Talk: NACD Director Professionalism: Fiduciary Duties of Corporate Boards

Director Professionalism
Philadelphia, PA
June 8-9, 2010

Course description at https://secure.nacdonline.org/source/meetings/meetingshome.cfm?sID=DP

Fiduciary Duties of Corporate Boards

John Gorman
Partner, Luse Gorman
Director, SmartPros Ltd: member Audit and Comp committee

Great presentation by a lawyer, presenting on fiduciary duties of board members.  Lots of great examples of legal cases in this talk.  And explaining liability risks and even covering relevant criminal code (prompting laughter, somewhat nervous?).

(Disclaimer: I'm not a lawyer, so my notes may contain inaccuracies.)

• Learning objectives
  • basic fiduciary duties as applicable to director service
  • application of the Business Judgement Rule
  • reality of liability from director standpoint
  • impact of U.S. sentencing guidelines (very funny)
• General principles
  • business affairs of a corporation are managed under the direction of the Board the Directors
    • Citbank has failed 3 times in his career: if board isn't held liable despite all these failures, then boards are truly safe (a good finding for board members)
  • they owe a Duty of Loyalty to Company; and Duty of Care in administration of corporate affairs
  • subsidiary duties
    • duty of "candor" when communicating w/shareholders
    • duty of confidentiality as to board room deliberations
    • duty to disclose conflict of interests or possible conflicts of interests to the board
      • cites example Compaq case where investigation started violating California law, trying to find source of leak, suspected board member
      • cites example of Dow, trying to find board member leak: ended up with defamation lawsuit
• Discharge duties: in good faith, with the care, an ordinary person in a like position, would exercise under similar circumstances, in a manner he reasonably believed, etc...
• Duty of loyalty exposure
  • often happens in acquisitions
  • insider on both sides of transaction
  • "interested" when receives personal financial benefit not equally shared by other stockholders
  • "lacks independence" when decisions is based on extraneous considerations or influences
  • Discussion: someone brings up outside board members, especially from shareholders (even controlling), may lacks independence, especially from investment firm
    • Not a problem: director is entitled to shorter-term outlook than others.  Nothing wrong with that. Common goal is to create value for shareholders.
    • Bigger loyalty issue: CEO deciding on exec comp
    • Example: Viacom: Redstone lucrative comp was overturned because independent director found too much lack of independence between board members and CEO; raised doubt that the majority board was really independent.
  • Most common case law contexts
    • derivative litigation: "we want to sue in the name of the company, and the board won't sue themselves."  breach of fiduciary duty, substantial risk of liability; board can create "special litigation committee" to take over lawsuit
      • Discussion: "any shareholder can sue: regardless of number of shares owned"
    • approval of related-party transactions, e.g., compensation decisions
    • majority shareholder buyout of the minority shares
• Legal standard of independence
  • financial relationships between a director and the company
  • Famous case: 
    • Oracle in 1990s (insiders sold stock, tens/hundreds of millions of dollars): company announces disappointing earnings; shareholder lawsuit sues; majority of board sold stock; hired new outside directors including SEC commissioners to determine whether to sue; $10M+ legal fees; decided we shouldn't sue insiders
      • Plaintiff Bar: found all sorts of trails: Ellison Standford donation; all on Stanford steering committees, endowed chairs
      • Social ties called enough doubt on initial finding
    • Martha Stewart
      • Martha Stewart and Imclone: allegation: she was tipped by CEO, not material to her well-being. SEC went after her for insider training; not guilty, but lied to SEC, so went to jail for perjury
      • Resulting Imclone lawsuit: found social ties: were on same board, kids went to same kindergarten, etc. Despite trying to make ties to Oracle case, Delaware court found that directors were still independent
    • Risk: "you don't want board full of your softball friends"
• Good faith requirement
  • "Failure of oversight" the Caremark decision, director inaction cases: involved HCA, Medicade referring fees to related parties, HHS, etc.  Caremark tried to comply, had big fines,
  • world of compliance makes "our job isn't to find wrongdoing" just doesn't cut it anymore. It's not enough to say "you didn't know about it." -- it's part of the Good Faith obligation to bring about compliance
  • Requires a "sustained or systematic failure to exercise reasonable oversight"
  • What red flags were coming to the board that should have brought more scrutiny?
  • Confirmed as duty of loyalty issue in Stone v. Ritter (AmSouth)
  • Quote: "intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties"
• Duty of care
  • requires that boards make informed decisions
  • usually characterized by failure to obtain adequate information, failure to give thorough consideration to a decision
• Duty of care is very much a question of the adequacy of the process
  • how many board meetings
  • how thorough committee reports
  • how detailed are management reports
  • existence of outside counsel
  • use of consultants/experts
  • Discussion
    • M&A: was an investment banker used to set fair price?
    • "record is as important as decision itself"
• Directors may rely in good faith on information prepared by officers, employees, committees, experts
  • Question: "if director abstains or votes against, can be they be absolved of liability?" "Likely"
  • Question: "can board be liable for appointment of trustee, for say, employees 401K plans". "you don't want senior management on these committees, because of ARISA. Especially because retirement funds are in company stock. Every major decline in stock price leads to lawsuits, supported by ARISA." "Board can't delegate away fiduciary duties."
  • Example
    • Smith v. Van Gorkom: directors held liable for breaching duty of care, because board considered proposal for only two hours ("because it was such a great deal", "stock hasn't traded at proposed acquisition price for years.")
      • Saturday board meeting, board piling over each other trying to sign purchase agreement
      • Agreement negotiated by the president
      • Board relied solely on a presentation by the president
      • $80M of liability, some carried personally by the board (!!)
    • Disney case: directors were considered negligent, but not grossly negligent: about Ovitz compensation: more on this later
      • No meeting minutes
      • TODO: pull prior meeting minutes
• Business judgement rule
  • Presumption is that informed, independent and disinterested directors acted in best interests of company and shareholders
  • "it used to be a race to the courthouse whenever the stock price dives. whoever got there first got to lead the plaintiff's case."  Courts got tired of this, now different statutes.
• Burden of proof is to challenge duty of care/loyalty/conflict of interest/etc.
  • Courts will then go director by director to see who's liable
• Impeding stockholder volting
  • Examples: Blasius, Liquid Audio, In Re The MONY Group, Inter-Tel
    • Blasius: board felt certain transaction left company vulnerable. acquiring firm suggested elected 8 new board members; board saying "this is a terrible transaction."; board elected 2 new officers to fend off takeover. 
      • Court backed this up: "fundamental to legitimacy of board power".  Business judgement rule trumped by shareholders right to elect board
• Failure of board oversight cases
  • Example: Citigroup 
    • Despite $100M+ losses, shareholder launched derivative suit for failure to properly oversee the risks associated with sub-prime lending
    • Court stated said decisions were "wrong", but directors properly evaluated risk and made "right" business decision.
    • Court distinguished vs. Caremark case:
    • "This is the right decision, not imposing liability for bad risk judgements. This is good for board members"
  • Example: back to the Disney/Ovitz case and compensation
    • Eisner designated Ovitz as successor, put together contract. Ovitz is terminated, and severage package valued about $140M range
    • Shareholder launches case
    • Shareholder requests board notes on contract creation, termination: no records are found, only a few sentences in board minutes that resulted $140M package. Despite "small amount that didn't jeopardize Disney viability", courts found directors were derelict in duties and "bad faith"
    • They did find that board made informed decision: "record keeping as important as the decision -- the process was sloppy, but record-keeping was far worse"
    • Court called out that "board were sycophants to Eisner"
    • Reputational risk: 5 years of Wall Street Journal coverage
    • Question: "how do you decide what information goes into the meeting minutes?" "Committees are now so much more careful in compensation, tally sheets, documenting what was promised, etc."
  • Emerging Communications: about share price and fraud
    • One board member was defrauding shareholders; one was a lawyer who was getting fees; one investment banker liable because he should have known price was wrong ("unique position to know" due to "his expertise")
• Corporate takeovers
  • Board can choose to take 100 year outlook or short-term outlook. Price of acquiring offer can't cause liability, no matter how attractive, if board can reasonably justify it.  "We just said no" is a fine response.
    • Unless of course, CEO is saying monthly, "our best years are behind us, our competitors are eating our lunch..."  (haha)
    • Question: "how about SEC 13-D?" (didn't understand answer)
• Defending against corporate takeovers
  • can trigger "modified" business judgment rule
  • According to Delaware Supreme Court: "board of directors is the defender of the metaphorical medieval corporate bastion and protector of shareholder value" -- when sees threats, has broad authority to respond and take combined defensive precautions.
• D&O insruance
  • How much is enough? Look at market cap, trends in settlement and trial results and peer limits
  • Expenses are included in the coverage amount, subject to retentions
  • "Insurance business is one of the worst businesses I've seen."
  • "Would never suggest less insurance." "Unfortunately, lawsuit settlements track amount of insurance carried."
  • $10M market cap, $5M coverage, 50% loss coverage: lawyer expenses could top $5M in course of even straightforward litigation ("a couple million won't cover your legal fees.")
• D&O Insurance
  • Side C coverage: entity coverage
  • Side B coverage: coverage for directors, company indemnifies
  • Side A coverage: need this if company is not around
• Curent issues
  • Severability: insurance can't pay if there is wrongdoing. What happens if CFO defrauded, what happens to other directors? will they be denied coverage?
    • Was very applicable during tech bust: because of fraud involved
    • More insiders on the board would eat up Side A coverage
  • So, now there's Independent director liability (IDL) to mitigate this risk
• Policy rescission
  • When company restates financials, say company losing money for three years, instead of making money as stated: underwriter may rescind policy; "I wouldn't have provided insurance"
• Deliberate fraud exclusion
• Indemnification: "insurance is basically accepting premiums and denying claims" (haha)
  • "because these cases never get to trial, insurance is to cover legal expenses"
• U.S. sentencing guidelines
  • Initially adopted in 1991, substantially revised and expanded in 2004 in Section 905 of SOX
    • Arthur Andersen: 95K put out of work, because of a "few bad apples."
    • "They've really backed off since those days"
    • Example: when someone went after KPMG partners for wrongdoing.
  • This may be reversed given recent economic catastrophes
  • Reduced criminal penalties if there is an effective ethics and compliance program
  • Board shall establish standards and procedures to prevent and detect criminal conduct
  • Governing authority must know about the content and operation of the compliance/ethics program, involving senior officers, given adequate resources (budget, etc.), report back to board
  • Mechanisms to allow for anonymity and confidentially submit reports of wrongdoing ("whistleblower program")