By Cydney Posner
An article in the WSJ today, "H-P Under Fire for CEO's Role in Remaking Board", illustrates that personal and business relationships between directors and CEOs that may not affect the directors' "independence" under SRO definitions may still be viewed to influence directors' attitudes and performance and may even be sufficient to trigger negative recommendations from proxy advisory firms. The article describes ISS's charge that the new H-P CEO was too involved in re-making the company's board: when four of the most outspoken H-P board members decided not to stand for re-election, "new board members were identified by an ad hoc committee which included [the CEO and Chairman]. H-P told ISS that the committee played a role "akin to that of a search firm," and stressed that the candidates identified by the panel were vetted by H-P's nominating and governance committee and approved by the company's full board, the ISS report states. ‘However, the fact remains that the new CEO was involved from the earliest stages of the process.' …. The direct participation of [the H-P CEO] ‘raises red flags,' the group's report says. ‘A CEO's participation in the appointment of directors, especially if the director has a significant relationship with the CEO, can make it difficult for such directors to be objective.' " ISS recommended against the election of three members of the company's Nominating Committee; however, in its defense, H-P contended that ISS just misinterpreted H-P's process for identifying directors.
While the H-P example reflects a subtle form of potential influence, the case below provides an egregious example of a board that is beholden to the CEO and subject to his very tight control. It also provides a kind of a punch list of practices that audit and compensation committee members should not follow when confronted with "red flags" signaling potential misconduct. In the complaint, the SEC charged DHB Industries (now known as Point Blank Solutions), a major supplier of body armor to the U.S. military and law enforcement agencies, with engaging in pervasive accounting and disclosure fraud through its senior officers and misappropriating company assets to personally benefit the former CEO. A copy of the article from the SEC can be viewed here and the SEC Litigation Release can be viewed here. Of perhaps even more significance is the complaint the SEC also filed against the company's audit and compensation committee members, who were alleged to be "willfully blind" to red flags signaling problems at the company. While the company has settled the charges against it, the three outside directors have not settled, and the SEC is seeking injunctive relief, disgorgement of ill-gotten gains, monetary penalties, and officer and director bars against them.
The action arose after the company restated its financial statements for 2003, 2004 and 2005, disclosing that the company's gross profit margins and net income for 2003 and 2004 were materially lower than previously reported and eliminating all 2003 and 2004 profits. As noted above, the complaint charges that the three directors willfully overlooked red flags. These directors, the SEC charged, "lacked impartiality to serve as independent Board or Audit Committee members. They were [the CEO's] longtime friends and neighbors, with personal relationships with [the CEO] that spanned decades." In addition to family dinners among the CEO, the directors and their families, there were some sticky business relationships.
As described by the SEC, the red flags were certainly apparent, including resignations by several accounting firms (along with material weakness reports regarding various matters, threats to withdraw prior audit opinions and issuance of a 10A advisory report), union complaints, SEC subpoenas and other inquiries regarding failure to disclose a related-person relationship (allegedly involving siphoning $10M out of the company and into the CEO's horse-racing pastime) and resignation by the controller after alerting the audit team to his belief that the company's inventory was overvalued. The audit committee apparently failed to investigate (or apparently even understand that its role was to investigate) these charges as part of its oversight responsibilities. Incredibly, when the auditors raised questions regarding the related-person transaction, the directors allowed the CEO to commission and control the investigation, including choosing the law firm (a major firm) to investigate and controlling the flow of documents and witnesses. The audit committee was apparently mollified by reports from the CEO on the status of the investigation, statements that the disclosure omission was inadvertent and a recommendation in the final investigation report by the law firm that the relationship be disclosed without any other finding of clear impropriety. However, when the law firm later resigned and called into question its previously issued report because of the discovery of previously undisclosed information about the relationship, the directors did not exactly spring into action, according to the SEC. Rather, although they thought the situation was a "smelly fish," they characterized the attorneys as "spineless" and "disloyal" and, under pressure, allowed the CEO to control a second investigation into the matter. They also failed to look into $4.7 million of personal expenses charged to the company by the CEO for luxury cars, horse training, jewelry and prostitutes –and authorized it by an after-the-fact resolution that permitted reimbursement for business and personal expenses in an amount not to exceed 10% of the company's annual net income. (!) (The resolution is alleged to have appeared about the same time as the SEC subpoenas.) The audit committee even allowed the CEO to control the investigation into his own personal expenses, and did not flinch when he terminated the firm he had engaged to perform the investigation. At the same time as all of problems were continuing, these directors were making substantial sums from sales of the company's securities.