Second Circuit Reaffirms Standard For Director and Officer Bar

Originally DLA Piper client alert May 2013

Introduction: Congress changes the statutory language for imposing a bar

One regulatory tool of the Securities and Exchange Commission ("SEC") is its ability to ask a court to bar a securities fraud defendant from serving as a director or officer of a public company, either permanently or for a specified period of time. This particular remedy frequently causes immense concern to defendants, as it can lead to reputational injury and adversely affect future employment opportunities.

Prior to 2002, the statutory basis for the bar remedy, Section 21(d)(2) of the Securities Exchange Act, required the SEC to show "substantial unfitness to serve as an officer or director" on the part of the defendant. The leading case interpreting this standard, SEC v. Patel, 61 F.3d 137 (2d Cir. 1995), set forth a non-exclusive list of six factors for a court to consider in assessing whether a bar should be imposed:

1. The egregiousness of the underlying securities law violation.

2. Whether the defendant is a repeat offender.

3. The defendant's role or position when he or she engaged in the fraud.

4. The defendant's degree of scienter.

5. The defendant's economic stake in the violation.

6. The likelihood that the misconduct will recur.

Patel derived this list from a law review article by Professor Jayne W. Barnard, When is a Corporate Executive "Substantially Unfit to Serve"?, 70 N.C. L. REV. 1489 (1992).

In 2002, as part of the Sarbanes-Oxley Act, Congress lowered the standard for imposing a bar from "substantial unfitness" to "unfitness to serve as an officer or director." Courts and commentators have asked whether the elimination of the word "substantial" warranted a change in the standard for imposing a bar. Some observers reasoned that Congress had acted because "substantial unfitness" was perceived to be such a high standard that courts had been deterred from imposing bars even in cases involving egregious misconduct, and hence that the change in statutory language did not materially change prior standards but rather clarified that a bar was appropriate if those standards were met. Hence, many courts continued to follow Patel, while other courts followed a nine factor test that expanded upon the Patel factors, as proposed in a new article by Professor Barnard. [FN1]

On May 14, the court that issued Patel, the Second Circuit, reaffirmed its validity notwithstanding the change in statutory language, in SEC v. Bankosky, No. 12-2943-cv (2d Cir. May 14, 2013) (per curiam). This client alert analyzes Bankosky and its implications.

The District Court imposes a ten year bar in an insider trading case

In Bankosky, the SEC alleged that an employee of leading international pharmaceutical company had purchased call options in four companies his employer was attempting to either acquire or enter into agreements with, in advance of the anticipated public announcements of the transactions. Five weeks after the case was filed, the defendant consented to an injunction not to violate the securities laws, without admitting or denying liability; and agreed to disgorge his trading profits ($63,000) and pay a civil penalty in the same amount as his profits.

The defendant, however, contested the SEC's motion for a permanent director and officer bar. District Court judge Harold Baer, Jr., adjudicated the motion using the Patel factors. The court found that in the defendant's favor, his conduct was not the sort "typically considered egregious," even though it was serious. (Here, the court contrasted the defendant's insider trading to cases involving public misrepresentations to investors about companies' financial statements and products.) [FN2] Moreover, the defendant was not a repeat offender. The other factors, however, weighed against the defendant. He was acting in a corporate fiduciary capacity, even though he was not an officer or director, as he and his colleagues were involved the due diligence and negotiations for the anticipated transactions; and he had a personal economic stake in the call option purchases made in violation of the law. Moreover, the court found it "particularly troubling" that the defendant had provided misleading testimony under oath in the SEC's pre-lawsuit investigation, as he had denied having advance knowledge that his employer was entering a global alliance with another pharmaceutical company when the documentary evidence showed that he had worked on that very transaction. [FN3] Furthermore, there were no assurances against future misconduct on the part of the defendant, given his continued effort to contest the wrongfulness of his actions in opposing the motion and his assertion that the injunction itself would deter future misconduct. Balancing all of these factors, the court held that a ten year bar was warranted.

The Second Circuit affirms the bar

On appeal, the Second Circuit held that the district court had not abused its discretion in imposing the ten year bar upon the application of the Patel factors.

With respect to the underlying standards for a bar, the SEC contended that Patel was "no longer applicable" due to the change in the statutory language from the Sarbanes Oxley Act. The SEC also opposed the new nine factor test set forth by Professor Barnard. Instead, the SEC proposed a six factor test from Steadman v. SEC, 603 F.3d 1126 (5th Cir. 1978), which addressed the propriety of injunctive relief in light of a defendant's past violation of the securities laws. In response, the Second Circuit expressed its agreement with the comments that Congress had changed the statutory language for a bar because the prior standard was perceived to be so high that courts were leery of imposing bars even in cases involving egregious misconduct. The Second Circuit also found that the Steadman list "closely resembled" Patel, and that both cases emphasized that the factors in their respective lists were not exclusive in any event. In the end, both cases set forth factors to assess whether a defendant is unfit to serve as a fiduciary, and hence whether he or she should be barred from serving as an officer and directors.

The Second Circuit then reasoned that in the final analysis, the district court had not made a clear error of judgment in the conclusion it had reached. The court noted that in addition to the adverse factors cited by the district court, the defendant had purchased call options in a company his employer was attempting to acquire. This could have increased the demand and hence the price of the target company, making it more difficult or expensive for the employer to purchase the company. As such, the defendant had betrayed an impulse to place his self-interest ahead of the interest of his employer and its shareholders, which is contrary to a fiduciary duty.


Bankosky has two important implications for defendants facing the potential SEC demand for a director and officer bar (and their counsel).

First, the case reaffirms the adage that the cover-up can be as detrimental as the offense itself. Even after deciding not to contest liability on the merits, the defendant in Bankosky had some factors in his favor when it came to opposing a bar: his status as a first-time offender and the relatively benign nature of his offense. Under relatively similar circumstances, a judge in the same city as the Bankosky court had denied the SEC's motion for a bar, just two months before the Bankosky court ruled in the opposite direction. In SEC v., No. 04 CV 4057 (DRH), 2012 WL 716928 (E.D.N.Y. Mar. 3, 2012), the defendant entered into a consent decree under which he agreed not to argue that he had not violated the securities laws, but challenged a bar. Judge Denis Hurley the reasoned that this was not a case of broad-based deception such as misrepresentation to the public at large, and that the SEC had not proffered evidence that the defendant knew that the company's representatives were making false telephone solicitations to potential investors. While the defendant had been involved in two misleading documents, the SEC had not provided the court with a clear picture of his role (including that he knew that they contained misrepresentations). Hence, the violations, while serious, were not sufficiently egregious to support a bar for this first-time offender.

To be certain, the defendant in had an additional basis to oppose a bar: the SEC had not shown that violations were likely to occur, for the events in question had occurred twelve years earlier and there had been no violations in the meantime. At the same time, the misconduct at issue in involved misrepresentations to broad sets of investors, which arguably adversely affects more persons than the insider trades at issue in Bankosky and hence would weigh more heavily in favor of a bar. Reading the two opinions in tandem, the most significant difference is that in Bankosky, the courts (at both levels) were troubled by the fact that the defendant had lied under oath in the SEC's pre-lawsuit investigation. This error at the outset, which the defendant had tried to downplay even after it had been exposed, proved to be a major factor in appending a ten year bar to the money the defendant ended up paying the SEC. This factor, in turn, counsels that individuals should retain legal counsel as soon as they become aware that they are a potential target of the SEC.

Second, Bankosky should be read to endorse the use of an expansive set of arguments against a bar. While the Second Circuit reasoned that the district court had not erred in using the Patel factors, it did not hold that those factors, and only those factors, were relevant. To the contrary, the court pointed to the non-exclusive nature of the Patel list (and the SEC's alternative Steadman list) as a reason why the district court had not erred in following Patel. This, in turn, suggests that defense counsel should respond to a bar demand by analyzing not only the Patel factors, but the nine factor test in Professor Barnard's article. Moreover, Professor Barnard also endorsed a special inquiry for first-time offenders: she reasoned that a bar may be appropriate for a first time offender only for a fraud that was "outside the heartland" of "conventional" frauds, either because of its magnitude or its impact on investors; and that "courts should sanction only those defendants who by their conduct and attitude both in business and before the court, have demonstrated that they are 'opportunity seekers' or worse." [FN4] Defense counsel should consider these advancing arguments as well, if the facts warrant.


[FN1] See Jayne W. Barnard, Rule 10b-5 and the "Unfitness" Question, 47 ARIZ. L. REV. 9 (2005). For example, the first decision to address the statutory change, SEC v. Levine, 517 F. Supp. 2d 121 (D. D.C. 2007), applied Professor Barnard's nine factor test as well as Patel.

[FN2] This account of the district court's decision is derived in principal part from the Second Circuit's account of the opinion, as the Second Circuit's perspective on what had transpired in the district court is important to understanding its assessment of the decision. I also reviewed the district court decision itself, to confirm and in some instances supplement the Second Circuit's account.

[FN3] The SEC's motion for a bar in the district court demonstrates that the defendant had been deposed on March 4, 2011, eleven months before the lawsuit had been filed.

[FN4] See Barnard, Rule 10b-5 and the "Unfitness" Question, 47 ARIZ. L. REV. at 54-55.