It would appear to be in everyone's best interests to encourage qualified financial professionals to serve as an outside director of a public corporation. However, the SEC Division of Enforcement recently announced its intention to target outside directors for "falling asleep at the switch." The SEC then filed a complaint against Chancellor Corporation, which included an outside director as a defendant, who is conceded not to be a direct participant in the alleged accounting fraud.

In effect, the SEC is asserting that this outside director violated the anti-fraud provisions of the federal securities laws "by signing a number of false financial statements and, as an outside director with fiduciary responsibilities, ignoring red flags that financial improprieties were occurring at the company and by failing to ensure that the company's public filings were accurate."

Specifically, the SEC contends that the director signed restatements of financial results which contained misstatements and contradicted earlier statements that he had signed. This appears to be the SEC's first attempt to file a case against an outside director based on allegations that he was reckless in his oversight of management and was asleep at the switch when red flags were waving in his face. There is obviously a question of whether the anti-fraud provisions of the federal securities laws provide a statutory basis for the SEC to pursue directors for negligence or breach of fiduciary duty by reframing the claim as one for aiding and abetting a securities fraud.

Traditionally, claims against directors of corporations sounding in negligence and breach of fiduciary duty are matters of state law. The only exception was that such conduct is actionable under the federal securities laws if the conduct can be viewed as manipulative or deceptive within the meaning of Section 10(b) of the Exchange Act. In contrast, director liability under state law is directly tied into breaches of fiduciary duty. Delaware, which is considered the leading state on issues of director liability, recognizes three types of fiduciary duty: loyalty, care and good faith.

Traditionally, Delaware requires that plaintiffs must overcome a very high threshold to establish director liability. Two decisions rendered in 2003 illustrate the difficulty of this threshold. In a case against the outside directors of Martha Stewart Living Omnimedia, the Delaware Chancery Court dismissed fiduciary duty claims against certain directors holding that the directors had no duty to monitor Martha Stewart in her personal affairs. There would only be liability if "the directors knew or should have known that a violation of the law was occurring" and "the directors took no steps in a good-faith effort to prevent or remedy that situation."

In a suit against the directors of the Walt Disney Company concerning the directors' approval of the employment/severance agreement of Michael Ovitz, the Delaware Chancery Court summarized the deference generally afforded directors and  the high benchmark required to impose liability:

It is rare when a court imposes liability on directors of a corporation for breach of the duty of care, and this Court is hesitant to second-guess the business judgment of a disinterested and independent board of directors. But the facts alleged in the new complaint to not implicate merely negligent or grossly negligent decision making by corporate directors. Quite to the contrary; plaintiffs' new complaint suggests that the Disney directors failed to exercise any business judgment and failed to make a good-faith attempt to fulfill their fiduciary duties to Disney and its stockholders.

The case was allowed to proceed past the pleading stage only because the complaint alleged "knowing and deliberate indifference to a potential risk of harm to the corporation."

In private civil suits filed in the federal courts, courts have also shown an unwillingness to impose liability under the federal securities laws unless the complaint can allege an intent to deceive with the requisite particularity required by the Private Securities Law Reform Act (the "PSLRA"). For example, the WorldCom case addressed potential liability for certain directors who were members of the audit committee who were alleged to have totally missed the massive accounting fraud. Plaintiffs contended that the magnitude of the fraud in conjunction with the directors' duty of oversight to review financial statements, internal controls and filings with the SEC, and certain alleged red flags that arose after the misrepresentations were made, satisfied the scienter requirement of Section 10(b) and the PSLRA. The court rejected each of these theories as a basis for liability under section 10(b).

Similarly, in the Enron civil litigation, the court dismissed claims against certain of Enron's outside directors, based on a failure to adequately plead scienter. The court rejected plaintiff's contention that the minutes of various meetings of the Board of Directors and committees put the directors on actual notice of the accounting fraud.

Even if the SEC's attempt to invade areas that appear to be a matter of state law is rejected by the courts, it does not and should not undermine the duties of the financial professional outside director. Almost always that person is  the head of the audit committee. The director's duty is to utilize the position and the tools now specifically available -- such as the right to use truly independent counsel and outside financial consultants -- to ensure that as a director he or she is asking the appropriate questions. Under the new regulatory scheme, the financial professional outside director is expected to attempt to see and understand warnings and then do the right thing upon learning of any actual or potential financial wrongdoing.

In view of the SEC's new offensive, how much detail should there be in the minutes of the audit committee meetings? Some counsel believe that the minutes should be "bare bones," while others believe that showing what steps you took to discharge your legal responsibilities, what you uncovered, if anything, and what you did about following through on any possible financial improprieties is a better approach. If the audit committee discovers a possible financial impropriety, how much detail should there be in its follow-up? Although this new offensive of the SEC appears to be laudable on its face, it may force audit committees to proceed even more cautiously because their vigilance, without the appropriate remedial action, as such appropriate remedial actions are "defined" by the staff of the Division of Enforcement of the SEC, may substantially increase their potential liability.

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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC.