In the line of fire

Apr 01, 2006
<p>Director liability concerns are increasing, but Sox may not be the real culprit.</p>

Along with all the corporate regulations put in place over the past five years, there’s also been a renewed focus on director liability. Indeed, it is generally accepted that company directors face a greater risk of civil prosecution than ever before. There are some in the legal community who suggest that there is no increased liability as a result of Sarbanes-Oxley, claiming instead that the real cause behind the rise in risk-related issues is actually the more intense focus on directors themselves as well as their increased involvement in company operations.

It has been suggested that directors who seek to protect themselves by getting more involved in company activities may in reality be putting themselves at greater risk. What’s more, the precautions that many company directors and officers once relied upon may not be as sound as they once were.

For example, Seattle-based golf apparel manufacturer Cutter & Buck had to restate its earnings for 2000 and 2001, because inaccurate reporting and handling of some transactions artificially inflated earnings. Then came an SEC investigation and shareholder lawsuits. In response, directors and officers confidently turned to the company’s D&O policy. However, Genesis Insurance rescinded the policy, claiming that the restatement made the financials attached to the original application false. A partial severability clause let Genesis attribute that knowledge to all the officers and directors, whether they were involved in creative accounting or not. Cutter & Buck lost twice in court.

Directors have historically depended on a legal safety net of indemnification and exculpation. ‘That’s all backed up by the insurance policy,’ says Michael Morgan, a partner with Seattle law firm Lane Powell and the attorney who represented Cutter & Buck. ‘Now everybody’s wondering, Do I have insurance? – and for good reason.’

Many corporations have been concerned about increased personal liability and are looking at Sarbanes-Oxley as the culprit. For directors, there’s good and bad news. The good? Sox actually doesn’t increase the liability of directors at all. The bad? Lawsuits are more likely in today’s business and investing climate, D&O policies may not cover what corporations and their lawyers think they do, and the longer oversight hours that boards spend can actually make them more vulnerable to civil actions.

Sox scare

Certainly, Sarbanes-Oxley has changed the way boards operate. ‘We’re spending substantially more time on compliance-related issues and education issues to make sure that all directors understand their obligations and responsibilities,’ states Cary McMillan, CEO for True Partners Consulting and a member of the board of directors for McDonald’s and Hewitt Associates. McMillan adds that the board members he knows aren’t worried about perceived increased liability under Sox, but he believes that ‘they need to spend more time to execute the responsibilities.’

The irony – especially with all the complaints about Sarbanes-Oxley that one can hear in corner offices and boardrooms – is that directors actually face no more liability than they have for years under the Securities Act of 1933, the Securities Exchange Act of 1934 and 1977’s Foreign Corrupt Practices Act as well as their various modifications over the years.

It could be that some boards, looking at empirical evidence, see that circumstances still favor them. Even in the case of Enron, where large investors named board members in their suits, the penalties were relatively light. ‘The [directors] … paid $13 million, but that represented 10 percent of the pretax profits that they saw in selling [their] stock,’ says Gary Brown, chairman of the business department at the law firm Baker, Donelson, Bearman, Caldwell & Berkowitz. ‘If that’s the worst that happens to the directors, every [one] should sleep like a baby.’

Boards like that of McDonald’s have reputations for effective governance, however. For many corporations of less lofty stature, directors have felt increased burdens.

‘It’s not only financial pressure; it’s reputation pressure,’ says Eugene Fram, a professor of business at the Rochester Institute of Technology who has written extensively on corporate boards and, up until a few years ago, served on them for decades. ‘A lot of these people have spent decades and decades building fine reputations. You get into one of these [problems] and, bingo, your reputation goes down. The search firms don’t call any more; your internal contacts don’t call – [it’s] the information network.’

And even if directors haven’t been forced to dig deeply into their own pockets, the costs of a legal defense cannot be ignored.

At the end of the day, although Sox focuses its sanctions on CEOs and CFOs, directors do face a new source of danger: an increased and relentless scrutiny that brings together duty and fear into one neat package. ‘Directors are being sued personally more,’ says Albert Adams, a partner with Cleveland law firm Baker & Hostetler LLP who has served on corporate boards for the last decade. ‘There’s much more process in place now.’

Relying on existing legal protections and concepts like the business judgment rule – in which the law presumes that, absent a breach of fiduciary duty, directors act in good faith and in an informed manner and therefore are not liable for making bad decisions – as a defense is insufficient.
‘As a by-product of all the recent focus on corporate governance issues, it seems that the scope of the protection afforded by the business judgment rule is eroding,’ says attorney David Rosen, partner with Murphy Rosen & Cohen. ‘At the very least, it seems that the public – i.e., jurors – are less willing to accept as an excuse that the director was just trying to do the right thing.’

An interesting example is the Disney board and the directors who found themselves in court. ‘In the first round, a judge refused to dismiss the case against the directors on the basis of the business judgment rule because there was no evidence that they had exercised business judgment,’ Brown says. ‘Fast forward to 2005. They spent 37 days in trial documenting what a good set of minutes would have done.’

Document torment and unpleasant trends

The answer would seem simple: Dot the i’s, cross the t’s and document everything. Unfortunately, things aren’t quite that simple. There are two schools of thought when it comes to the minutes of board and committee meetings. One is to have little.

‘The more papers you have, nine times out of ten the worse off you are in litigation,’ says William Sherman, a partner at the law firm of Morrison & Foerster and a lecturer in the Haas School of Business at the University of California at Berkeley. Minutes can become a target, and generally speaking, the more details contained in them, the bigger the target. Lawyers would often prefer to have board members testify in person, because they ‘can put better spins on it, and they can’t be skewered on the unfortunate use of one word. That’s what happens in litigation. They will take a completely innocent or purposeful context and jump on it.’

However, what had been a sound practice in the past is now ‘under attack from several fronts,’ he says. Lawyers representing shareholders suing a company will look for discrepancies in which the board seems to give as much attention to something minor as to other things, like executive compensation. In sparse minutes, everything can seem to have the same degree of importance – and some courts have begun to take this view.

‘In some of these cases, the courts are looking at the minutes and deciding that until there is fuller discovery, I’m going to assume that the amount of space given to something in the minutes is roughly proportional to the amount of discussion it received,’ notes Mike Tankersley, a partner with the law firm Bracewell & Giuliani.

So if a board spends half its meeting discussing a CEO bonus, but this discussion only forms a tenth of the minutes, it might not get due credit for the deliberation. Tankersley’s recommendation is to either let the length of sections in the minutes reflect the relative attention to issues or, for boards that want to straddle the old and new worlds of scrutiny, use the traditional approaches and simply list the amount of time spent on each topic. ‘People can understand, and the company can explain pretty simply, that some topics are more controversial and have more potential legal interest down the road, and that those topics get more attention in the minutes,’ he says.

The dangers lurking in documentation don’t end with board minutes. Though it is difficult in practice to sue directors under Section 10b-5, according to Tankersley, because directors typically wouldn’t know ‘if a CEO was cooking the books,’ there is another area of liability from Section 11 of the 1933 Securities Act. ‘It says that the director is liable for misstatements that are included in a prospectus unless the director establishes that by exercising reasonable diligence, they could not find the misstatement,’ he says. ‘Historically, in IPO transactions, the lawyers for the company would directly take on the work to establish for the directors the due-diligence defense. In the last ten years, people seem to have lost sight of that.’

The danger isn’t only in an IPO, but in other regulated transactions such as secondary and debt offerings. There are time limits, though. Shareholders must sue within twelve months of an offering. Although problems usually take longer to emerge, should things go bad within that period of time, directors face a burden of strict liability. That means a suit’s plaintiffs don’t need to show actual fault or negligence, just a problem with the prospectus. The only defense is to establish clear due diligence on the part of the board, which means having ‘qualified lawyers go through all the statements in the disclosures and report back to them on it,’ Tankersley says.

One more trend presenting a threat to boards is how federal prosecutors are approaching investigations. At one time, prosecutors largely saw junior employees as only sources and seldom as serious candidates for jail time. But they are increasingly going after such people now.

‘Either they really believe that these people were involved, or they know that the only way to get the people at the top is to get the lower people to say something,’ states Andrew Margulis, a partner with the New York office of Ropers Majeski Kohn Bentley. ‘If you had to put some pressure on low-level people to get testimony that was marginal in order to get Ken Lay, would you do it? That might be what prosecutors are faced with.’

But most employees do not have the financial resources for proper legal representations. ‘If you are a lower-level employee and all of a sudden you have law enforcement after you, you are going to have people trying to save themselves,’ Margulis continues. That could even mean people falsely testifying against upper management to avoid possible prosecution themselves.

Insurance headaches

One might think that expanding D&O insurance to cover employees would be a possible, though expensive, answer. That can actually work against a company, says Tankersley. Over the last five years or so, prosecutors have created a system where companies, if they cooperate, get highly reduced penalties, which keeps the legal system from effectively punishing shareholders. ‘One of the things that is not cooperation is funding the defense of employees,’ he says.
So directors had best be certain that their own insurance is unassailable. That, too, has become difficult because carriers, interested in bolstering their own bottom lines, are often following an old practice of finding ways to deny claims. In the D&O world, the landscape has become particularly treacherous, as the experience of Cutter & Buck shows. The problem is that insurance companies are increasingly using complex industry language – often not even understood by corporate attorneys – to stack the decks in their favor. ‘Many D&O policies are written in almost a foreign tongue, like old English, and it’s very hard to understand them,’ says Adams. Boards need to bring in insurance experts to help them understand just what coverage they are getting.

‘Then there are many other ways in which your D&O policy may not protect even innocent directors,’ adds K. Viswanathan of ICA Risk Management Consultants. The Cutter & Buck case brought up two. One is the issue of severability. ‘More and more, we are seeing insurance carriers rescind the policies and say there’s no coverage for the innocent directors,’ he says.

The other issue is the definition of exactly what an application comprises. Although Genesis Insurance pointed to the submitted financial statements, ‘[some insurance companies] say all the filings you’ve made with the SEC constitute application,’ he explains. ‘Others say that everything you’ve put out as a public statement constitutes application … whether it’s an SEC filing or press release or conference call.’

If any of those statements are eventually found to contain incorrect information, the carrier can claim that such a mistake invalidates coverage, as could any restatement of earnings, even if a company’s auditor had misinterpreted an accounting rule, according to the Public Company Accounting Oversight Board, necessitating the correction.

If there is a bright side for directors, it’s that the problems they potentially face are on the civil front, not criminal, and are therefore subject to indemnification and exculpation. But shoring up personal protection will mean spending more attention to process and more time with experts and lawyers – just what directors were probably hoping not to hear again.

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