Audit Committee Exposure to Liability

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Exposure to Liability

Under state corporate law, the “business judgment” rule can protect members of the Board from liability.

Under the business judgment rule, the Board’s decisions are generally respected, absent bad faith or self-dealing, if members of the Board inform themselves of all material information reasonably available to them prior to making their decisions. This includes overseeing the implementation of best practice procedures that will provide the company with adequate corporate information in order to allow its representatives to make informed judgments and that will provide the company with adequate reporting systems.

Failure to satisfy this minimum standard of best practice can result in liability of the directors for breach of their fiduciary duties.

In addition to liability for breach of state corporate law duties, members of the Board of Directors also face liabilities under the federal securities laws. For example, directors may be liable for material misstatements and omissions in a registered securities offering, unless they can satisfy a “due diligence” defense.

Another example of potential securities law liability is fraud liability under Rule 10b-5. The antifraud provisions of the federal securities laws cover statements made by the company in all sorts of communications, including routine communications to investors and periodic filings made by the company with the SEC. Note that the business judgment rule does not protect directors from liability under the securities laws.

Liability can arise through an enforcement action from the SEC or through a private plaintiff’s action.

Potential remedies can include money damages and penalties, imprisonment (if the fraud is significant enough to warrant criminal prosecution), an SEC cease-and-desist order and injunctions, including being barred from service as an executive officer or director of other publicly traded companies.

Securities fraud liability generally depends on the extent of the directors’ knowledge of and participation in the fraudulent conduct. However, reckless conduct may also be sufficient to create liability.

Standards of liability under the securities laws are often different for outside directors from those for inside directors, since outside directors generally do not have access to the same amount of information as inside directors, and do not exercise the same level of control over the company. While the SEC has recognized that outside directors may find it difficult to perform their duties if management seeks to withhold necessary information, the SEC expects that outside directors must nevertheless take steps to remain informed of the corporation’s activities.

It is possible that some courts may in certain circumstances apply higher standards of conduct and best practice to members of the audit committee than to other outside directors, given the audit committee’s responsibilities and access to information. As a result, audit committee members may face greater liability in certain circumstances as a result of their service on the audit committee.

Based on the standards and best practices described above, audit committee members can minimize their exposure to liability if they oversee implementation of procedures designed to provide them with adequate information about the company’s financial statements and financial disclosures and if they carefully review those financial statements and financial disclosures in light of that information and other information that is reasonably available. Audit committee members should be proactive and not passive in carrying out their responsibilities.

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