February 08, 2006
On December 7, 2005, a blue ribbon commission of the National Association of Corporate Directors issued a report 1 containing several recommendations for addressing the "new liability landscape." Among these recommendations are that directors should:
AND DIRECTORS SHOULD TAKE SPECIAL CARE:
Despite an increase in litigation and investigations targeted at boards and their individual directors, and headlines about staggering settlements, the authors dispute the common perception of changing or new standards or an increased likelihood of liability. Instead, the commission sees recent cases as applying, upholding and clarifying long-standing standards of liability in the face of sometimes egregious facts.
Although the report believes that the standards of review against which directors are measured for purposes of legal liability have not changed, in a world of increasing scrutiny and potential for enforcement actions and litigation, directors should aspire to the highest standards of conduct and best practices enabling them to "focus on the strategic issues that can build long-term stockholder value, [thus] fulfilling the essence of their duties as fiduciaries."
Empowering Directors Through Clarification of Liability
The report reviews recent state and federal law developments in order to help directors "sharpen their understanding of their fiduciary duties, the requirements imposed by securities laws, and where the risks to their own personal assets lie."
Using Delaware as the model, the authors outline applicable state law standards for review of director conduct. Generally, state law binds directors as fiduciaries "to act with loyalty to the corporation, to exercise care in the performance of their responsibilities and to carry out those responsibilities in good faith." Loyalty requires action in the best interests of the company free from conflicts of interest. Due care requires that directors' business decisions be adequately informed and the result of appropriate due diligence. Good faith requires that directors responsibly carry out their duties with honesty of purpose and in the best interest of the corporation. State courts will apply the business judgment rule in assessing whether directors have violated these fiduciary duties. State courts will focus not on the result of the directors' business decision but on the process by which the decision was made so as to encourage "entrepreneurial risks by protecting [directors] from liability for good faith, non-conflicted, informed, rational business decisions." The report also discusses certain state law and other protections or protective devices available to directors in defending themselves in and against litigation, including non-conflicted director independence as a defense in and against derivative lawsuits, the use of state exculpation and indemnification statutes, good faith (but not blind) reliance on experts and insurance.
According to the authors, recent cases, such as the Emerging Communications case in 2004 2 and the 2005 Disney case, 3 demonstrate that:
The report recommends that directors adopt the "aspirational" (or highly ambitious) best practice standards of conduct that can help them avoid claims that they have not met their fiduciary duties.
Under federal law, the report emphasizes that:
The report primarily focuses on the director's obligations under Section 11 of the Securities Act of 1933. 4 Defending against these claims is difficult and extremely fact-sensitive, requiring directors to prove that they acted with "due diligence," meaning, in practical terms, that a director must have been actively involved in ensuring that the registration statements and the other reports and filings (e.g., Forms 10-K, 10-Q and 8-K) that are incorporated therein do not contain material misstatements or omissions. This requires best practice approaches, such as "substantial probing of management, bankers and experts" (even when awkward), particularly with respect to red flags about which directors must "inquire until satisfied as to the integrity" of the information. It also requires "receiving reports; requesting information from management; meeting periodically; and analyzing, planning and participating in the corporation's business."
Fulfilling Board Responsibilities to Meet and Exceed Compliance
The authors also believe that going beyond compliance reduces litigation and liability risks and allows for greater focus on the real business of the corporation, which is the proper province of an empowered board. Going beyond compliance requires:
First, that the board understand its own authority and determine "which issues merit [board] action" from among the wide range of matters on which the board may be required or called upon to act. The board should devise and adopt "levels of authority" guidelines, which prescribe the matters that must come before the board for action or merely for review and/or discussion.
Second, that the board assure that it has access to a reliable system of formal and informal, real-time information flow. Such a system provides directors with important management, non-management and expert information upon which the directors can rely. The information must be geared to the nature and complexity of the company's business and its strategies, as well as to the particular issues or matters confronting the company at any given time. The primary source of such information will be management, but boards and their directors must not be constrained to such sources. Instead, directors "should seek and obtain additional information from any source they deem appropriate, while taking care to ensure that they have sufficient basis to rely on that information." These sources include senior and non-senior management, as well as non-management employees, fellow directors, third parties such as experts and academics, on-site visits, employee hotlines and stockholder and customer/creditor surveys. All such information should be subject to active discussion, which includes asking tough and critical questions.
Finally, that the board's composition be comprised of directors who have an independent perspective characterized by the courage and integrity "to ask searching questions and to follow through until they have a proper understanding of the matter at hand." The board should also have a diversity of experience and expertise (including industry, functional and product/service expertise) and should engage in periodic self-assessment and evaluation.
Structurally, the report underscores the great importance of conducting executive sessions of non-management directors and the increasing importance of board committees in carrying out the workload of the board, including the value of committee work being regularly shared with the entire board. The report stresses the need for a lead director to preside at executive sessions and to communicate with the CEO afterwards. Among other things, executive sessions should also be opportunities for the non-management directors to meet with individual executives (such as the CEO, the CFO or the chief legal officer) and others in order to "probe more deeply into certain issues" affecting or likely to affect the company.
The report also examines three important areas that have been the subject of recent increased scrutiny: executive compensation 5, mergers and acquisitions, and capital formation.
The report emphasizes that executive compensation decisions require appropriate measurements of executive and company performance and effective assessment against those metrics. Directors making compensation decisions require a full and complete understanding of the financial implications of such decisions under all scenarios reasonably likely to unfold.
In the merger and acquisition area, a reliable and continuous systematic flow of information to directors is critical at all times and not just in specific transactions, because the board should be prepared for opportunities and threats even when there is no pending or foreseen transaction. In this vein, directors should periodically receive information regarding comparative analyses of various strategic options, possible acquisition targets, and the merger activity of competitors. Of course, particular transactions require specific detailed information about price, timing, certainty, proposed financing and impact, as well as the possibility of independent outside expert assessments, all of which must be evaluated critically and independently by the directors.
Capital formation, credit transactions and securities offerings also require a reliable system of information flow so that directors are familiar with the company's financial situation through an ongoing understanding of the company's business, its financial needs, sources of funds, financial controls and financial disclosures.
Endnotes
1. This 81-page report, published by the Natonal Association of Corporate Directors and sponsored by the Center for Board Leadership, is comprised of three substantive chapters and six appendices containing pertinent articles on class action lawsuits and settlement data, selected cases, guidance with repect to corporate minutes and D&O insurance information.
2. In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. 2004).
3. In re Walt Disney Co. Derivative Litigation, Cons. C.A. No. 15452, 2005 Del.Ch. LEXIS 113 (Del. Ch. August 9, 2005). (Currently on appeal to the Delaware Supreme Court).
4. Section 11 imposes strict liability (i.e., proof of intent is not required) for materially false and misleading statements and omissions in registration statements relating to the public offering of corporate securities. Neither the business judgment rule nor other state law protections apply in federal cases involving disclosure violations in public offerings, where the size of damage claims can be staggering. The authors chose this focus because claims of securities fraud require plaintiffs to prove reckless misconduct by directors and thus are difficult to prove and, in the authors' view, are unlikely to present a personal liability threat to a director.
5. The report anticipated the announcement on January 17, 2006 by the SEC of a proposal for further executive compensation disclosures, which the SEC has now issued for public comment.
Thelen LLP can address your questions or concerns about these and other related issues. To discuss these matters further, please contact the Thelen attorney with whom you work or any of the following:
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| Walter J. Godlewski, III | 212.603.2349 | wgodlewski@thelenreid.com |
| Richard S. Green | 212.603.2202 | rgreen@thelenreid.com |
| John T. Hood | 212.603.2140 | jhood@thelenreid.com |
| Thomas J. Igoe, Jr. | 212.603.2110 | tigoe@thelenreid.com |
| Ira H. Jolles | 212.603.8958 | ijolles@thelenreid.com |
| Eulalia M. Mack | 212.603.2517 | emack@thelenreid.com |
| Philip W. Peters | 415.369.7009 | pwpeters@thelenreid.com |
| Robert J. Reger, Jr. | 212.603.2204 | rreger@thelenreid.com |
| Welton O. Seal, Jr. | 212.603.6516 | wseal@thelenreid.com |
©2006 By Thelen LLP. This article has been published as an information service for clients and friends. Please recognize that the information is general in nature and must not be relied upon as legal advice. The author or your Thelen contact would be pleased to discuss the information in this article, and its application to your specific situation, in greater detail. We welcome your comments and suggestions.
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