Corporate Governance

In re: DHB Industries, Inc. Derivative Litigation ? SOX § 304, Power lies with SEC

By Charles Nichols

In a win for the Securities and Exchange Commission ('SEC') and Department of Justice ('DOJ'), the Second Circuit Court of Appeals, reversed a settlement in a shareholder derivative case against DHB Industries, Inc. ('DHB') because the settlement "impermissibly releases and indemnifies DHB's former Chief Executive Officer and Chief Financial Officer against all liability arising under § 304 of the Sarbanes-Oxley Act".  Section §304 requires a CEO and CFO to rimburse an issuer for performance based compensation following a restatement due to the material noncompliance of the issuer.  See 15 U.S.C. § 7243. 

The settlement arose out of allegations relating to DHBs decline in share prices following news that body armor manufactured by the Company was prone to rapid deterioration.  Class actions and derivative suits followed and were consolidated in the U.S. District Court for the Eastern District of New York.  The parties reached a settlement ('the Settlement') of the claims.  As part of the Settlement, the parties agreed to a release of claims under Section 304.  As the Settlement provided:

• Released Derivative Claims includes, without limitation, a release by DHB of David H. Brooks and Dawn M. Schlegel, and each of them, from any and all liability under §304 of the Sarbanes-Oxley Act of 2002 to reimburse DHB for any bonus or other incentivebased or equity based compensation received by them or either of them, or for any profits realized by them or either of them from the sale of any securities of DHB.

The Settlement also provided for indemnification with respect to liability under the provision. 

• DHB shall indemnify defendants David H. Brooks and Dawn M. Schlegel, and each of them, against any liability under §304 of the Sarbanes-Oxley Act of 2002 incurred by them, or either of them, in any action brought by a third party under §304, and to pay to them, and to each of them, an amount equal to any payment made by them, or either of them, to DHB pursuant to any judgment in any such action.

The DOJ (in consultation with the SEC) and David Cohen (apparently a shareholder) both objected to provisions of the Settlement that released and indemnified DHB's former CEO, David H. Brooks, and CFO, Dawn M. Schlegel, from liability under § 304.  The district court, however, rejected the objections and approved this settlement. 

The Second Circuit first concluded that Section 304 did not provide a private right of action, relying on both the legislative history and the holdings in two other circuits.   Only the SEC could bring an action for violation of the provision.  See 15 USC 78u(d)(1).  The release, therefore, effectively sought to deprive the SEC of the authority to enforce the provision.  This, according to the Second Circuit, it could not do. 

• The Settlement's release and indemnification provisions attempt an end-run around § 304 that vitiates the SEC's role and is inconsistent with the law. If allowed to stand, it would effectively bar the relief the SEC is authorized to seek. It is true the SEC could order disgorgement. The terms of the indemnification agreement, however, would allow Brooks and Schlegel to pass that claim on to DHB so that they, individually, would suffer no penalty at all. The Supreme Court has held that agreements of private parties cannot frustrate the power of a federal agency to pursue the public's interests in litigation.  Here, the Settlement's release and indemnification provisions would accomplish exactly that, flying in the face of Congress's efforts to make high ranking corporate officers of public companies directly responsible for their actions that have caused material noncompliance with financial reporting requirements.  [citations omitted]

While applicable to Section 304, the decision also indicated that other attempts to indemnify officers for violations of the securities laws might be invalid.  See Id.  (" While no court has previously addressed whether a company may indemnify an officer subject to a § 304 remedy, courts have addressed indemnification against liability under other provisions of federal securities law and have concluded that indemnification cannot be permitted where it would effectively nullify a statute.").  The SEC has obtained relief in other instances from officers who relied on indemnification agreements to pay all or a portion of the amount.  See SEC v. Mozillo (portion of settlement amount paid pursuant to indemnification agreement).  

The primary materials for this case may be found on the DU Corporate Governance website.  

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Full post as published by The Race to the Bottom on November 01, 2010 (boomark / email).