them
(and warn their counterparts in other
companies) in reports issued pursuant to
Section 21(a) of the Securities Exchange
Act of 1934 (the Exchange Act).2 Even
post-Enron and WorldCom, SEC cases
charging outside directors for failing to
heed red flags remain rare. Against this
backdrop, any SEC enforcement action
against outside directors for failing to
take reasonable steps is noteworthy and
educational.
The SEC’s first action against an
outside director for failing to take
reasonable steps came in 2003 when it
sued an outside director of Chancellor
Corporation, Rudolph Peselman, for
financial fraud.3 Peselman, who served
on Chancellor’s audit committee,
had allegedly failed to take steps to
determine whether management’s
position on the accounting for a
transaction was correct despite there
being a disagreement between
management and the company’s
auditors, and had allowed Chancellor
to replace the auditors over the
disagreement.4 According to thenSEC Enforcement Director Stephen
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Cutler, Peselman was “reckless in [his]
oversight of management and asleep
at the switch.” Cutler called the case
the “first salvo” against board members
who ignore misconduct and said the
Commission would use the Peselman
case as a model.5
Three years later, in 2006, the SEC
charged two outside directors of Spiegel,
Inc. in connection with the decision to
withhold required financial reports to
avoid issuance of a “going concern”
opinion by the company’s auditors.6
Four years after that, in March 2010, the
SEC filed charges against the former
chairman of infoGROUP Inc.’s audit
committee for failing to take appropriate
action with respect to “significant
red flags” related to the company’s
failure to disclose millions of dollars
in compensation and other benefits
provided to the CEO.7 Allegedly,
the outside director had failed to
appropriately investigate the CEO after
serious questions were raised.
SEC v. Krantz
The Commission’s most recent case in
this area came on February 28, 2011,
when the SEC filed fraud charges
against Jerome Krantz, Cary Chasin, and
Gary Nadelman, three former outside
directors and audit and compensation
committee members of DHB Industries,
Inc. (DHB or the Company), a supplier
of body armor to the military and law
enforcement.8 The SEC is seeking fraud
injunctions, disgorgement of ill-gotten
gains, monetary penalties, and officer
and director bars against Krantz, Chasin
and Nadelman. At the same time that
it filed the litigated action against the
three former directors, the SEC filed a
settled enforcement action against DHB.9
The SEC alleges that DHB, through its
senior executive officers, engaged in
accounting and disclosure fraud and
misappropriation of company assets
that resulted in the Company filing
materially false and misleading periodic
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Number 1161 | March 10, 2011
reports with the SEC. Ultimately, the
Company was compelled to file for
bankruptcy.
The cases against the Company and
the former directors are only the most
recent actions involving the financial
fraud at DHB. Beginning in 2006, the
SEC and the Department of Justice
(DOJ) charged DHB’s former CEO
David Brooks (a recidivist securities
law violator) and two other former DHB
senior officers for their roles in the fraud.
Last year, following an eight-month
trial, Brooks was found guilty of insider
trading, fraud and obstruction of justice.
Brooks was also found guilty of lying to
the Company’s auditors.10
The pervasive misconduct at DHB
is detailed in a series of charging
documents filed by the SEC and the
DOJ as well as the company’s own
filings and a Second Circuit opinion
rejecting the settlement of a derivative
case filed against the DHB Board.11
Briefly, from at least 2003 through 2005,
senior management at DHB engaged
in widespread accounting fraud,
disclosure fraud and misappropriation
of Company assets. DHB lacked
adequate internal accounting and
financial reporting controls. As a
result, senior management was able to
manipulate DHB’s gross profit margins
and earnings by overstating inventory
values, falsifying journal entries and
failing to include appropriate charges
for obsolete inventory. DHB’s lack of
internal controls also enabled Brooks to
funnel at least $10 million out of DHB
through fraudulent transactions with a
related entity he controlled. Brooks and
others also misappropriated millions
from the Company through the use of
Company funds to pay for personal
expenses, including luxury cars, jewelry,
extravagant vacations, prostitutes and
Brooks’ horse racing empire. In 2007,
DHB restated its financial results for
2003, 2004 and 2005, which eliminated
all of DHB’s previously reported 2003
and 2004 profits.
Latham & Watkins | Client Alert
As charged by the SEC, another reason
that Brooks and the other two senior
managers guilty of criminal fraud
were able to carry out their scheme
for three years was a failure by DHB’s
three non-management directors
“to carry out their responsibilities as
‘independent’ directors and Audit and
Compensation[] Committee members”
because they “were willfully blind
to numerous red flags signaling
accounting fraud, reporting violations
and misappropriation at DHB. Instead,
as the fraud swirled around them, they
ignored the obvious and merely rubberstamped the decisions of DHB’s senior
management while making substantial
sums from sales of DHB’s securities.”
The SEC’s complaint against Krantz,
Chasin and Nadelman describes a
number of red flags that should have
put the outside directors on notice
of the misconduct. For instance,
DHB’s then-auditors issued a material
weakness letter to the Audit Committee
concerning DHB’s internal controls
over financial reporting, particularly
with respect to inventory. When that
audit firm resigned,12 DHB’s new
auditors also identified multiple internal
control deficiencies. The directors also
learned that DHB’s then-controller had
concerns over the Company’s inventory
valuation and had resigned. Despite
these concerns raised by the Company’s
auditors and controller, Krantz, Chasin
and Nadelman allegedly failed to
take any meaningful actions. Further,
the directors were aware of specific
allegations about DHB’s undisclosed
related-entity transactions through
a company that Brooks controlled.
Instead of conducting an independent
investigation, the SEC alleges that
Krantz, Chasin and Nadelman “allowed
Brooks to commission and control an
investigation into the issue, which
essentially allowed senior management
to investigate itself.” The law firm
that Brooks hired ultimately resigned
and called into question its report of
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Number 1161 | March 10, 2011
the investigation based on previously
undisclosed information. Brooks
thereafter hired a second law firm
and a consulting firm to investigate
the issue, again controlling the
investigation. Brooks subsequently fired
the consulting firm when it questioned
his personal expenses. The directors
also became aware that the SEC had
subpoenaed DHB for documents and
requested information regarding
the company that Brooks controlled.
Despite the resignations of the auditors
and law firm, Brooks’ termination of
the consulting firm and several SEC
subpoenas and request letters, Krantz,
Chasin and Nadelman allegedly
“continued to ignore these numerous
red flags” and failed to take reasonable
steps to address them.
The SEC’s complaint further alleges
that Krantz, Chasin and Nadelman
“willfully ignored red flags because of
their loyalty to Brooks and their own
self-interest” and “lacked impartiality
to serve as independent Board or Audit
Committee members.” The three outside
directors were longtime friends and
neighbors of Brooks and had personal
relationships with Brooks that spanned
decades. Further, they each had
business relationships with Brooks that
allegedly influenced their impartiality
and independence. Krantz served as the
insurance agent for DHB and Brooks’
family while also serving as a board
member. Chasin and his family went
out to dinner with Brooks and his family
two or three times a month. Chasin also
worked for DHB for a few months on
two occasions prior to joining DHB’s
board and each time Chasin was paid
approximately $100,000. Nadelman and
his family regularly attended Brooks’
family social functions and he was a
significant investor in one of Brooks’
private companies. The complaint
further alleges that the outside directors
were influenced by Brooks’ wealth and
the perks that he provided to them,
including lucrative stock warrants
Latham & Watkins | Client Alert
and seats to DHB’s skybox at Madison
Square Garden, which Brooks told the
directors they could use to help their
outside businesses.
Implications for Public
Company Outside Directors
As alleged, the failures charged put the
DHB outside directors on the wrong end
of the continuum of directors’ failures
to respond reasonably to red flags.
Nevertheless, despite the extreme facts,
the case against the DHB directors
provides a useful primer on what the
SEC believes outside directors should
and should not do when confronted with
red flags. In Krantz, as in Chancellor,
Spiegel, and infoGROUP, the SEC
focused on the fact that the directors
ignored red flags indicating significant
misconduct by senior management.
Clearly, it is critical for directors to take
appropriate action when the apparent
misconduct of senior management
comes to their attention.
Of course, in addition to SEC
enforcement actions, directors may face
liability to shareholders for failing to
take reasonable steps in response to red
flags. Outside directors are routinely
named as defendants in shareholder
derivative lawsuits asserting claims
for breaches of the duties of care and
loyalty and less frequently named as
defendants in securities fraud class
actions. The Delaware Supreme Court
has explained that “[w]here directors
fail to act in the face of a known duty to
act, thereby demonstrating a conscious
disregard for their responsibilities, they
breach their duty of loyalty by failing
to discharge that fiduciary obligation in
good faith.”13
Krantz also illustrates how critical it is
for outside directors to maintain their
independence from management in
fact and appearance. When C-suite
misconduct occurs and the SEC learns
that outside directors have close
personal or business ties to senior
officers, the SEC will closely scrutinize
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Number 1161 | March 10, 2011
the directors’ oversight of management
and response to any red flags. Delaware
law provides useful guidance on
the standard for evaluating director
independence. The Delaware courts
have said that the mere existence of a
personal or business relationship with
management does not compromise an
outside director’s independence, but
certain friendships or business dealings
may suggest that a director is incapable
of acting in the best interests of the
company. “At bottom, the question
of independence turns on whether a
director is, for any substantial reason,
incapable of making a decision with
only the best interests of the corporation
in mind.”14
The Commission gives credit for selfpolicing and cooperation in considering
whether to bring an enforcement
action, what charges it brings and what
sanctions it seeks. As set forth a decade
ago in the Seaboard Report, the SEC
will consider, among other things, what
steps the company took upon learning
of misconduct to resolve the issues and
ferret out the information necessary to
learn the truth fully and expeditiously.15
When the facts indicate possible
misconduct by senior management,
Seaboard suggests that the Board
needs to consider carefully whether a
committee consisting solely of outside
directors should oversee and perform
the review and that where appropriate,
that committee should hire outside
persons to perform the review who have
no previous ties to the company. Section
10A of the Exchange Act, as amended
by the Sarbanes-Oxley Act of 2002,
provides that audit committees have
the authority to engage independent
counsel and other advisers as they
determine is necessary to carry out their
duties.16 Further, public companies must
provide for appropriate funding, as
determined by the audit committee in its
capacity as a committee of the board of
directors, for payment of compensation
to any advisers employed by the audit
committee.17
Latham & Watkins | Client Alert
More recently, in early 2010, the SEC
introduced new cooperation initiatives
that provide further guidance to
directors in the event of unlawful
conduct by management. The initiatives
include cooperation agreements,
deferred prosecution agreements
and non-prosecution agreements.18 In
December 2010, the SEC entered into
its first non-prosecution agreement
with a company, in a matter involving
children’s clothing marketer Carter’s,
Inc. The SEC explained that the
agreement “reflects the relatively
isolated nature of the unlawful conduct,
Carter’s prompt and complete selfreporting of the misconduct to the
SEC, its exemplary and extensive
cooperation in the investigation,
including undertaking a thorough and
comprehensive internal investigation
and Carter’s extensive and substantial
remedial actions.”19
What Outside Directors
Should Do When Red Flags
Appear
Taken together, the SEC’s Seaboard
Report and the cases against
independent directors from Chancellor
in 2003 to Krantz in 2011 provide
a useful review of the SEC’s views
on what outside directors should do
when red flags suggest a potentially
significant problem with management
misconduct that could call into question
the company’s financial statements
or other disclosures. First, the outside
directors should determine whether
the allegations are sufficiently serious
and credible that Board oversight is
necessary and appropriate. If the answer
is yes, either the audit committee or
another Board committee exercising
their business judgment, with assistance
of independent counsel as needed,
should:
• Determine whether to engage counsel
to represent the company in the
matter.
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Number 1161 | March 10, 2011
• Determine whether the matter poses
sufficiently small risk that it can be
investigated internally (by internal
audit, for example) or whether the
committee should retain experienced
outside counsel to conduct an
investigation.
• If the committee retains outside
counsel, consider whether the
circumstances allow the use of
counsel previously engaged by the
committee or company or whether
fresh counsel are required.
• Discuss with outside counsel whether
forensic investigators should be
retained to assist counsel.
• Determine whether and when
the matter should be reported
to regulatory authorities and/or
prosecutors.
• Refrain (as a committee or
individually) from approving SEC
filings and other public disclosures
before addressing all material red
flags.
Responding to the New SEC
Whistleblower Regime
We also suggest that all directors of
companies subject to the US federal
securities laws pay close attention to the
SEC whistleblower regime established
by The Dodd-Frank Act of 2010.
Effective July 21, 2010, the date DoddFrank was enacted, whenever eligible
individuals voluntarily provide the
Commission with original information
that leads to an SEC enforcement
action resulting in monetary sanctions
exceeding one million dollars, the
Commission is required to pay one or
more of the whistleblowers a total of 10
to 30 percent of monies recovered in the
SEC enforcement action and any related
actions by the DOJ, US bank regulators,
US self-regulatory organizations and
US state attorneys general in a criminal
case.20 While the final SEC rules for
whistleblowers remain to be adopted,
the Dodd-Frank whistleblower award
and anti-retaliation systems are already
in effect. Boards should not wait until
Latham & Watkins | Client Alert
the final rules are in place before
reacting to the new challenges. We
suggest the following steps:
• Ensure that hotline systems
implemented in response to SarbanesOxley are operating effectively and
have provisions for anonymity, where
allowed. If your company operates in
countries where anonymous hotlines
are restricted, implement separate
hotlines for those countries tailored to
local requirements.
• Ensure that the organization is
prepared to respond to complaints
in a timely and appropriate
manner. This includes making early
case assessments, involving the
appropriate individuals in the process,
resolving complaints quickly and
accurately and tracking complaints
from initial contact through
investigation and resolution.
• Initiate a robust training and
communications effort to ensure that
employees know what and how to
report internally and that they are
aware of the protections given to
good-faith reporters.
• Ensure that best anti-retaliation
practices are implemented throughout
the organization, including at all
consolidated subsidiaries wherever
located.
• Ensure that developments are
monitored so that when final SEC
whistleblower rules are issued, the
company’s policies, procedures,
training and communications can be
appropriately amended.
Endnotes
1
Litigation Release No. 21867 (Feb. 28, 2011).
2
See, e.g., Report Concerning the Conduct of
Certain Former Officers and Directors of W.R.
Grace & Co., Exch. Act Release No. 39157
(Sept. 30, 1997); Report on the Conduct of the
Board of Directors of The Cooper Companies,
Inc., Exch. Act Release No. 35082 (Dec.
12, 1994); Report in the Matter of National
Telephone Co., Exch. Act Release No. 14380
(Jan. 16, 1978); Report in the Matter of Stirling
Homex Corp., Exch. Act Release No. 11516
(July 2, 1975). Section 21(a) authorizes the SEC
6
Number 1161 | March 10, 2011
to issue “Reports of Investigation” articulating its
views on conduct without bringing charges.
3
Christopher Cox, Chairman, SEC, Remarks
at Corporate Directors Forum (Jan. 31, 2006),
available at http://www.sec.gov/news/speech/
spch013106cc.htm.
4
SEC v. Chancellor Corp., No. 03-10762 MEL (D.
Mass. filed Apr. 24, 2003); Litigation Release No.
18104 (Apr. 24, 2003).
5
Bloomberg, SEC to Target ‘Reckless’ Directors
in Fraud Cases, Cutler Says (Aug. 20, 2003),
available at http://www.bloomberg.com/apps/new
s?pid=newsarchive&sid=a6uDwWeMCtRM&refer
=us%20.
6
SEC v. Crusemann and Otto, No. 06-CV-5969
(N.D. Ill. filed Nov. 2, 2006); In the Matter of
Horst Hansen, SEC Admin. Proc. No. 3-12470
(Nov. 2, 2006); Litigation Release No. 19897
(Nov. 2, 2006).
7
SEC v. Raval, No. 8:10-cv-00101 (D. Neb. filed
Mar. 15, 2010); Litigation Release No. 21451
(Mar. 15, 2010).
8
SEC v. Krantz, Chasin, and Nadelman, No.
0:11-cv-60432-WPD (S.D. Fla. filed Feb. 28,
2011); Litigation Release No. 21867 (Feb. 28,
2011).
9
SEC v. DHB Indus., Inc., No. 0:11-cv-60431-JIC
(S.D. Fla. filed Feb. 28, 2011); Litigation Release
No. 21867 (Feb. 28, 2011).
10
11
Press Release, U.S. Attorney’s Office, Eastern
District of New York, David H. Brooks, Founder
and Former Chief Executive Officer of DHB
Industries, Inc. and Sandra Hatfield, Former
Chief Operating Officer, Convicted of Insider
Trading, Fraud, and Obstruction of Justice (Sept.
14, 2010), available at http://www.justice.gov/
usao/nye/pr/2010/2010sep14.html.
See, e.g., U.S. Attorney’s Office, Eastern
District of New York, David H. Brooks, Founder
and Former Chief Executive Officer of DHB
Industries, Inc. and Sandra Hatfield, Former
Chief Operating Officer, Indicted for Insider
Trading, Fraud, Obstruction of Justice, and Tax
Evasion (Oct. 25, 2007), available at http://www.
justice.gov/usao/nye/pr/2007/2007oct25.html;
DHB Industries, Inc., Form 10-K (filed Oct. 1,
2007), available at http://www.sec.gov/Archives/
edgar/data/899166/000119312507210399/d10k.
htm; In re DHB Industries Inc. Derivative Litig.,
622 F.3d 188 (2d Cir. 2010).
12
The auditors who replaced this audit firm
ultimately resigned as well, following DHB’s filing
of its 2004 annual report with the SEC without
the auditors’ permission.
Latham & Watkins | Client Alert
13
Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)
(adopting the standard articulated in In re
Caremark Int’l Inc. Derivative Litig., 698 A.2d 959
(Del. Ch. 1996)).
14
In re Oracle Corp. Derivative Litig., 824 A.2d
917, 938 (Del. Ch. 2003) (internal quotation and
citation omitted) (emphasis in original).
15
Report of Investigation Pursuant to Section 21(a)
of the Securities Exchange Act of 1934 and
Commission Statement on the Relationship of
Cooperation to Agency Enforcement Decisions,
Exchange Act Release No. 44969 (Oct. 23,
2001) (“Seaboard Report”). U.S. Sentencing
Guidelines also offer reduced criminal penalties
to companies that have effective compliance
programs and take reasonable steps to respond
to misconduct.
16
15 U.S.C. § 78f(m)(5).
17
15 U.S.C. § 78f(m)(6).
18
Press Release, SEC, SEC Announces Initiative
to Encourage Individuals and Companies to
Cooperate and Assist in Investigations (Jan. 6,
2010), available at http://www.sec.gov/news/
press/2010/2010-6.htm.
19
Press Release, SEC, SEC Charges Former
Carter’s Executive with Fraud and Insider
Trading (Dec. 20, 2010), available at http://www.
sec.gov/news/press/2010/2010-252.htm.
20
The Dodd-Frank whistleblower provisions are
primarily clustered in Section 922 of the Act,
which added new Section 21F to the Exchange
Act. See 15 U.S.C. § 78u-6.
7
Number 1161 | March 10, 2011
If you have any questions about this
Client Alert, please contact one of the
authors listed below or the Latham
attorney with whom you normally
consult:
William R. Baker III
+1.202.637.1007
william.baker@lw.com
Washington, D.C.
Lawrence A. West
+1.202.637.2135
lawrence.west@lw.com
Washington, D.C.
Brian D. Nysenbaum
+1.202.637.2343
brian.nysenbaum@lw.com
Washington, D.C.
Brian G. Cartwright
+1.202.637.2274
brian.cartwright@lw.com
Washington, D.C.
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