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Much has been written recently about the creeping “federalization” of corporate governance, a subject traditionally reserved to state law. Exhibits A and B to the indictment have been the Sarbanes-Oxley Act and the recent changes to the corporate governance listing standards of the New York Stock Exchange and the Nasdaq. In the views of some, these changes threaten to diminish the states’ important role in regulating corporate behavior. There is some truth in the criticism, but there is also more than a little misinformation, or perhaps misunderstanding, about the relationships between the new federal requirements and traditional state law standards. True, the new federal requirements are different in significant respects from the standards that states have historically applied. But the federal standards and state laws also pursue different goals and use different tools. We believe they can and must coexist, occupying slightly different territories and carving out different areas of focus and emphasis. The most critical implication of differing standards is not the inconsistencies themselves. Rather, it is the way in which these two sets of standards may act to dry up the pool of eligible directors. Delaware and virtually every other state have adopted broad exculpation statutes designed to reassure those who agree to serve on the boards of complex business enterprises that innocent failures to discharge their duty-of-care obligations will not put their personal assets at risk. The federal expansion of director and officer obligations, the increased focus on director independence (including enhanced scrutiny of personal and social relationships), and recent judicial re-examination of what constitutes “good faith” may be jeopardizing the director’s bargain. AN INDEPENDENCE ARMS RACE The issue of director independence seems, at first blush, particularly intractable. Sarbanes-Oxley mandates stringent independence requirements for audit committee members, setting forth a limited number of bright-line disqualifiers. The new listing standards of self-regulatory organizations such as the New York Stock Exchange generally require a majority of independent directors and independent audit, compensation, and nominating committees. The standards use both bright-line disqualifiers and a more subjective assessment of independence. By contrast, state law was traditionally indifferent to independence as an absolute requirement for directors, recognizing that directors closely associated with the business may be better positioned to provide the oversight and advice that management needs. Nonetheless, state law has considered issues of independence in judging a wide range of director actions, including transactions involving conflicts of interest. State courts generally eschew bright-line tests, favoring a context-based “facts and circumstances” approach. Can these approaches be reconciled? We believe so, but only to a point. The federal and self-regulatory organization standards are focused primarily on providing a structural framework within which directors can discharge their obligation to oversee the affairs of the corporation. Key to that framework is directors’ ability to exercise disinterested judgment. Any entanglements with management or the company itself may impair their ability to do so. So, in theory, remove the entanglements, establish bright-line tests for independence, and you have ensured disinterested director decision-making. Of course, in theory, everything works in practice. State law mainly addresses actual situations where theory breaks down. Because they address live disputes, state courts focus on transactional independence, rooted firmly in traditional fiduciary law, which generally precludes persons from profiting at the expense of other persons to whom they owe fiduciary duties. The state courts ask: Is a director sufficiently independent from the particular transaction under review to justify judicial deference to his or her decision? Under this approach, director independence is a nimble concept, adroitly adjusting itself to the circumstances at hand. Recent Delaware decisions � most notably the Chancery Court’s 2003 decision in the Oracle derivative litigation and the state Supreme Court’s 2004 decision in Beam v. Stewart � highlight the fluid nature of the state common law approach. In the Oracle case, the Chancery Court noted that “ homo sapiens is not merely homo economicus” and concluded that “ ties among the [special litigation committee, or SLC], the [defendants], and Stanford [University] are so substantial that they cause reasonable doubt about the SLC’s ability to impartially consider whether the [defendants] should face suit.” The court noted that the “social atmosphere” was painted in “too much Stanford Cardinal red” for the SLC members to ignore. In contrast, the Delaware Supreme Court in Beam emphasized that “a relationship must be of a bias-producing nature. Allegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a director’s independence.” We believe that federal and self-regulatory organization regulation of the structural independence of directors will not meaningfully affect independence decisions in state courts. It will not make those decisions easier or less common. Transactional independence issues will continue to arise, and the courts will deal with them in the traditional case-by-case, context-driven manner. We are concerned, however, that stricter structural independence requirements and the atmosphere of the supremacy of independence over other director qualifications will prevent many otherwise qualified directors from serving on public company boards. That cannot be helpful. GOOD FAITH, WE HARDLY KNEW YOU Another area in which the federalization of corporate governance may discourage directors involves the expanding notion of the state-law fiduciary duty of good faith, which can be seen as a response, in part, to the enhanced federal corporate governance standards. Traditionally, corporate fiduciary duties were described as having two components, a duty of care and a duty of loyalty. In recent years, state courts (particularly in Delaware) have characterized fiduciary duties in terms of a “triad” consisting of the duties of care, loyalty, and good faith. Whether good faith can be subsumed in the duty of loyalty depends on whether loyalty merely requires abstention from self-dealing or extends to other forms of misconduct. Under a narrow view of loyalty, good faith is considered a separate duty encompassing and proscribing bad-faith conduct that does not necessarily serve the personal interests of the fiduciary. Under a more expansive view of loyalty, good faith can be subsumed within loyalty on the theory that a fiduciary cannot simultaneously act loyally and in bad faith toward the corporation. The two views ultimately proscribe the same types of conduct, including bad-faith conduct not motivated by self-interest. So why does this matter? The failure to discharge one’s fiduciary duty in good faith can nullify traditional protections from personal liability on which directors rely, such as exculpation provisions, indemnification provisions, and directors and officers insurance. After the proliferation of exculpation provisions in corporate charters, it was commonly believed that the only way a director risked personal liability was to violate the duty of loyalty through self-dealing. As the thinking went, all other duty breaches (such as being asleep at the switch, making uninformed business decisions, or being ignorant of loss-creating activities within the corporation) were breaches of the duty of care, for which exculpation, indemnification, and insurance apply. This is not a safe assumption under the developing state law of good faith. At what point will a failure to exercise due care cross the line into conduct lacking good faith? Identifying the intersection between the duties of care and good faith requires difficult distinctions. Consider, for example, the recent litigation in Delaware involving the Disney board of directors. The Disney case centers on the board’s alleged lack of involvement in deciding the employment and compensation of a new company president. The case is not about directors acting in their own self-interest, but rather about whether, in the words of the Chancery Court, “the defendant directors consciously and intentionally disregarded their responsibilities, adopting a ‘we don’t care about the risks’ attitude concerning a material corporate decision.” Alluding to the intersection of the duties of care and good faith, the court said that “[k]nowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct, in my opinion, that may not have been taken honestly and in good faith.” The duties of care and good faith often intersect in the directors’ oversight function. The duty of oversight is an element of the duty of care, but a failure of oversight often raises the issue of whether the directors discharged that duty in good faith. Directors discharging their oversight duty in good faith are expected to recognize and then respond to suspicious circumstances. On the other hand, directors cannot be (and, in fact, are not) expected to ferret out every problem that may exist. Where will courts draw these lines? Some fear that state courts and legislatures, motivated by a desire to avoid additional federal intrusion by showing that state law is adequate to deal with corporate scandals, will end up demanding too much of directors as proof of good faith. WHEN WISHES BECOME DEMANDS Federalism creeps into the directors’ equation in another unsettling way. Certain roles and responsibilities of directors that have historically been aspirational in nature under state law have now become requirements of federal law or of self-regulatory organizations. Examples include requirements for independent audit, compensation, and nominating committees; regular meetings of independent directors in “executive session” without management; maintenance of whistleblower hot lines; and adoption of codes of ethics. When a series of aspirational “best practices” become federal requirements, they also become a yardstick by which state courts can measure the extent to which a board of directors has discharged its responsibilities. Thus, these federal requirements may lead to expansive and less flexible notions of a director’s state-law fiduciary duty of care. Moreover, directors will be hard-pressed to claim ignorance of these well-publicized federal requirements. Accordingly, a failure to satisfy these requirements might lead to Disneylike accusations that a board “consciously disregarded” its responsibilities. Such accusations could convert a duty-of-care claim into a nonexculpable, nonindemnifiable, noninsurable good-faith claim. CRASH-TEST DUMMIES WANTED Where does this leave us? It leaves us with new federal notions of director independence that threaten to elevate form over substance unless state law remains a vital part of the equation. It leaves us with state judges and lawmakers who may have incentives to make state law tougher on faithless fiduciaries to preclude further federal intrusion. It leaves us with increasing pressure on exculpation provisions and the possibility that such provisions may be judicially eroded through expanding notions of the fiduciary duty of good faith. Ultimately, it leaves a concern that many qualified directors will be reluctant to serve as crash-test dummies during this re-engineering process. So while we share the general sense of outrage with respect to many of the recent corporate scandals, we urge a measured response from lawmakers and judges. There should be a continuing role for state law and its ability to take into account the many differing and unforeseeable circumstances that exist inside the corporate boardroom. David E. Brown Jr. is a partner in the D.C. office and Nils H. Okeson is a partner in the Atlanta office of Alston & Bird. They may be reached at [email protected] and [email protected], respectively.

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