Its Blue and Gold license plate proclaims Delaware to be “The First State,” but a more up-to-date slogan might be “The First Corporate Enabler.”
I found myself thinking about Delaware’s lax standards for corporate behavior earlier this year as I paged through Anton Valukas’s exhaustive report on the demise of Lehman Brothers. In the report, the court-appointed bankruptcy examiner and Jenner & Block chairman skillfully lays out the foolhardy path that Lehman traveled before skidding into well-deserved bankruptcy.
Most of the media attention that greeted the report’s release focused on Valukas’s account of Lehman’s nefarious-sounding Repo 105 transactions, which allowed the investment bank to shift $50 billion on and off its balance sheet every quarter, thus fooling ratings agencies and regulators about the dire state of its finances. Notably, Valukas concludes that because Lehman executives did not disclose these transactions to the company’s board and the Securities and Exchange Commission, the Lehman estate has “colorable claims” for breach of fiduciary duty against former CEO Richard Fuld and former CFOs Chris O’Meara, Erin Callan, and Ian Lowitt, as well as a claim for professional malpractice against accounting firm Ernst & Young.
But what really struck me as I read the report was how much truly bad conduct is not actionable, at least in Valukas’s analysis. The examiner describes a parade of corporate horrors — decisions ranging from inane to deceptive — as he chronicles Lehman’s self-destruction. And yet most of the mistakes, he concludes, leave the estate without a remedy under Delaware law.
Here’s just a partial catalogue of Valukas’s findings:
Lehman’s senior management disregarded the company’s own risk-management guidelines, intentionally and repeatedly brushing aside the advice of its risk managers. Not actionable.
Lehman management continued to tell its board, the rating agencies, and regulators that Lehman was prudently managing risk through its risk-management system, even though it was not. Not actionable.
Management hid from the board vital information about the company’s ballooning level of risk. Not actionable.
In each case, Valukas explains, these decisions, however rotten, fall under the protection of Delaware’s hallowed business judgment rule.
It’s no mystery why corporate America loves Delaware. The state’s courts are extravagantly tolerant of corporate misconduct. Directors — and officers, it appears — are protected by Delaware’s business judgment rule unless their actions are so outrageously bad that they rise to the level of “gross negligence.”
(Valukas notes that the business judgment rule has rarely been applied to corporate officers, as opposed to directors. But he points to a recent Delaware Supreme Court decision that says officers and directors are bound by the same standard of fiduciary duty. As a result, he writes, Lehman executives would presumably get the same business judgment protection as its directors.)
That protection means that the Leh-man executives who devised and oversaw the firm’s reckless pursuit of profit and market share — despite repeated warnings from inside and outside the firm — are insulated from claims by the estate. Valukas says the officers can’t be considered “grossly negligent” because they “inform[ed] themselves of the basic facts of the transactions” before they engaged in the suspect deals. And their disregard of the company’s risk-management guidelines, Valukas concludes, is not actionable because those guidelines were voluntary.
Lehman’s officers are also protected by the company’s disclosure to the Securities and Exchange Commission of what Lehman called its “risk-appetite excesses,” which, Valukas says, suggests management didn’t believe it was acting imprudently. And the directors get a pass from liability because they are entitled to rely on management’s (albeit misleading) representations that Lehman had a manageable level of risk.
Valukas does find claims against Fuld and the others arising from the (allegedly) fraudulent Repo 105 scheme. But remember, Lehman only had to resort to such accounting sleight-of-hand tricks because of the myriad bad decisions that led it to the brink of collapse. And for those decisions, Delaware law precludes liability.
I’ve written elsewhere about the way in which overly broad indemnification agreements for executives hinder corporate accountability. Overly lenient concessions to “business judgment” have the same deleterious effect. Directors and officers do need some protection from litigation, especially from certain types of shareholder suits. But Delaware’s exceedingly generous insulation has, I believe, contributed to laziness in board rooms and recklessness in executive suites.
The First State can do better. •