01.19.2005
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Updates
The Sarbanes-Oxley Act and recent changes in Securities and Exchange Commission and stock exchange requirements have imposed ever greater responsibilities on corporate directors. As these additional responsibilities expose directors to increasing risks, companies have struggled to attract and retain qualified candidates to serve as independent directors.
Most companies agree to shield the members of their boards of directors from personal liability in litigation and carry special insurance policies to cover the cost of defense, and until very recently, these were considered effective protection for directors in all but the most egregious cases of board mismanagement. However, recently announced settlements in high-profile securities class action lawsuits, recent actions of federal and state prosecutors and developing trends in the insurance industry may signal a new trend in personal accountability for directors.
This Update outlines recent events related to this trend and offers practical guidance.
Recent Securities Litigation Settlements Conditioned on Personal Contributions by Outside Directors
Two recently announced securities litigation settlements required directors to personally contribute a significant portion of the total settlement amount.
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WorldCom Settlement Required Former Directors to Personally Pay $18 Million. On January 5, 2005, the lead plaintiff entered into a $54 million settlement with ten of WorldCom's former directors. In an unusual twist, the settlement required the directors to pay one-third of the total settlement amount—$18 million—from their personal assets. The requirement that the directors make a substantial personal contribution—believed to be as much as 20% of their collective, nonjudgment-proof assets—was consistent with the position taken earlier in the case by the lead plaintiff, who indicated that the directors should personally feel the pain of WorldCom's demise as a reminder that as directors they must take their responsibilities seriously.
In re WorldCom, Inc. Sec. Lit., No. 02-Civ-3288 (DLC) (S.D.N.Y. lead plaintiff's complaint filed Oct. 14, 2002).
- Enron Settlement Required Former Directors to Personally Pay $13 Million. Just a few days after the WorldCom settlement was reported, on January 7, 2005, the lead plaintiff in the Enron securities class action lawsuit announced a previously confidential agreement with 18 former directors of Enron to settle shareholder claims for $168 million. Like the WorldCom settlement, the Enron settlement required ten of the former directors to pay $13 million out of their own pockets. The amount paid by these former directors is believed to be equivalent to 10% of the pretax proceeds from their trading in Enron stock during the alleged class period.
Enron and WorldCom Settlements May Signal a Trend.It is possible that the directors of WorldCom and Enron were uniquely culpable given the truly staggering losses suffered by shareholders in two of the largest bankruptcies ever filed. It is also possible that the requirement for personal payments reflected the fact that in both cases the lead plaintiff was a public entity—the New York State Comptroller as trustee for an employee retirement fund in the WorldCom case, the University of California in the Enron case. Nevertheless, the plaintiffs' insistence that directors make a hefty personal contribution toward settlement may be the start of a new trend, raising the bar for future settlements of securities class actions.
Recent Cases Erode Safe Harbor Provided by the Business Judgment Rule
The Business Judgment Rule Traditionally Protected Directors Who Acted in Good Faith and With Due Care. Under a long-standing doctrine known as the business judgment rule, the decisions of corporate boards have been largely immune from judicial second-guessing, so long as the directors acted in good faith and with due care. Corporate directors have traditionally been permitted to demonstrate good faith and due care by relying on reports prepared by expert advisors to the company, such as bankers and accountants, regardless of the directors' personal qualifications.
Two Recent Cases Erode This Safe Harbor.Two recent cases threaten to erode these important elements of the business judgment rule.
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Board's Must Inquire and Deliberate To Satisfy "Good Faith" Requirement
- . In one recent case, the Delaware Court of Chancery found that the directors of the Walt Disney Company failed to act in good faith by approving the hiring, compensation and subsequent severance package of former Disney president Michael Ovitz without adequate information and deliberation. The corporate laws of several states, including Delaware, permit companies to limit the personal liability of directors who fail to exercise due care in performing their corporate duties, but not of those who fail to act in good faith. Corporate directors who "rubber stamp" important decisions may find themselves personally liable notwithstanding charter provisions that purport to limit their exposure to fiduciary claims.
In re Walt Disney Co. Derivative Lit., 825 A.2d 275 (Del. Ch. 2003).
- Directors With Special Skills Held to Higher Standards. Although corporate directors are generally permitted to rely on reports prepared by third party advisors, corporate directors who possess special knowledge or skill have increasingly been subjected to higher standards than their peers. In another closely watched shareholder lawsuit, the Delaware Court of Chancery determined that an outside director who possessed special expertise had no right to rely on a fairness opinion prepared by the company's financial advisors. The court further held that the director violated his duties of loyalty and/or good faith in approving the transaction because, given his particular business background, he had reason to know that the proposed payment to minority shareholders in connection with the proposed privatization of a telecommunications company was unfair. In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. Ct. May 3, 2004).
Federal and State Regulatory Environment Growing Increasingly Aggressive
Both federal and state regulators are devoting more attention to the criminal prosecution of corporate crime. The SEC, for example, has taken an increasingly aggressive posture on the responsibilities and liabilities of corporate directors and others by
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requiring individual directors and officers to pay cash settlement amounts and fines from their own pockets;
- announcing in September 2004 that staff investigations against public companies will increasingly focus on whether outside directors are properly performing their duties as guardians for the shareholders; and
- seeking to bar 300 individuals from continued service as officers or directors of public companies since the passage of the Sarbanes-Oxley Act in 2002.
State attorneys general also have taken an increasingly active role in prosecuting corporate abuse. New York state's Attorney General, Eliott Spitzer, for example, has filed several high-profile cases, including a variety of actions filed against major mutual fund companies and leading insurance companies.
Insurers Are Aggressively Limiting or Denying Directors' Insurance Coverage for Securities Claims
Due to the unprecedented magnitude of recent high-profile corporate scandals, many insurers have aggressively tried to avoid or limit their liability under directors' and officers' insurance policies in connection with securities claims. Some carriers have used the restatement of financial statements as a basis to rescind a D&O insurance policy, typically just as the first securities class actions are being filed. Last year, for example, the United States District Court for the Western District of Washington held in Cutter & Buck, Inc. v. Genesis Ins. Co., 306 F. Supp. 2d 988 (W.D. Wash. 2004), that rescission of a D&O policy was proper and applied to all insureds, regardless of whether they were involved in or knew of the alleged misrepresentations.
| Practical Tips
Educate Directors on the Limitations of Existing Risk Management Devices. Corporate directors should review their companies' charter documents, indemnification agreements and insurance policies to ensure that these mechanisms provide for the maximum allowable protection. Corporate directors should also understand that even the most robust protection will remain subject to certain limitations in the evolving legal environment. Keep Directors Informed About Corporate Developments and Decisions. The most effective way for directors to reduce their exposure to fiduciary claims is to adopt effective corporate governance and compliance procedures, monitor compliance with those processes and actively oversee the business and operations of their companies. When directors actively inquire into and inform themselves about the corporate decisions that they make, comply with their duty of loyalty to their companies and create a robust record that demonstrates that they have met their duties of care and loyalty, the business judgment rule will still protect them from personal liability. |
Additional Information
This Update is intended only as a summary of recent events related to this trend. You can find discussion of other recent cases and other topics of interest on our website.
