The frequency and fervor of SEC enforcement actions against directors and officers are at record levels and will likely only get worse in the future. This is not only increasing the financial and reputational exposure of the directors and officers who become targets of the SEC, but is also increasing the risk presented by, and complexities of defending, any related securities class action litigation.

This new era of SEC vigilance is a direct result of the strong criticism the SEC received for failing to identify sooner the Madoff and Stanford Ponzi schemes, failing to require earlier disclosures of facts underlying the subprime and related credit crisis disaster, and failing to pursue executives of the large financial institutions that contributed to the credit crisis. In response to this criticism, the SEC now appears committed to restoring its reputation as an effective and aggressive enforcer of the federal securities laws. To better equip the SEC in those heightened enforcement efforts, Congress granted to the SEC greater enforcement powers in the so-called Dodd-Frank Act and significantly increased funding for the SEC. Now, the SEC enforcement staff is much larger, and the SEC enforcement activities appear to be much more thorough and aggressive.

The practical consequences of these developments to directors and officers and their insurers are discussed in this article.

Increased SEC Enforcement Powers

The Dodd-Frank Wall Street and Consumer Protection Act (Dodd-Frank Act) bestowed on the SEC unprecedented responsibilities and powers. In addition to the more than ninety provisions that require SEC rulemaking, the Dodd-Frank Act strengthened the SEC enforcement activities in three important ways. First, the Act now permits the SEC to seek monetary penalties in an SEC administrative proceeding. Previously, the SEC could obtain only a cease and desist order in such a proceeding, which required the defendant to cease further violations of the securities laws. If the SEC wanted to collect money from the defendant in the form of penalties or otherwise, the SEC previously was required to file a lawsuit in U.S. District Court. Now, the SEC can recover monetary penalties in a less formal administrative proceeding.

This change in the law is important because directors and officers can now become personally liable for potentially large sums of money in a forum clearly tilted in favor the SEC. For example, the defendants in this type of administrative proceeding have fewer discovery rights than in federal court, and the administrative judge who decides the case is employed by the SEC.

Second, under the Dodd-Frank Act, the SEC can more easily prosecute a claim against directors and officers for aiding and abetting a securities law violation. Prior to the Dodd-Frank Act, the SEC had to prove a director or officer had actual knowledge that someone was violating the federal securities laws in order to hold the director or officer liable for aiding and abetting that securities law violation. The Dodd-Frank Act substantially decreased the SEC's burden of proof in aiding and abetting claims by requiring the SEC to merely prove the director or officer was reckless in not knowing of the violation.

This change in the law is significant because the SEC (unlike private plaintiffs) can prosecute an aiding and abetting claim against directors and officers for someone else's violation of the securities laws. This new reckless standard has applied to lawsuits by shareholders for direct violations of the securities laws for several decades and has been a relatively easy burden for civil plaintiffs to satisfy. As a result, it is likely the SEC will bring more aiding and abetting claims against directors and officers and will more frequently recover money from directors and officers in those claims.

Third, and perhaps most troubling, the Dodd-Frank Act required the SEC to adopt rules for the implementation of a robust whistleblower program that is intended to incentivize company employees and third parties to identify and disclose to the SEC illegal conduct within the company. Those new SEC rules, which became effective in August 2011, allow a whistleblower who voluntarily provides to the SEC new information that leads to the SEC obtaining monetary sanctions exceeding $1 million to recover up to 30 percent of those sanctions. Since the new rules became effective, the number of whistleblower disclosures to the SEC has increased significantly and will likely result in a larger number of SEC investigations and proceedings against directors and officers who are identified by whistleblowers as committing wrongdoing.

The net effect of these Dodd-Frank provisions is a sobering message: directors and officers are more vulnerable to SEC enforcement actions than ever before.

Increased SEC Enforcement Activity

The Dodd-Frank Act also increased the SEC's funding by an extra $1.3 billion for 2011 and approved further budget increases in future years which will result in up to $2.25 billion of increased funding by 2015. Not surprisingly, this enormous additional investment in SEC activities has resulted in a significant increase in the size and capabilities of the SEC enforcement staff and a record number of enforcement actions being filed by the SEC. For the fiscal year ending September 30, 2011, the SEC filed a record 735 enforcement actions, which resulted in more than $2.8 billion in penalties and disgorgement. These cases target all types of securities law violations, including financial fraud and insider trading by directors and officers.

Not only is the number of proceedings increasing, the SEC's success rate in the proceedings that are filed is remarkably high. For each of the last several years, the SEC has successfully resolved in its favor more than 90 percent of all proceedings filed.

In other words, the SEC is now a well-funded, aggressive, and formidable opponent for any director or officer who is targeted by the SEC.

Increased SEC Negligence Claims

One of the most disturbing trends in SEC enforcement activity is the apparent new strategy by the SEC to prosecute enforcement claims based upon a negligence theory rather than proving intentional wrongdoing or recklessness. In the past, although the SEC had the legal authority to assert claims for direct violation of the securities laws based upon negligence, it very rarely did so. However, in late 2011, senior SEC officials stated publicly that the SEC would more frequently be asserting negligence-based claims. This new strategy has been described by commentators as a “major shift” from past enforcement philosophy and places many more directors and officers at risk since seemingly innocent mistakes may now give rise to an SEC proceeding.

The decision to pursue more negligence-based claims presumably grew out of the SEC's inability to find evidence of intentional or reckless fraud by executives of many of the financial institutions that contributed to the credit crisis. To date, most of the negligence-based proceedings brought by the SEC have been against executives of financial institutions. Whether the SEC will limit this broad legal theory to only that industry remains to be seen. However, it is a frightening notion that the SEC, which is motivated by a unique set of priorities, incentives, and political pressures, is now willing to subject at least some directors and officers to potentially severe financial and reputational consequences not for perpetrating frauds but for making a mistake. Particularly in the context of financial reporting by a large company, proving negligence by the CEO or CFO may be relatively easy.

Impact on Securities Class Actions

If the SEC is investigating a company or its directors and officers for possible violations of securities laws, there is a high likelihood the plaintiffs' bar will file a securities class action lawsuit based on the same circumstances. The existence of and developments in the SEC proceeding typically add complexity and additional risks to the defense of the related securities class action for several reasons.

First, plaintiffs' lawyers view an active SEC investigation as one of several factors they believe increase the value of their securities class action. The SEC's involvement tends to add credibility to plaintiffs' allegations and may allow the plaintiff lawyers to ride the coattails of the SEC's enforcement efforts. Plus, the SEC proceeding further incentivizes the plaintiff lawyers to seek higher recoveries in the class action in order to avoid criticism for underpricing the class action settlement if the SEC later proves wrongdoing.

Second, SEC investigations and proceedings can be extremely time-consuming and expensive to defend, thereby diverting management's limited time and insurance resources from defending the securities class action. In addition, it is virtually impossible to settle the class action and resolve the SEC proceeding at the same time since both matters are independently prosecuted. Frequently, the defendants settle the securities class action prior to resolving the SEC matters, in which case the defendants and their insurers do not obtain global peace despite the payment of a potentially very large class action settlement. If the class action settlement erodes a large portion of the available D&O insurance, the defendant D&Os can be left with inadequate insurance to properly defend and resolve the SEC proceeding.

Impact on D&O Insurance and Indemnification

SEC proceedings create a meaningful risk that directors and officers will not have adequate insurance and indemnification protection for either the SEC proceeding or the related securities class action. There are two primary reasons for this risk. First, more SEC proceedings go to trial than securities class actions, which means there is a higher risk the “final adjudication” trigger in the D&O policies' conduct exclusions will be invoked in SEC proceedings than in securities class actions. Once those exclusions are triggered with respect to a director or officer, that defendant director or officer not only loses coverage for his or her future defense costs and other loss, but is also liable to repay to the insurer defense costs previously advanced by the insurer in connection with his or her defense of both the SEC proceeding and the securities class action.

Second, the settlement dynamics in SEC proceedings can be very problematic for the defendant director or officer. Although a settlement with the SEC can avoid the risk of the conduct exclusions applying, the defendant director or officer may be unable or unwilling to settle the SEC charges since the SEC frequently demands more than just money in its settlement. For example, the SEC may insist upon a bar order which prevents the director or officer from serving as a director or officer of any public company for a defined time period or may insist upon certain admissions by the defendant director or officer which would seriously taint his reputation and future employment opportunities. In addition, as an increasingly popular condition to the settlement, the SEC may insist that the director or officer agree not to accept any indemnification or insurance to fund the monetary portion of the settlement. Obviously, that type of provision severely reduces the willingness and ability of the defendant director or officer to settle with the SEC.

Given these complexities, directors and officers should reevaluate whether the amount and structure of their D&O insurance program are adequate. The amount of limits purchased should reflect not only anticipated defense costs and worst case settlement scenarios in securities class action and derivative lawsuits but also potentially very large defense costs by multiple directors and officers in an SEC investigation and proceeding. Unlike in private litigation where several directors and officers are frequently represented by the same defense counsel, each director and officer in an SEC proceeding usually insists on separate defense counsel, thus increasing dramatically the amount of defense costs payable under the D&O insurance program.

D&O Insurance Planning Issues

Several coverage issues can arise under D&O insurance policies relating to SEC investigations and proceedings. The following discussion explains how those issues can be minimized or eliminated when purchasing a D&O insurance program.

1.Definition of Claim. Most D&O policies define a “claim” to include not only a civil or criminal proceeding, but also a regulatory or administrative investigation and proceeding. For purposes of entity securities coverage under Side C, D&O policies typically exclude from the definition of “claim” regulatory or administrative proceedings or investigations against the company, although some policies afford entity coverage for such proceedings if the proceeding is also against a director or officer.

The inclusion of regulatory or administrative investigations in the definition of “claim” is not a guarantee of D&O coverage for those investigations. Pursuant to the insuring agreement in the D&O policy, coverage exists only for certain claims (including investigations) made against Insured persons for wrongful acts. This provision can limit coverage for SEC investigation costs in several contexts. First, the investigation must target Insured Persons for alleged wrongdoing. In its early stages, an SEC investigation frequently does not identify a target of the investigation or specific alleged wrongdoing, and therefore may not constitute a claim against an insured person for a wrongful act. Even if the SEC issues a subpoena to a director and officer, that subpoena may simply seek to obtain information and documents from the director and officer as a witness and does not necessarily mean that the SEC is targeting that individual or is alleging that individual committed any wrongdoing.

To solve that coverage issue, most Side-A D&O policies (and some ABC D&O policies) now contain a provision that affords coverage for costs incurred by a director or officer as a fact witness in an investigation. That provision includes within the definition of “claim” any request by a regulatory or administrative authority to interview or depose an insured person or to produce documents, even if the insured person is not a target of the investigation or alleged to have done anything wrong. That type of provision can afford valuable protection for directors and officers in the early stages of an SEC investigation when it is unclear who will become the focus of the investigation.

2. Loss Incurred by Insured Persons. Two coverage issues may arise in SEC investigations or proceedings relating to what is covered loss. First, pursuant to the insuring agreements and the definition of “loss” in the D&O policy, coverage is afforded only for certain costs or “legally obligated to pay.” Frequently, counsel and other experts retained to respond to a regulatory investigation are retained by the company and represent only the company. In that case, directors and officers would have no obligation to pay the fees and expenses incurred by the counsel or expert. Because no entity coverage typically exists under the D&O policy for SEC investigations, those fees and expenses incurred by the company would not be a covered loss under the policy. A company's obligation to indemnify its directors and officers does not change that coverage result since indemnification law, like the D&O policy, requires the director or officer to be legally obligated to pay the amount which is purportedly being indemnified. However, if a director or officer personally retains legal counsel or hires experts to respond to an investigation otherwise covered under the policy, the fees and costs of such counsel or expert should be loss under the policy.

Some companies may be surprised and disappointed to learn that costs incurred by the company in responding to an SEC investigation are not covered under the D&O policy even though the company's response to the SEC may ultimately benefit the defense of directors and officers. But the lack of coverage under the D&O policy for such costs is consistent with the underlying purpose and premise of D&O insurance. Those investigation costs by the company are, in many instances, business expenses incurred by the company that should not erode coverage afforded under the D&O policy for claims against directors and officers.

Second, the definition of “loss” in D&O policies typically excludes “fines or penalties imposed by law.” One of the main sanctions imposed in SEC proceedings is a fine or penalty. As a result, many times defense costs are the only insured loss incurred by directors and officers in an SEC investigation or proceeding. But, some D&O policies today include a provision that applies the fine or penalty exclusion only to fines or penalties for intentional or willful violations of law, thereby affording coverage for fines or penalties resulting from unintentional and nonwillful violations. This type of provision can be an important coverage enhancement in light of the increased likelihood of claims by the SEC for negligence and recklessness, as previously described.

Conclusion

SEC enforcement activities now create unprecedented risks, exposures, and challenges for directors and officers. As a result, the terms and structure of D&O insurance programs need to be reevaluated to assure that directors and officers have maximum financial protection. For example, larger limits of liability may be appropriate, and the definitions of “claim” and “loss” may need to be revised to properly address SEC-related exposures. Because many ABC D&O policies afford entity coverage for SEC proceedings (not SEC investigations), additional Side-A limits should also be considered to protect against excessive erosion of the D&O insurance program limits by the often enormous company defense costs in SEC proceedings.