Will Litigation Risk Drive Directors Out of the Boardroom?Published: March 24, 2009 in Knowledge@Emory
Originally Published - 2004
The 2004 Goizueta Directors Institute, presented by UPS, was held on May 26th and 27th at Emory University’s Goizueta Business School. Now in its second year, the Goizueta Director’s Institute has created a unique forum for board members and officers of publicly traded companies. This year’s event, titled “Creating a New Culture: Balancing Director Oversight and Management Entrepreneurship,” focused on the effects of Sarbanes-Oxley and how corporations should address issues in the new climate of heightened governance. James F. Kelley, executive vice president and general counsel for Georgia-Pacific Corporation, moderated a panel organized to discuss “Will Litigation Risk Drive Directors Out of the Boardroom?: What Directors Can Do to Protect Themselves.”
The role of the board member has evolved throughout the last century. At the beginning of the 20th century, corporations began using a board of directors as a way to represent large numbers of shareholders in corporate transactions. There were charters and bylaws and a belief that these individuals would operate honestly within those boundaries. When the Great Depression hit, the federal government got into the game with the 1933-34 Securities Act, which established the Securities and Exchange Commission. There were more rules to follow, but corporations remained chartered entities of the state where they incorporated. (The Delaware courts became the recognized forerunner in matters of corporate governance, a role they still hold today.)
As the century progressed, the role of the corporate director shifted from representative to overseer, and the role became less clearly defined. Board slots were often filled by friends and colleagues of executives, creating an environment more aligned with management and less representative of shareholders.
Directors and their actions have long been insured by their corporate entity, and when necessary, backed up by the courts. Before Sarbanes-Oxley (SOX), there were key state law decisions, most notably the Caremark decision, delivered in the Delaware courts. “In Caremark, the courts said that liability would be imposed on corporate directors only if there was a lack of good faith in the exercise of their duties as evidenced by a sustained and systematic failure of a director to exercise reasonable oversight. And I think that is a pretty good description of what the law is today,” said GDI panel moderator Kelley.
Basically, under Caremark, directors are not held liable if they can prove they have been doing their job correctly; that is, making thoughtful and informed decisions. But this is changing, said Alan Schulman, attorney and partner with Bernstein Litowitz Berger & Grossman LLP. “The attitudes of the judges are changing and the judges are looking much more skeptically at these cases than they did before,” he said.
Kelley believes that SOX is going to generate new litigation ideas, “simply because there are so many more regulatory requirements that have been put on corporations,” he said. “One of the issues that I’ve had to deal with is a real concern by senior employees in the corporation—the CFO, the director of internal audit, the corporate controller, even the chair of the audit committee in its role as chair, not just as a director—that they will become individual defendants in some of this litigation.”
To stay safe, boards need to have their own controls, policies, and investigation of questionable behavior. It’s not enough just to have them, says Kelley. You have to show that you’re serious. As of yet, nobody is sure what that means. “Let’s posit a situation where the board has adopted a good corporate conduct and ethics program, where all of the reporting requirements that are imposed by SOX with respect to financial and accounting regularities are in place,” he said. “What further steps does the board have to take to satisfy the requirements of SOX and the proposed additions to the federal sentencing guidelines, that they really have exercised reasonable oversight over the program and its implementation throughout the corporation?”
For example, he continues, “Does the board have to do a videotape which is widely distributed through the corporation, that makes it clear that they are really committed to this program? Or is that further than we have to go? How often does the audit committee have to require a report from management or from the internal audit group about the number of allegations of fraud or improper accounting or hotline calls that have come in? What are the requirements?”
Corporations are learning as they go, but what is clear is that boards and senior management need to set up systems to go after fraud and criminal activity before it even happens. Douglas Bain, senior vice president and general counsel for The Boeing Company, outlined a set of protective measures that board members and management should take.
“One is a prevention process,” Bain says. “How do you make sure, as best you can, that this thing does not happen in the first place? Second, you need a detection process. If something bad happens, how do you find out about it? Third, an investigation process--once you’ve heard something what do you do to get to the bottom of it? And fourth is a fix-it process. How do you get to the root cause of what happened, and make sure it does not happen again.”
Today’s directors cannot assume that the corporations have their backs, even if only one individual causes the problems. “Most corporations have bylaws stating that officers and directors will be indemnified unless you do something really, really bad. You have insurance to back all that up, and that tends to work fairly well except lately in criminal investigations,” says Bain. “Now most of the U.S. attorneys are saying if you are even advancing fees, you are in essence trying to help a wrongdoer get out of trouble by the mere fact that you’re paying for it.”
“The purpose of indemnification is to frankly encourage directors and officers to take the normal business risks that you want businesses to take. No business can exist today in a risk-free environment,” Bain continues. “If I, as a manager, have to worry that if I pick this employee over that employee and if I’m going to get sued, then it’s going to be on my personal ticket, I’m going to tend not to make a decision that may be best for the corporation. I think the things that happen, particularly at the U.S. attorney’s offices today are really beginning to undercut the kinds of reasonable risk-taking you want people to take.”
Schulman says the recent corporate scandals have exposed some inadequacies in the typical Directors & Officers (D&O) coverage, especially for outside directors when they are sued in connection with an alleged securities fraud. “In the restatement (of earnings) cases, the insurers are seeking to rescind their policies by alleging that the corporate client misled the insured in the application for the insurance coverage when the subsequent financial statements are restated. In almost every restatement case that I’ve seen over the last three or four years, the insurers have taken the position that they were threatening to rescind coverage, they were filing relief action to rescind coverage,” he says. “Sometimes it’s a tactic to buy down the coverage, but it has become a very serious problem.”
A second issue is the wrongful acts exclusion, Schulman continues. “A director or officer who was directly involved in the fraudulent conduct will lose coverage, but unless there is a severability clause in the insurance policies, the wrongful acts of an officer of the company can also initiate the coverage for everyone insured under the plan. But if you don’t have a severability clause, I’m telling you right now, the insurers are moving away from severability clauses. You are at risk, by the conduct of one bad apple, of losing your D&O coverage.”
Some insurers now offer independent director insurance, which separately insures the outside directors. It kicks in if the overall policy is rescinded or if the wrongful acts exclusion kicks in. But insurance companies, some of whom were burned badly by corporate fraud, are not interested in making it easy. “The business they are in is the premium collection business,” says Don Kempf, general counsel for Morgan Stanley. “They are not in the claims paying business.”
The big question in the minds of most directors, says Kempf, is “Can they take my house? The short answer is yes. But the practical reality is that directors and officers of publicly held companies are rarely found personally liable for acts they take on behalf of the corporation. Once you get a court determination that there is a risk of liability, people tend to address that in various ways and most often those are settled, and they are most often settled with insurance company involvement.”
So how can a board’s members protect themselves? Getting rid of those “bad apples,” is one way, and GDI panelists recommend directors receive annual evaluations. Paper trails, such as meeting minutes, the agenda, and information notebooks should be well documented. Those asked to join boards should do their homework, learning not just what a corporation does, but how well that corporation has been governed in the past. Finally, board members must be prepared for meetings and ask questions. Not being aware of an issue is no longer an acceptable defense.
All of this means much more work for directors. Board meetings are expanding in size, scope, and length. To cut down on time, members must come to meetings prepared to discuss the contents of thick notebooks, sent to them in advance by management. And those on committees, especially the compensation and audit committees, have even more large notebooks to consume.
“I’ve done a little calculation,” says Kelley. “We have six board meetings a year. We’ve a relatively small board, 12 at the present and four full-standing committees. I estimate that between committee meetings, which run four to five hours at each meeting, and then a board meeting which usually runs four hours, and then travel time…every director of Georgia-Pacific is spending the equivalent of two full working weeks annually being a director.”
“Being an independent director for a public company is a huge investment of time. And it’s more likely to become greater than to diminish,” says Kelley.