Reprint permission from the October 6, 2003 issue of Crain's Chicago Business.
Headline-grabbing criminal prosecutors and civil litigators are gunning for high-profile executives of public companies who commit corporate fraud. But, until now, subservient directors who do nothing wrong but ignore wrongdoing have skated.
All of that is about to change: Complicit outside directors are soon likely to earn the comeuppance they deserve.Amid more controversy than is really warranted, the Securities and Exchange Commission (SEC) is finally starting to crack down on reckless directors who don't happen to be company employees or significant stakeholders and, for that reason, never profited from corporate chicanery. The shift in the agency's enforcement policy is a healthy signal to public companies and their directors that board service is a real job with real responsibilities.
The SEC's first federal lawsuit against an allegedly sleeping watchdog targets Rudolph Peselman, a former outside director of Chancellor Corp., a Boston-based transportation equipment company.
The agency's complaint asserts that Mr. Peselman, while a member of the board's audit committee, broke securities laws by signing false financial statements, disregarding warnings of financial improprieties at the company and failin g to ensure that the company's public filings were accurate. Along with Chancellor's controlling shareholder and others, he is accused of cooking the company's books and grossly overstating its revenue, income and assets.
Here's the back story, gleaned from public records:
Chancellor canned its independent auditor because it didn't agree with the way the company recognized revenue, then hired another auditing firm, which was willing to sign off on the suspect financial statements prepared by the company's management. The sacked auditor also disputed the way Chancellor's management handled $1 million in payments to other companies controlled by its then-CEO.
The SEC claims that Mr. Peselman knew why the auditor was replaced but still approved the financials — in the agency's view, breaching his fiduciary duty to the company. Mr. Peselman has denied any violation of law.
According to press reports, Stephen Cutler, the commission's enforcement chief, sees the case against Mr. Peselman as a model for enforcement actions against corporate board members who aren't directly involved in fraud, but fail to prevent or report it.
And that's where the controversy comes in.
Some legal authorities, citing ancient federalism principles grounded in the U.S. Constitution, have argued that directors' conduct should be policed only by the states, which have historically exercised that authority, and not by the SEC. And if directors are also going to be held accountable to the feds, some commentators fear that it will become tougher than ever to recruit capable directors.
But the jurisdictional turf warriors should hold their fire. The SEC needs to act boldly and autonomously in protecting shareholders and, ultimately, the integrity of the capital markets.
However tough it becomes to recruit and retain competent directors, shareholders have the absolute right to demand that board members protect them from executives who are scoundrels or fools. Directors who don't direct, those who are ineffective at countering arrogant managers who lose their moral bearings, invite questionable practices in executive suites.
There is simply no room for compromise.
Marc J. Lane ([email protected]) is a Chicago lawyer and financial planner and an adjunct professor of law at Northwestern University School of Law.
Copyright © 2003 by Crain Communications Inc.