Audit Committee Chairs in the Hot Seat? D&O Implications from the SEC’s Kubient Case

The Securities and Exchange Commission (SEC) has brought charges against independent directors who allegedly failed to take appropriate action when management was engaged in accounting fraud. These cases have been surpassingly rare—the SEC files such a case once every few years, at most. However, in September 2024, the SEC sued a public company audit committee chair, suggesting the agency may have a renewed focus on ensuring that independent directors carry out the role of “gatekeepers” to prevent accounting fraud.

Who Does the SEC Sue?

The SEC loves to talk about holding individuals accountable in public company securities fraud cases. Who are these individuals? Here are the key historical targets, in non-scientific, non-order of priority for the SEC:

• CEOs
• CFOs
• CAOs
• COOs
• Controllers 
• Finance VPs

Who is missing from this list? Plenty of folks. General counsel, for one. 

Also, where are the directors? Despite suggestive remarks by SEC leaders over the years, charges against independent board members are exceedingly rare. While these cases pop up from time to time, they are a very uncommon exception, not the rule, even in cases of blatant fraud.

There are several very good reasons for this. For one, executives cooking the books usually refrain from bringing independent directors under the tent on their scheme. And it is executives—not directors—who are directly responsible for corporate disclosures.

Also, most public company board members take their obligations very seriously, taking prompt and appropriate action when they learn about alleged misconduct by senior executives. In fact, this is the way many—probably most—accounting frauds are identified: 

• An internal whistleblower raises highly credible allegations.
• The complaint makes its way to the audit committee.
• The audit committee conducts an independent investigation, often with the help of outside counsel and outside forensic accountants.
• If necessary, the company restates earnings and/or potentially self-reports fraud to the government.

As you can see from this fact pattern, audit committees play a key role in the process of rooting out accounting fraud. 

In this sense, the audit committee chair has an elevated position of responsibility—and an elevated SEC risk profile when compared to other non-executive board members. 

Like some past administrations, the current SEC administration has talked a lot about holding “gatekeepers” accountable. When securities enforcers talk about gatekeepers in the accounting fraud space, they are mostly talking about lawyers and external auditors.

But the government also considers boards—and, specifically, audit committees—to be gatekeepers. A recent SEC case seems to signal an increased level of scrutiny on boards as “gatekeepers” and an increased appetite by the government to target individual board members.

Let’s take a look at the facts of the case so our D&O Notebook readers know how to discharge their oversight responsibilities appropriately and stay far away from the SEC line. We’ll then review D&O insurance implications for board members who may find themselves in the crosshairs of an SEC investigation. Strong efforts around robust financial reporting controls and whistleblower hygiene will go a long way to making this case a one-off event. And if the government does prove to have an increased appetite for suing board members, you’ll want an expertly crafted D&O insurance program at your back.

The Audit Committee Chair as Gatekeeper

Nestled among the flurry of cases filed during the agency’s September 2024 fiscal year-end push, the SEC recently brought accounting fraud charges against an audit committee chair at a small publicly traded company called Kubient.   

Kubient is a case of an IPO gone terribly wrong. Here are the SEC’s key allegations against the AC Chair:

• Kubient’s CEO allegedly fabricated 95% of the company’s pre-IPO revenue. 
• One of the company’s senior employees learned about the scheme and reported it to the AC Chair. (As an aside, this is exactly the right thing to do if you discover that your company is engaged in accounting fraud. Indeed, you probably have an obligation to do this.)
• When the AC Chair learned about the scheme, she allegedly said, “We could all get fired.” (Well, yeah.)
• After the conversation, the AC Chair had discussions with the company’s CEO, CFO, and outside securities counsel.
• Despite these conversations, according to the SEC, the AC Chair took no steps to inform the company’s external auditors about the problem or to explore whether revenue might need to be restated. 
• In fact, when presiding over an audit committee meeting to discuss the issue, the AC Chair allegedly did not invite Kubient’s external auditors to that meeting, and no meeting minutes were created. (The external auditors were invited to every other audit committee meeting during the relevant period, and minutes were created for every other such meeting.)
• The minutes for the next audit committee meeting—to which the external auditors were invited—allegedly suggested that the previous meeting had not taken place. The AC Chair signed these minutes despite, according to the SEC, knowing or being reckless in not knowing that they were false. 
• Then, according to the SEC, when the AC Chair was later interviewed by the external auditors for the annual audit, she stated that she was not aware of complaints about Kubient’s financials and that she did not have knowledge of any fraud or suspected fraud.

The SEC brought a host of charges against Kubient’s former CEO, CFO, and the AC Chair (the CEO was also criminally charged). The AC Chair was personally charged with securities fraud, aiding and abetting the company’s securities fraud, and lying to the company’s external auditors. 

The AC Chair and CFO are currently fighting the SEC case in court, and we’ll have a close eye on those proceedings. For now, here is what board members should know:

• The SEC wants audit committee members to understand that they may be on the hook if they fail to take appropriate action after learning about potential accounting fraud. As an SEC official stated in the agency’s press release: “This case should send an important signal to gatekeepers like CFOs and audit committee members that the SEC and the investing public expect responsible behavior when critical issues are brought to their attention.”
• The AC Chair is facing a variety of SEC claims, a common tactic in a litigated case in which the SEC is trying to get a win by any means necessary. The complaint includes a Section 17(a) “negligent fraud” claim, which is one of the SEC’s favorite tools in public company cases. To win on this claim, the SEC does not need to prove that the AC Chair acted with bad intent, only that she failed to act reasonably. 
• The SEC did not directly allege that the AC Chair received any specific financial benefits as a result of her conduct. The case is premised entirely on her failure to take appropriate action in the face of allegedly credible facts suggesting that accounting fraud may have taken place.

Lessons from the Kubient Case

With this in mind, what lessons can board members—and audit committees in particular—­take from the Kubient case? Here are a few:

• Make sure you have robust whistleblower policies and procedures that work in theory and in practice. 
• Personnel is policy, and tone at the top matters. Responsible board members spend time with senior management. If someone walks like a fraudster and quacks like a fraudster, they may be a fraudster. Make sure the right people are responsible for making the key decisions about your company’s financial disclosures so your neck is not ultimately on the line. 
• If you are an audit committee chair presented with credible allegations of material financial misconduct by senior management, take appropriate action. This will often include retaining highly experienced outside counsel to conduct an independent investigation. It always includes keeping your external auditors informed of significant developments. 
• Do not ride through this desert alone on a horse with no name. Strong outside securities counsel will be essential to making sure that you make the right decisions for the company and yourself in an environment of significant risk and uncertainty.
• If your independent investigation finds no fire, you will have done the company, the management team, and your fellow board members a great service by overseeing a careful and thorough internal investigation that will stand up to external scrutiny. 
• If you find a conflagration, the folks responsible for making bad decisions will be in for it—and you will have acted as a responsible corporate steward for shareholders, your fellow board members and non-implicated executives, and yourself.

D&O Insurance for Board Members in SEC Matters

Notwithstanding the Kubient case, I expect that SEC claims against non-executive board members will remain quite rare—although, depending on the composition of future SEC leadership, we could see a sustained uptick. It is also important to remember that you may find yourself embroiled in a lengthy, expensive, and painful SEC investigation even if you have done everything right and are ultimately cleared of wrongdoing.

This is one of the reasons why carefully crafted D&O insurance—and an expert claims team that includes securities litigation experts—is so critical for board members. Here are a few key considerations to keep in mind:

• As a board member, you should be indemnified for the costs of responding to an SEC investigation. While an investigation may not involve any allegations of wrongdoing, you will still incur legal fees and expenses to respond to document requests and subpoenas and to prepare to give interviews and testimony. Side B of the D&O insurance policy may or may not kick in to reimburse the company for these costs—but, if it does perform, only after the company has exceeded its self-insured retention (i.e., deductible).
• The company’s costs for conducting an audit committee investigation are unlikely to be covered under a D&O policy. Still, management should keep the company’s insurance advisors closely informed so that they can help you navigate considerations surrounding notice to your carriers and policy renewals. 
• The company’s costs for responding to an SEC investigation into the company are also unlikely to be covered under a generic modern public company D&O policy. However, endorsements for “entity investigations coverage” are sometimes being offered to public companies in today’s soft D&O market. While this coverage has historically not been especially attractive from a price perspective, it may be worth a look in today’s heightened SEC risk environment. If you do decide to kick the tires, try to get coverage that is untethered from any requirement that there be a securities class action running concurrently with the SEC investigation (which is a common limitation on this coverage).

• If you make some big mistakes and you are also very unlucky, you could find yourself in the small cohort of non-executive directors who are sued by the SEC. In this context, the D&O insurance implications get very tricky, as I explained in more detail last year: 

  “[I]f the government sues you and you decide to fight the charges in litigation, you may have coverage (and you also may be indemnified by the company). But litigating against the government is dangerous for many reasons. One reason is if a judge or jury decides you are liable, that finding can be used by shareholder plaintiffs bringing securities class action litigation. By contrast, if you settle with the SEC, you can typically do so on a no-admit, no-deny basis, which does not have the same effect in private litigation. Also, if you lose in an adjudicated proceeding, D&O insurance becomes problematic. D&O insurance has an exclusion for willful wrongful acts, and carriers will also want the defense fees they advanced paid back to them.”

Finally, a pro tip: D&O insurance buyers are often highly focused on pricing, and pricing is extremely important. However, careful executives and board members are equally focused on working with D&O experts (1) who can obtain the best possible coverage from the best possible insurers, (2) have dedicated claims specialists who can advocate on their behalf should the very bad day arrive, and (3) with whom they would want to share a foxhole if the government or private litigants decide to go to war.