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It has frequently been said that the passage of theSarbanes-Oxley Act and its progeny has not altered the fiduciary duties ofdirectors under applicable state law. It is equally clear, however, thatjudicial interpretations of state fiduciary duty law, and the standards ofacceptable director conduct, are shifting in response to both recentlegislation and regulatory initiatives and the highly publicized corporategovernance failures that prompted their passage. Courts and government regulators are growing increasinglyimpatient with inadequate board oversight and are heightening their scrutiny ofboard independence and oversight. Recent judicial decisions, and an unusualSecurities and Exchange Commission enforcement proceeding, indicate that thetraditional safeguards of the business judgment rule, and charter provisionswhich eliminate personal liability for duty of care violations, will notprotect directors who intentionally disregard their duties. Although diligent directors acting in good faith should notbe unnerved by these developments, directors are well-advised to becomeproactive in matters of corporate governance. Independent directors shouldassume a corporate leadership role through focused oversight and periodicself-evaluations. At the same time, directors should be proactive in reviewingthe corporate law protections and insurance coverage available to them, to bewell-positioned if, despite their good faith and diligent efforts, they becomedefendants in a shareholder suit. EXAMINING DIRECTOR CONDUCT Director conduct is generally measured by the businessjudgment rule, which defers to the judgment of the board of directors andpresumes the directors’ action is in good faith and in the best interests ofthe corporation. To rebut the presumption, plaintiffs must show that thedirectors breached their fiduciary duties of due care, loyalty or good faith.Historically, directors were thought to have the greatest exposure to personalliability in situations where they sought to personally profit from corporateactivity. Recent judicial decisions suggest, however, that courtswill more closely examine director conduct, even where there are noself-interest concerns, if a board appears to have abdicated its oversightfunction. Each of the Disney, [FOOTNOTE 1] Abbott [FOOTNOTE 2]and Cogan [FOOTNOTE 3]casessuggest that directors may be held personally liable, and may not be entitledto the benefit of the business judgment rule or exculpatory charter provisions,if they consciously fail to consider significant matters and such failureconstitutes a lack of good faith or a breach of the duty of loyalty. Thesecases are significant not so much for their holdings, which in Disneyand Abbottare procedural, but for their focus on board process. In Disney, the plaintiffs sought to hold the Disneydirectors personally liable for damages arising from Disney’s severancepayments to former Disney President Michael Ovitz, because the boardconsciously determined not to review the terms of Ovitz’s employment andtermination arrangements. The Delaware Chancery Court determined that theplaintiffs’ allegations, if true, established that the board failed to exerciseany business judgment, and therefore its conduct was not in good faith orinvolved intentional misconduct. In Abbott, the plaintiffs sought to hold the Abbottdirectors personally liable for damages incurred by Abbott in connection withAbbott’s violations of Food and Drug Administration regulations, because theboard knew of the violations, occurring over a six-year period, but took nopreventative or remedial measures. The 7th U.S. Circuit Court of Appeals found that the Abbott directors were not insulated from personalliability by the exculpatory provisions of Abbott’s charter because theallegations, if true, showed a sustained and systematic failure to exerciseoversight, constituting a conscious disregard of known risks, which amounted toa lack of good faith. In Cogan, the trustee in bankruptcy for TraceInternational Holdings, Inc. brought an action against, among others, thedirectors of Trace alleging a violation of their fiduciary duties in regard toself-dealing by Marshall Cogan, Trace’s majority stockholder and chiefexecutive officer, when Trace was in the “zone of insolvency.” Aftera bench trial, the Southern District of New York found that the directors ofTrace, a private company, violated their fiduciary duties of loyalty and duecare with respect to Cogan’s self-dealing because they were aware, orshould reasonably have been aware, of such self-dealing but took no action toreview, discuss or investigate it. The court ruled that exculpatory provisionsin a corporation’s charter will not shield directors from personal liability ifthey have abdicated their functions or completely failed to exercise anydiligence in the performance of their duties. The SEC Enforcement Division took a similar approach tosupport a finding of a securities law violation in a recent proceeding againstan outside director of Chancellor Corp. In a particularly egregiousfactual situation, the SEC found that the director, an audit committee member,had caused Chancellor’s violation of federal securities laws because he wasreckless in not knowing that Chancellor’s periodic filings contained materiallymisleading statements; the director never reviewed Chancellor’s accounting proceduresor internal controls, and completely failed to exercise any oversight overfinancial reporting. In Oracle, [FOOTNOTE 4]the Delaware Chancery Court, in another instance of heightened scrutiny,focused on the issue of independence by examining the social and personalconnections among directors. The court determined that a special litigationcommittee of Oracle directors could not terminate a derivative action alleginginsider trading by other Oracle directors because the committee did notestablish that it was independent. The court found that certain ties unrelatedto the traditional “domination and control” analysis of independence,such as the web of connections among Oracle directors and Stanford University,were so substantial that they caused reasonable doubt about the committee’sability to impartially consider whether the other directors should face suit. EFFECTIVE CORPORATE MONITORS The most effective response to concerns about directorconduct is for directors to become proactive about corporate governance. It isincumbent upon independent directors to consider whether they are truly free ofimproper influence, to exercise the right degree of diligence, oversight andcritical analysis, and to seek the timely advice of qualified and independentexperts. Although directors are not expected to guarantee corporate conduct,proactive directors can serve as the best safeguard of the shareholders’interests. Richard Breeden’s recent report, “Restoring Trust,” whichrecommends far-reaching corporate governance improvements for WorldCom Inc.,while not a viable model for most corporations, does reflect the critical roleof active directors in restoring investor confidence. Effective corporate directors are diligent, involvedmonitors, but not day-to-day managers, of the corporation. To provide effectiveoversight of management performance, independent directors should understandthe corporation’s capital structure, cash flows, debt levels, strategy, growthopportunities, risks, vulnerabilities and marketplace. They must also have theinformation necessary to enable them to make informed judgments. Most state corporate law provides that directors areentitled to rely on management, and independent outside advisors and auditors,if due care was used in selecting such persons. It is imperative that whendirectors rely on management and experts, they ascertain that such reliance isreasonably justified. Care should be taken in hiring and reviewing seniormanagement and outside advisors and auditors with a view toward trustworthiness,qualifications and appropriate compensation and incentives. Most importantly, directors should continually questionmanagement, outside advisors and the external auditors, on significantcorporate matters. One commentator has said that directors would do well toemploy the Socratic method: “Ask enough of the right questions, in theright way and at the right time, and the probabilities are high that everythingworth knowing will be known and everything worth exposing will be exposed.” [FOOTNOTE 5] Directors should examine their ties to the corporation, itsmanagement, those entities with which the corporation has business orphilanthropic relationships, as well as to the other directors, to determinewhether their independence is, or would reasonably be perceived to be,compromised. In the current environment, conformity with the standardspromulgated by recent legislation and proposed by the stock exchanges, and theabsence of financial relationships, should not necessarily be viewed asdispositive on the issue of independence. Directors should also commit the time necessary to beactive, involved board participants. They should regularly attend board andcommittee meetings and make sure they are kept fully informed by management andthe outside counsel and auditors. They should take an active role in settingand reviewing board agendas. They should participate in director and otherappropriate education programs. And, they should limit the number of boardsthey join. SELF-EVALUATIONS The board, and each board committee, should undergoperiodic self-evaluations. The Business Roundtable, numerous institutionalshareholders and corporate governance experts have identified annualself-evaluations as a corporate governance “best practice” for assessingwhether a board is effectively performing its oversight function. Indeed, theproposed New York Stock Exchange corporate governance rules specificallyprovide that the board should conduct an annual self-evaluation, and that eachof the audit, compensation and nominating/corporate governance committees musthave a charter which addresses an annual performance evaluation. By conductinga disciplined evaluation process, a board dramatically demonstrates that it isproactive and will hold itself accountable for its performance. Board self-evaluations typically focus on the board’sinternal functioning and its relationship to management, particularly: � Board size, composition, and committee structure. � Communication with management, management performance,and management succession planning. � Corporate strategic planning. � Financial statements, financial reporting systems andinternal controls. � Crisis management. � Conflicts of interest. Self-evaluation processes do entail risks. Aself-evaluation has the potential to produce information that could lead tocivil or criminal liability. Significantly, Delaware courts have not recognizeda privilege for critical self-analysis by directors. If the evaluation processuncovers information which could indicate a serious problem, counsel must bealerted immediately and the matter must be pursued until it is resolvedappropriately. It is also important to monitor the board after the evaluationhas been completed to ensure that the board acts promptly to address anyidentified issues. ACTIVE AUDIT COMMITTEES Effective board oversight hinges on the Audit Committee,which serves as the critical connection among the directors, management, theoutside auditors and the internal control process. The Business Roundtableadvocates that the board, and in particular the Audit Committee, should have athorough understanding of the corporation’s financial statements, including whythe corporation’s critical accounting principles were chosen, what keyjudgments and estimates were made and how they impacted the financial results.Similarly, the Audit Committee also should review the corporation’s internalcontrol procedures and compliance with applicable legal requirements. Members of the Audit Committee should understand thebusiness purposes, appropriate accounting and general risks associated with allmajor corporate transactions and should review the corporation’s projections.The Audit Committee also should review the procedures for the identification,assessment and reporting of non-accounting risks of the corporation, sincethese risks typically have financial statement and disclosure implications.Most importantly, the Audit Committee should meet separately with the outsideauditors on a periodic basis and should be alert for signs of financialproblems — SEC accounting comments on public filings, financial statementrestatements, precipitous declines in stock prices, repeated failures to meetmanagement’s or analysts’ expectations, or serious regulatory issues. At a minimum, the Audit Committee should have a writtencharter that complies with the applicable legal and regulatory requirements,and should comply with the charter’s mandates. Many Audit Committees have foundit advisable to meet in person at least quarterly, and by conference telephonein between meetings, in order to fulfill their important responsibilities. REVIEWING PROTECTIONS Even the most well-intentioned and diligent director canbecome a defendant in a shareholder suit. Directors would be well-advised tocommission a review of the legal provisions and insurance policies that wouldbe applicable to their conduct in the event of litigation. Directors who arevigilant in exercising their responsibilities should be entitled to appropriatecorporate protections. The corporation’s charter and bylaws form the basis of adirector’s available legal protections. These documents should containexculpatory provisions which eliminate or limit, to the fullest extentpermitted under applicable state law, the personal liability of directors formonetary damages for certain breaches of their fiduciary duties, generally theduty of due care. Directors should also review the provisions of the charterand bylaws that mandate indemnification by the corporation of directors andofficers in identified situations. Under Delaware case law, a provision thatsimply mandates indemnification does not also mandate advancement of expenses.Accordingly, any indemnification provision should expressly require the timelyadvancement of expenses before final disposition of an action. The provisionshould also obligate the corporation to reimburse attorneys’ expenses in asuccessful effort to enforce the indemnification obligation. Corporate D&O insurance policies should be reviewed toclarify the scope of the coverage provided. D&O policies should have bothSide A and Side B coverages. Side A coverage insures directors and officers incircumstances where the corporation cannot or does not indemnify them, and SideB reimburses the corporation for proper indemnification payments. Directorsshould be aware of the deductible or co-insurance amounts, the type ofinsurance (typically “claims made,” providing coverage only forclaims made during the policy period) and the term (typically one year). Directors should have a clear understanding of whatexclusions apply to their policy. D&O policies generally exclude fromcoverage matters which are uninsurable under state law (i.e., for public policyreasons), criminal or fraudulent acts, acts involving illegal profit orpersonal advantage and violations under the Employee Retirement Income SecurityAct. It is particularly important to have D&O insurance protections wherethe coverage provided may extend beyond corporate law indemnification, such as:judgments and settlements in derivative suits; securities law violations;liability based on gross negligence (but not intentional dishonesty); andinsolvency. It is also important to consider the limits of D&Ocoverage. Coverage of the corporation under the same policy as the directors’could adversely affect the directors to the extent that per-claim and aggregatelimits are satisfied or reduced by the corporation’s costs. A betteralternative is to obtain completely separate primary or excess policies forindividuals with limits that cannot be affected by claims against thecorporation. Moreover, a D&O policy that insures only individuals will notbe treated as property of a debtor’s estate. In addition, the D&O policyshould be reviewed to ascertain that the acts of one insured are not imputed tothe other insureds for purposes of coverage. An indemnification agreement, which affords a director abasis in contract to sue the corporation, may serve as an important complementto a corporation’s exculpatory charter provisions and D&O policies.Indemnification agreements cannot be unilaterally amended, unlike charter andbylaw exculpatory and indemnification provisions, and cannot be rescinded,unlike a D&O policy. Payments under indemnification agreements can also be securedwith letters of credit or trust arrangements. Of course, an indemnificationagreement cannot indemnify a director beyond what is permitted by law. CONCLUSION In the current climate of heightened scrutiny, directorsare well-advised to assume a more proactive role in corporate governance.Continuing attention to corporate conduct, through focused and disciplinedoversight, is the best means of preventing, identifying and remedying corporatemisconduct. But, if that misconduct occurs, or is alleged to have occurred,despite the board’s good faith and diligent oversight, the directors should beable to avail themselves of the protections afforded by applicable law andavailable insurance coverage. Lois F. Herzeca is a corporate and securities law partner,and Ruth Ku is an associate, of Fried, Frank, Harris, Shriver &Jacobson ( www.friedfrank.com ). If you are interested in submitting an article to law.com, please click here for our submission guidelines. ::::FOOTNOTES:::: FN1 In Re The Walt Disney Company Derivative Litigation,825 A.2d 275 (Del. Ch. May 28, 2003). FN2 In Re Abbott Laboratories Derivative ShareholdersLitigation, 325 F.3d 795 (7th Cir. March 28, 2003). FN3 Pereira v. Cogan, 294 B.R. 449 (S.D.N.Y. May 8,2003). FN4 In Re Oracle Corp. Derivative Litigation, 824 A.2d917 (Del. Ch. June 13, 2003, revised June 17, 2003). FN5John S. McCallum, “Viewpoint: The SocraticDirector,” Ivey Business Journal, May/June 2003.

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