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Corporate Directors on the Firing Line
"The buck stops here."
It's a phrase immortalized by a sign on the desk of President Harry Truman, and it's often associated with the willingness of chief executives to accept responsibility for the performance of their companies. These days, however, the buck is often landing on the conference table where the board of directors sits. And the results aren't always pretty.
Consider recent events at Yahoo! Inc. In May the Sunnyvale, Californiabased Internet services company announced the resignation of CEO Scott Thompson, after just five months on the job. Third Point, a hedge fund that holds a substantial chunk of Yahoo's stock, had notified the board 10 days earlier that Thompson had misstated his academic credentials. He held a bachelor's degree in accounting, but had not completed a second in computer science, as he'd claimedand as a simple Google search would have revealed, the fund's letter stated. Beyond the false credentials, Third Point said in a letter filed with the Securities and Exchange Commission that "shareholders must also question how the board of directors, specifically the search committee chaired by Ms. Patti Hart, could permit the company to hire a CEO with this discrepancy in the public record."
Third Point then turned its attention to Hart herself. The director, who chaired Yahoo's nominating and corporate governance committee, and was a member of its audit and finance committee, claimed to hold a degree in marketing and economics. Yet, Third Point noted, her degree was actually in business administration.
The hedge fund, which had been engaged in a no-holds-barred proxy fight to nominate its own slate of directors to Yahoo's board, won a complete coup. After Thompson left, Yahoo and Third Point agreed to a settlement. The company appointed three Third Point nominees to its board, while five Yahoo directors resigned immediately.
One of them was Hart. She said that her decision to resign was made at the request of the board of International Game Technology, where she is CEO. Embarrassingly, IGT's chairman, Philip Satre, was forced to issue a statement that his board "unanimously stands behind Patti as our CEO," and had found "no material inconsistencies in Patti Hart's academic credentials." (Hart did not respond to a request for comment.)
And all this occurred just a few months after Carol Bartz, Thompson's predecessor, told Fortune magazine, after she was fired, that Yahoo's directors were "doofuses."
Doofuses? Once upon a time, directors lived in a kinder, gentler world. They got paid for meeting a few times a year with their friends and listening to the company's officers tell them what to do. It was all very chummy and exclusive, and they didn't have to worry about nasty comments in the pressat least not about them. Or so it seemed.
These days, in a time of economic uncertainty and fraying public confidence in the integrity of business leaders, directors face challenges from myriad sources. Boards are expected to question management, play an active role in overseeing corporate strategy, have a role in risk oversight, and ensure that executive pay matches performance. The role of lead director has been created to provide leadership to other independent directors and counterbalance the weight of the CEO.
Increasingly, directors find themselves in the firing line. Activist shareholders have a greater voice in corporate decisions. Litigation seems to be a constant threat: Class action lawyers launch investigations into big mergers even before a plaintiff shows up. Regulators are stepping up enforcement. And generous incentives for whistle-blowers under Dodd-Frank are bringing tales of hidden misconduct to light.
In this environment, there's a risk that directors may be tempted to shirk tough decisions because they're looking over their shoulders at the potential fallout. Or they'll simply bail out.
What may be lost in the hubbub is that there's also a positive aspect to these developments. Boards are rising to accept these challengessome quietly by choice, others under pressure. Either way, the results are sometimes yielding better corporate governance. And general counsel are playing a role in helping directors do their jobs.
"Boards of directors are now asking for the ability to have more direct communications with senior management that don't go through the CEO," says Stasia Kelly, a partner with DLA Piper in Washington, D.C.and a former general counsel of companies that have weathered scandals of their own, including American International Group Inc. and WorldCom. "This is an incredibly important dynamic," Kelly says. And general counsel are also playing a more active role. "Fifteen years ago," she adds, "management, including the general counsel, did not have important communications with members of the board."
Proxy season has brought shareholder activism to the fore. And with it has come an institutional invasion into a province that was once the exclusive domain of directors: executive compensation. The SEC's "say-on-pay" rule, which requires listed companies to allow shareholders an advisory vote, has received much attentioneven though "no" votes against CEOs of Standard & Poor's 500 companies succeeded at only five this year. But the one against Citigroup CEO Vikram Pandit made a very big impression, and it didn't take majority "no" votes to get the attention of boards.
Shareholder advocates are also pushing for more. Proxy fights to replace directors, like the one that was threatened at Yahoo, seem to be cropping up everywhere. Institutional shareholders that once might have raised concerns in backroom meetings with executives and boards are now going public in calling for votes against directors. Pension funds are spearheading efforts to defeat individuals supported by the boards of Wal-Mart Stores Inc., which was recently rocked by a bribery scandal in its fast-growing Mexican subsidiary, and of Chesapeake Energy Corp., whose CEO allegedly borrowed $1.4 billion for personal use from financial institutions that do business with the company.
If Harvard law professor Lucian Bebchuk has his way, these elections will be a lot more common going forward. Bebchuk, head of the Shareholder Rights Project, has mounted a campaign to put all board members up for election every year, instead of having them serve staggered terms. At press time he claimed that 44 S&P 500 companies had already agreed to do so.
Directors also face a regular diet of litigation. Generally, they are shielded from personal liability by the business judgment rule, which states that directors are assumed to have acted on an informed basis and in the best interests of the corporation, unless the opposite can be shown or they breached their fiduciary duties. But that doesn't slow the onslaught, or mean that directors can simply ignore the attacks.
Among the most common types of lawsuits they face are derivative suits, brought by shareholders on behalf of corporations. CalSTRS, the giant California teachers retirement fund, recently filed one against current and former board members of Wal-Mart, accusing them of covering up the corruption in its Mexican operations. CalSTRS CEO Jack Ehnes said in a statement: "The focus of this action, unprecedented in CalSTRS history, is corporate governance reform to ensure that similar conduct is not repeated in the future."
Many derivative actions have been driven by "say-on-pay" issues, according to Advisen Ltd., a provider of strategic information services for commercial insurers. Also, Advisen reports that as the amount of M&A litigation surges, so do the claims for breach of fiduciary dutyoften charging that directors failed to secure the best dealand these have also grown rapidly as a percentage of all securities suits. Directors of companies involved in a merger or acquisition of any size have virtually a 100 percent chance of being sued, says Alan Goudiss, a partner in Shearman & Sterling's New York office who specializes in M&A and securities litigation.
"It used to be that the plaintiffs bar was more discerning in M&A cases, but now whatever passed for discernment has disappeared," Goudiss observes. "Even large strategic deals get sued." Most at risk are "going private" deals where a CEO is attempting to buy a company and there is a risk of potential conflict of interest, Goudiss says. In those cases, special committees are usually appointed. Mergers in which conflicts of interest involving directors are alleged are another frequent target, he notes.
The group perhaps most exposed to liability is bank directors. An analysis by Cornerstone Research published in May showed that the Federal Deposit Insurance Corporation filed 29 lawsuits against 239 former directors and officers of failed financial institutions between July 2010 and April 2012. Eleven lawsuits were filed this year. Aggregate damages claimed totaled $2.4 billion. Outside directors were named as defendants in addition to inside directors and officers in 20 of the suits.
The burden on directors of community banks is especially onerous, says Thomas Vartanian, a partner and banking expert in Dechert's Washington, D.C., office. Generally, the board is drawn from members of the community, which frequently does not offer a large pool of qualified people. Directors therefore tend to rely on management for direction.
"Compliance standards are the same for big and small banks," says Vartanian. "The difference is, the simpler the transaction, the easier to prove gross negligence. In very complex cases, it is difficult to prove a financial crime to a jury. You are much more likely to be investigated and to be sued if you are a director of a small bank."
Though directors are rarely held personally liable, there have been a few instances over the years in which they were not only ordered to pay penalties but were required to pay out of their own pockets. The two most prominent cases were from accounting scandals a decade ago and were wrapped up prior to 2006. Former WorldCom directors paid $20.25 million, and Enron Corp. directors paid $13 million.
A 2006 study by Michael Klausner, a professor at Stanford Law School, uncovered only 13 cases (including the two above) that resulted in out-of-pocket damages payments by outside directors in the period 1980 to 2005. Corporate insolvency and lack of directors and officers coverage were key factors when outside directors were held personally liable, the study concluded.
The threat still looms, however. In July 2011 the U.S. Court of Appeals for the Third Circuit ruled that it could be concluded that the board of a Pittsburgh residential care facility called the Lemington Home for the Aged had failed to exercise reasonable diligence under the business judgment rule and had breached its fiduciary duty. The court remanded the case to the trial court for a determination.
Even if the risk of personal liability is remote, it's a matter of real concern to directors that their personal assets may at risk, says Kevin LaCroix, an attorney and partner at Oakbridge Insurance Services who closely monitors D&O insurance matters through his blog (dandodiary.com). Directors often raise the topic at conferences he attends, he says.
Finally, directors are subject to oversight by the SEC and other regulators. While historically the commission has rarely pursued outside directors, that changed last year, according to Amy Goodman, cochair of Gibson, Dunn & Crutcher's securities regulation and corporate governance group (and former chief of the SEC's corporate accountability task force).
Gibson cited cases in which directors were alleged to have personally violated the law and repeatedly ignored red flags. For example, in November 2011 the SEC settled charges of accounting fraud against three directors of military contractor DHB Industries, based in Pompano Beach, Florida, for $1.6 million. The three were permanently barred from serving as officers or directors of listed companies.
However, Goodman says she does not expect the SEC to act against directors where boards simply make decisions that turn out to be wrong. Instead, she predicts, the SEC will focus on violations of securities laws where board conduct contributed to the violations.
"Enforcement cases against directors are few and far between," Goodman says. "And we have a long history under Delaware law of the business judgment rule." Business decisions are by their nature risky, and companies are supposed to disclose the risks in their annual reports, she adds.
On top of all this, there's the public embarrassment factor. As these issues emerge more frequently from boardrooms into public forums, directors are more likely to find themselves the subject of unwanted attention. And being called a doofus may be detrimental to more than one's social calendar. Professional reputations may be at stake. Directors are often executives at other companies, and these firms may not always be as supportive as Patti Hart's company has been to her.
A company's general counsel can't shield directors from attack, of course. But the job description of a modern GC usually includes training board members in fulfilling their fiduciary duties.
D. Cameron Findlay, senior vice president and general counsel of Medtronic Inc., the Minneapolis-based medical device maker, says his company set aside a full day of orientation last year for its newest director. The day included meetings with Findlay and key executives, a discussion of risk factors, and instruction on company policies on insider trading, fiduciary duties, liability, and protections for directors, as well as regulations on fair disclosure. In addition, all directors are required to go through the same compliance training that employees go through, and directors are required to complete a questionnaire that would alert the company to potential conflicts of interest. Many companies also encourage directors to attend the various "director colleges" offered by law schools and other institutions.
These days, many general counsel prepare a comprehensive legal report to present to the board that outlines the major legal risks confronting the corporation. "We have a legal report at every board meeting, where I present the status of the top 10 legal and investigative issues," says Findlay.
"I don't want to get down in the weeds, but I discuss trends in the risks facing the company," Findlay says. "Any good GC is going to have to assume that there could be litigation or inquiries by a government regulator. It is a fact of life, and you have to live with it." And Findlay isn't the only executive who delves into these issues. The chief compliance officer also gives a report, he notes.
GCs who have been hired to help rebuild a company's governance following a spectacular public breakdown say that there are survival strategies. When William Lytton became GC of Tyco International Ltd. in 2002, the corporation was in turmoil. Its CEO, Dennis Kozlowski, had resigned. (He was convicted in 2005, along with Tyco's former CFO Mark Swartz, of multiple counts of grand larceny, conspiracy, and falsifying business records.)
Lytton was brought in by new CEO Edward Breen to help sort out the mess. He had to deal with directors who were shell-shocked and deeply concerned about their potential individual liability, while they also had to adjust to a new executive team.
"I spent a lot of time reminding them that they had to act in the best interests of shareholdersand that included leaving the board and letting a new team come on," says Lytton, now a senior counsel at Dechert in Hartford.
Some were happy to leave. Others were concerned that resigning might seem an admission of wrongdoing and hurt their reputations. In the end, each hired a personal lawyer for advice. This created another set of problems for Lytton, since the advice given to an individual by a personal lawyer might conflict with the interests of the shareholders as a whole. In addition, most debt instruments have provisions stating that any change in a company's situation could trigger an immediate need to repay the funds. Therefore, Lytton had to ensure that the directors' departures would not change the status of these covenants.
Attracting new board members was yet another challenge. Lytton says Breen succeeded by bringing on a highly respected lead director, former DuPont CEO John Krol, whose reputation made it easier to fill out the remaining slots. The new team drafted a new set of corporate governance rules and made sure that they were internalized by the company's employees throughout the world.
But how is a general counsel supposed to help a board fend off a crisis? One thing lawyers can do is prepare for a Yahoo-type situation well before trouble comes knocking. As DLA's Kelly puts it: "One of the best things a GC can do for herself and for the company is to have a consensus-driven protocol where the management teamfrom the board to the CEOunderstands there's a process that will be followed when a crisis happens."
The plan should include everything from who is informed first, which outside lawyers are to be called in, and what documents should be protected under privilege to who will speak to the media. There's no way to inoculate a company from disaster, but preparation does pay. "You can control the response," Kelly says, "even if you can't control the event."
More general advice is offered by Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. Elson cochaired a study group that recently released a report, "Bridging Board Gaps," that conveyed recommendations for improving corporate governance. Directors would have a greater incentive to act in the company's interest, Elson says, if they were all required to have some of their personal wealth invested in the companies they serve.
And they could save themselves and their companies a lot of trouble, he adds, by following one simple rule: In every decision you make as a director, ask whether it's in the long-term interests of shareholders.